Corporate Finance - Module 4 - Cost of Capital

Corporate Finance

Module 4

Cost of capital

• The cost of capital of a firm is the minimum acceptable rate of return required by the firms’ investors to provide funds. Also known as “required rate of return” or the “hurdle rate”
• The firm raises found using a mixture of debt and equity:

• Equity cost of capital and the debt cost of capital

The weighted average cost of capital (WACC)

• Given estimates of the cost of debt and equity capital

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• Debt cost of capital

• Is very often estimated using the interest rate that would be charged on newly issued debt.
• If there is little risk the firm will default, this approach yields reasonable estimates of the cost of debt.

• Equity cost of capital

• It is an opportunity cost: Expected rate of return on available alternative investments with similar risk
• Typically, the riskier the business of a firm, the higher its cost of equity
• Two main issues while estimating:

• How do we measure risk?

• A common measure of risk of an investment along these lines is the standard deviation (SD) of its return
• Two kind of risk:

• Individual risks (idiosyncratic, firm-specific, diversifiable)
• Common risks (systematic, market-wide, non-diversifiable)
• The exposure to individual risks can be reduced by holding diversified portfolios and should not matter. However, the exposure to common risks cannot be diversified and is therefore important

• Estimating the Equity cost of capital

• Capital Asset Pricing Model (CAPM): attempts to measure non-diversifiable risk and estimate the corresponding risk premium. Idiosyncratic risks are irrelevant because they can be eliminated in well diversified portfolio. Hence, only market-wide risks matter and require a risk premium
• Dividend Discount Model: uses dividend yields to estimate the equity cost of capital, thus avoiding the difficulty of measuring non-diversifiable risk.

CAPM model

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• The equity beta of a firm is the expected percentage change in the firm’s equity returns associated with a 1% change in the return of the market portfolio.
• Because the market portfolio only contains market risk, the equity beta of a company measures to what extent the firm’s equity holders are exposed to market risk. In other words, the systematic risk of a firm’s equity can be measured by its equity beta
• The use of historical data to estimate future betas is problematic:

• Betas appear to be time-varying
• Betas are hard to forecast
• Betas are less stable for individual securities

• Clearly, a project’s beta cannot be estimated from its historical returns, but ...

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• A difficulty: comparable firms may have different capital structures, i.e., may be using debt and equity in different proportions than we do in our business.

• We can use an unlevered Beta (with no debt) or levered Bet (with debt)

• Unlevered beta

• Measures the systematic risk of unlevered equity
• Given the absence of debt, the unlevered equity beta also measures the risk of the firm’s assets

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• Levered Beta

• Debt financing adds financial risk to equity returns
• The beta of levered equity no longer measures assets' risk. However, the asset risk and returns are replicated by the portfolio of the firm’s debt and equity

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• Unlevered and levered cost of capital

• Unlevered cost of capital.

• If the comparable firm were 100% equity financed
• A first approach consists in estimating the cost of “levered equity” using CAPM

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• Then obtain:

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• An alternative approach is “un-lever” the equity Beta

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• Then use the CAPM to estimate the unlevered cost of

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The Dividend Discount Model (Gordon-Shapiro)

• Provides an alternative method to estimate the cost of equity.
• In general, the current price of a share of stock is:

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• If dividends are expected to grow:

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• Problems

• Not applicable to non-dividend paying stocks
• A constant g might be unreasonable
• g can be difficult to estimate.

• The divided discount model can be useful to estimate the expected return of large portfolios