corporate finance - week 6 lecture review
each source of capital has
has a cost (required rate of return) that may be called a component cost of capital. Total cost of capital is a weight weighted average We are dealing with a marginal cost-what it would cost to raise additional funds for the potential investment project.
optimal capital budget
is that amount of capital raised and invested at which the marginal cost of capital is equal to the marginal return from investing. The cost of capital should reflect the riskiness of the future cash flows of the projects. For an average-risk project, the opportunity cost of capital is thecompany's WACC.
cost of debt
is the cost of debt financing to a company when it issues a bond or takes out a bank loan. What is the cost the firm has to pay on its borrowing? The cost of debt will depends on three components: General level of interest rates Default premium Firm's tax rate The cost of debt is the rate at which the company can borrow at today, corrected for the tax benefit it gets for interested payments. NOT the interest rate at which the company got loans on the book.
cost of capital
is the rate of return that the suppliers of capital (creditors and shareholder) require as compensation for their contribution of capital. It is not fully observable. It is the opportunity cost of funds for the suppliers of capital. A potential supplier of capital will not voluntarily invest in a company unless its return meets or exceeds what the supplier could earn elsewhere in an investment of comparable risk. A company has different options to raising capital: equity, debt, and other instruments
taxes and the cost of capital
n many tax jurisdictions, the interest on debt financing is a deduction to arrive at taxable income. Taking the tax-deductibility of interest, we adjust the pre-tax cost of debt for this tax shield. Multiplying rd by (1 − t) results in an estimate of the after-tax cost of debt Debt capital involves a stated legal obligation on the part of the company to pay interest and repay the principal on the borrowing. Equity entails no such obligation.
Standard & Poor's Corporate Criteria Framework
ombines Business Risk and Financial Risk Profile to produce a single index of credit quality
cost of equity
s the rate of return required by a company's common shareholders. A company may increase common equity through the reinvestment of earnings (retained earnings) or through the issuance of new shares of stock. We can identify different methods to approximate the cost of equity: CAPM, dividend discount model, bond yield plus risk premium
how to estimate the growth rate
sustainable growth rate: rate of dividend growth that can be sustained over time for a given level of return on equity (keeping the capital structure constant): g = (1 + D/EPS) x ROE growth = company's retention rate x return on equity
Gordon Growth Model
we assume dividends are expected to grow at a constant rate, g. If we assume that price reflects intrinsic value (V0 = P0), we can rewrite the valuation of the stock as: Po = D1/re - g Furthermore, we can rewrite this equation and estimate the cost of equity: re = D1/Po + g
The weights in the weighted average
calculation are the current book values of shareholder equity and total interest bearing debt. How do we determine what weights to use? Ideally, we want to use the proportion of each source of capital that the company would use in the project or company. The target capital structure is the capital structure that a company is striving to obtain. Assume the company's current capital structure, at market value weights for the components, Examine trends in the company's capital structure or statements by management, 3. Useaveragesofcomparablecompanies'capitalstructures.
limitations of CAPM
1. Model makes unrealistic assumptions 2. Parameters of the model cannot be estimated precisely (dynamic) 3. Model does not work well If the model is right, there should be a linear relationship between returns and betas, hence the only variable that should explain returns is betas. Reality is that the relationship between betas and returns is weak, other variables (size, book value) seem to explain differences in returns better
methods of measuring cost of debt
1. Yield-to-Maturity 2. Debt-rating
marginal cost of capital structure
A company raises more funds, the costs of the different sources of capital may change, resulting in a change in the weighted average cost of capital for different levels of financing. Marginal cost of capital (MCC) schedule, which we often depict in graphical form as the weighted average cost of capital for different amounts of capital raised. Why would the cost of capital change as more capital is raised? Increasing marginal costs of capital is a deviation from the target capital structure. Because of economies of scale, companies tend to issue new securities such that in any given period, it may deviate from the proportions dictated by any target or optimal capital structure. In other words, these short-run deviations are due to the "lumpiness" of security issuance.
the risk free asset
A risk-free asset is defined here as an asset that has no default risk. A common proxy for the risk-free rate is the yield on a default-free government debt instrument. In general, the selection of the appropriate risk-free rate should be guided by the duration of projected cash flows. If we are evaluating a project with an estimated useful life of 10 years, we may want to use the rate on the 10-year Treasury bond.
credit ratings
AAA - "Highest rating... obligor's capacity to meet financial commitments is extremely strong" AA - "Very strong... it differs only a very small degree to AAA" A - "Somewhat more susceptible to adverse changes in economic conditions...capacity to meet financial commitments is strong" BBB - "Adequate protection... but changes in economic conditions could lead to weakened capacity" Sub-investing ratings: BB -"Faces uncertainty during adverse economic conditions" B - "Possesses current capacity... but is likely to be impaired" CCC- "Vulnerable to non-payment...needs favourable business climate to meet obligations"
Issuer Credit Rating vs Issue Credit Rating
Credit Profile relates to the overall credit profile of the issuer; focus is on total debt or net debt. Issue Credit ratings assess the credit worthiness of a specific financial obligation.
CAPM calculation
E(ri) = rf + Bi(E(rm) - rf) where 𝜷𝒊 = the return sensitivity of stock i to changes in the market return E(rm)= the expected return on the market E(rm) - rf= the expected market risk premium
different sources of capital
Each source of capital has a different cost because of the differences among the sources, such as seniority, contractual commitments, and potential value as a tax shield. cost of debt, cost of equity
Weighted Average Cost of Capital (WACC)
Let us focus on the cost of capital for the entire company. The cost of capital of a company is the required rate of return that investors demand for the average-risk investment of a company. The most common way to estimate this required rate of return is to calculate the marginal cost of each of the various sources of capital (debt and equity) and then calculate a weighted average of these costs. The WACC is also referred to as the marginal cost of capital (MCC) because it is the cost that a company incurs for additional capital. The weights in this weighted average are the proportions of the various sources of capital that the company uses to support its investment program.
estimating a project beta
One common method of estimating the company's stock beta is to use a market model regression of the company's stock returns (ri) against market returns (rm) over t periods: rit = ã + Brmt Beta estimates are sensitive to the method of estimation and data used: Estimation period Periodicity of return interval Selection of market index (benchmark) Other momenta important (small-capitalisation stocks have greater risk and hence return) Beta of a company/ project is affected by the systematic components of business risk and financial risk.
CAPM - expected market risk premium E(rm) - rf
Premium that investors demand for investing in a market portfolio relative to the risk-free rate. When using the CAPM to estimate the cost of equity, in practice we typically estimate beta relative to an equity market index (= equity risk premium (ERP)). Here, we assume that the only risk affecting the cost of equity is the market risk (and the sensitivity of the company responding to the market risk = β).
Cost of Equity - Dividend Discount Model Approach (Gordon Growth Model)
The dividend discount model in general states that the intrinsic value of a share of stock is the present value of the share's expected future dividends: Vo = D1/(1+re) + D2/(1+re)^2 + ... where, 𝑽𝟎 = the intrinsic value of a share 𝑫𝒕 = the share's dividend at the end of period t 𝒓𝒆 = the cost of equity
What do CFOs do?
The most popular method for estimating the cost of equity is the capital asset pricing model. Few companies use the dividend cash flow model to estimate a cost of equity. Publicly traded companies are more likely to use the capital asset pricing model than are private companies. In evaluating projects, the majority use a single company cost of capital, but a large portion apply some type of risk adjustment for individual projects. The lack of popularity of the dividend discount model indicates that this approach, which was once favoured, has lost its following in practice.
cost of debt - yield-to-maturity
The yield to maturity (YTM) is the annual return that an investor earns on a bond if the investor purchases the bond today and holds it until maturity: (similar to the NPV formula) Po = PMTt/(1+rd/2)^t + FV/(1+rd/2)^n where P0 = the current market price of the bond PMTt = the interest payment in period rd = the yield-to-maturity n = the number of periods remaining to maturity FV = the maturity value of bond This valuation equation assumes the bond pays semi-annual interest and that any intermediate cash flows (in this case the interest prior to maturity) are reinvested at the rate rd/2
Capital Asset Pricing Model (CAPM)
Uses variance as a measure of risk. • Only the portion of variance that is not diversifiable is rewarded. Any other idiosyncratic risk can be minimised via a portfolio creation. • Measures the non-diversifiable risk with beta, which is standardised around 1. • Translates beta into expected return.
Cost of Debt - YTM and Yield Curve
Usually, the longer dated debt instruments are priced with higher yield. It makes sense as the longer the creditor waits, the higher the risk will be. However, on occasions, short term debt can have a higher yield- this is what we called "yield curve inversion" It is a very strong predictor for recession. That's where we arestanding.
WACC formula
WACC = wdrd(1 - T) + were where wd = the proportion of debt that the company uses when it raises new funds rd = the before-tax marginal cost of debt t = the company's marginal tax rate we = the proportion of equity that the company uses when it raises new funds re = the marginal cost of equity can also include preferred stocks
Cost of Debt - Debt Rating Approach
When a reliable current market price for a company's debt is not available, the debt-rating approach can be used to estimate the before-tax cost of debt. Based on a company's debt rating, we estimate the before-tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the company's existing debt. A consideration when using this approach is that debt ratings are ratings of the debt issue itself, with the issuer being only one of the considerations. Other factors, such as debt seniority and security, also affect ratings and yields, so care must be taken to consider the likely type of debt to be issued by the company in determining the comparable debt rating and yield. The debt-rating approach is a simple example of pricing on the basis of valuation-relevant characteristics, which in bond markets has been known as evaluated pricing or matrix pricing.
default risk
applies generally to an issuer because of the cross-default clause.
credit risk
attaching to a specific financial obligation is determined by ultimate recovery prospects:• Seniority in capital structure • Guarantees • Covenants Rating agencies receive payment from issuers. Potential conflict of interests!
