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In endeavoring to practice sound corporate finance, there is perhaps nothing so critical, nor slippery, as cost of capital estimation. The second edition of Cost of Capital: Estimation and Applications combines a state-of-the-art treatise on cost of capital estimation with an accessible introduction for the nonprofessional.
This comprehensive yet usable guide begins with an exposition of basic concepts understandable to the lay person and proceeds gradually from simple applications to the more complex procedures commonly found in the marketplace. New features of the revised and expanded Second Edition include chapters on Economic Value Added (EVA) and reconciling cost of capital in the income approach with valuation multiples in the market approach, as well as expanded coverage of cost of capital in the courts and handling discounts for marketability. Cost of Capital remains an incomparable resource for all parties interested in effective business valuation.
Components of a Company's Capital Structure
Cost of Capital Is a Function of the Investment
Cost of Capital Is Forward Looking
Cost of Capital Is Based on Market Value, Not Book Value
Cost of Capital Is Usually Stated in Nominal Terms
Cost of Capital Equals Discount Rate
Discount Rate Is Not the Same as Capitalization Rate
Cost of capital is the expected rate of return that the market requires in order to attract funds to a particular investment. In economic terms, the cost of capital for a particular investment is an opportunity cost--the cost of forgoing the next best alternative investment. In this sense, it relates to the economic principle of substitution--that is, an investor will not invest in a particular asset if there is a more attractive substitute.
The "market" refers to the universe of investors who are reasonable candidates to provide funds for a particular investment. Capital or funds are usually provided in the form of cash, although in some instances capital may be provided in the form of other assets. The cost of capital usually is expressed in percentage terms, that is, the annual amount of dollars that the investor requires or expects to realize, expressed as a percentage of the dollar amount invested.
Put another way:
Since the cost of anything can be defined as the price one must pay to get it, the cost of capital is the return a company must promise in order to get capital from the market, either debt or equity. A company does not set its own cost of capital; it must go intothe market to discover it. Yet meeting this cost is the financial market's one basic yardstick for determining whether a company's performance is adequate.
As the preceding quote suggests, most of the information for estimating the cost of capital for any company, security, or project comes from the investment markets. The cost of capital is always an expected return. Thus, analysts and would-be investors never actually observe it. We analyze many types of market data to estimate the cost of capital for a company, security, or project in which we are interested.
As Roger Ibbotson put it, "The Opportunity Cost of Capital is equal to the return that could have been earned on alternative investments at a specific level of risk." In other words, it is the competitive return available in the market on a comparable investment, risk being the most important component of comparability.
The term "capital" in this context means the components of an entity's capital structure. The primary components of a capital structure include:
Preferred equity (stock or partnership interests with preference features, such as seniority in receipt of dividends or liquidation proceeds)
Common equity (stock or partnership interests at the lowest or residual level of the capital structure)
There may be more than one subcategory in any or all of the above categories of capital. Also, there may be related forms of capital, such as warrants or options. Each component of an entity's capital structure has its unique cost, depending primarily on its respective risk.
Simply and cogently stated, "The cost of equity is the rate of return investors require on an equity investment in a firm."
Recognizing that the cost of capital applies to both debt and equity investments, a well-known text states, "Both creditors and shareholders expect to be compensated for the opportunity cost of investing their funds in one particular business instead of others with equivalent risk."
The next quote explains how the cost of capital can be viewed from three different perspectives:
The cost of capital (sometimes called the expected or required rate of return or the discount rate) can be viewed from three different perspectives. On the asset side of a firm's balance sheet, it is the rate that should be used to discount to a present value the future expected cash flows. On the liability side, it is the economic cost to the firm of attracting and retaining capital in a competitive environment, in which investors (capital providers) carefully analyze and compare all return-generating opportunities. On the investor's side, it is the return one expects and requires from an investment in a firm's debt or equity. While each of these perspectives might view the cost of capital differently, they are all dealing with the same number.
When we talk about the cost of ownership capital (i.e., the expected return to a stock or partnership investor), we usually use the phrase "cost of equity capital." When we talk about the cost of capital to the firm overall (i.e., the average cost of capital for both ownership interests and debt), we usually use the phrase "weighted average cost of capital" (WACC) or "blended cost of capital."
As Ibbotson puts it, "The cost of capital is a function of the investment, not the investor." The cost of capital comes from the marketplace. The marketplace is the universe of investors for a particular asset.
Brealey and Myers state the same concept: "The true cost of capital depends on the use to which the capital is put." They make the point that it would be an error to evaluate a potential investment on the basis of a company's overall cost of capital if that investment were more or less risky than the company's existing business. "Each project should be evaluated at its own opportunity cost of capital."
When a company uses the cost of capital to evaluate a commitment of capital to an investment or project, it often refers to that cost of capital as the "hurdle rate." The "hurdle rate" means the minimum expected rate of return that the company would be willing to accept to justify making the investment. As noted in the previous paragraph, the "hurdle rate" for any given prospective investment may be at, above, or below the company's overall cost of capital, depending on the degree of risk of the prospective investment compared to the company's overall risk.
The most popular theme of contemporary corporate finance is that companies should be making investments, either capital investments or acquisitions, from which the returns will exceed the cost of capital for that investment. Doing so creates economic value added, economic profit, or shareholder value added.
The cost of capital represents investors' expectations. There are three elements to these expectations:
The "real" rate of return--the amount investors expect to obtain in exchange for letting someone else use their money on a riskless basis
Expected inflation--the expected depreciation in purchasing power while the money is tied up
Risk--the uncertainty as to when and how much cash flow or other economic income will be received
It is the combination of the first two items above that is sometimes referred to as the "time value of money." While these expectations may be different for different investors, the market tends to form a consensus with respect to a particular investment or category of investments. That consensus determines the cost of capital for investments of varying levels of risk.
The cost of capital, derived from investors' expectations and the market's consensus of those expectations, is applied to expected economic income, usually measured in terms of cash flows, in order to estimate present values or to compare investment alternatives of similar or differing levels of risk. "Present value," in this context, refers to the dollar amount that a rational and well-informed investor would be willing to pay today for the stream of expected economic income being evaluated. In mathematical terms, the cost of capital is the percentage rate of return that equates the stream of expected income with its present cash value.
The cost of capital is the expected rate of return on some base value. That base value is measured as the market value of an asset, not its book value. For example, the yield to maturity shown in the bond quotations in the financial press is based on the closing market price of a bond, not on its face value. Similarly, the implied cost of equity for a company's stock must be (or should be) based on the market price per share at which its trades, not on the company's book value per share of stock. It was noted earlier that the cost of capital is estimated from market data. This data refers to expected returns relative to market prices. By applying the cost of capital derived from market expectations to the expected cash flows (or other measure of economic income) from the investment or project under consideration, the market value can be estimated.
Keep in mind that we have talked about expectations, including inflation. The return an investor requires includes compensation for reduced purchasing power of the dollar over the life of the investment. Therefore, when the analyst or investor applies the cost of capital to expected returns to estimate value, he or she must also include expected inflation in those expected returns.
This obviously assumes that investors have reasonable consensus expectations regarding inflation. For countries subject to unpredictable hyperinflation, it is sometimes more practical to estimate cost of capital in real terms rather than in nominal terms.
The essence of the cost of capital is that it is the percentage return that equates expected economic income with present value. The expected rate of return in this context is called a discount rate. By a "discount rate," the financial community means an annually compounded rate at which each increment of expected economic income is discounted back to its present value. A discount rate reflects both time value of money and risk and therefore represents the cost of capital. The sum of the discounted present values of each future period's incremental cash flow or other measure of return equals the present value of the investment, reflecting the expected amounts of return over the life of the investment. The terms "discount rate," "cost of capital," and "required rate of return" are often used interchangeably.
The economic income referenced here represents total expected returns. In other words, this economic income includes increments of cash flow realized by the investor while holding the investment, as well as proceeds to the investor on liquidation of the investment. The rate at which these expected future total returns are reduced to present value is the discount rate, which is the cost of capital (required rate of return) for a particular investment.
Discount rate and capitalization rate are two distinctly different concepts. As noted in the previous section, discount rate equates to cost of capital. It is a rate applied to all expected incremental returns to convert the expected return stream to a present value.
A capitalization rate, however, is merely a divisor applied to one single element of return to estimate a present value. The only instance in which the discount rate is equal to the capitalization rate is when each future increment of expected return is equal (i.e., no growth), and the expected returns are in perpetuity. One of the few examples would be a preferred stock paying a fixed amount of dividend per share in perpetuity.
In the unique case where an amount of return is expected to grow at a constant rate in perpetuity, the capitalization rate applicable to that expected return is equal to the discount rate less the expected rate of growth. The relationship between discount and capitalization rates is discussed further in future chapters, especially in Chapter 4 on "Discounting versus Capitalizing."
It is market driven. It is the expected rate of return that the market requires to commit capital to an investment.
It is a function of the investment, not the investor.
It is forward looking, based on expected returns.
The base against which cost of capital is measured is market value, not book value.
It is usually measured in nominal terms, that is, including expected inflation.
It is the link, called a discount rate, that equates expected future returns for the life of the investment with the present value of the investment at a given date.
Notation System Used in This Book.
Part I: Cost of Capital Basics.
1. Defining Cost of Capital.
2. Introduction to Cost of Capital Applications: Valuation and Project Selection.
3. Net Cash Flow: The Preferred Measure of Return.
4. Discounting versus Capitalizing.
5. Relationship between Risk and the Cost of Capital.
6. Cost Components of a Company's Capital Structure.
7. Weighted Average Cost of Capital.
Part II: Estimating the Cost of Equity Capital.
8. Build-up Models.
9. Capital Asset Pricing Model.
10. Proper Use of Betas.
11. Size Effect.
12. DCF Method of Estimating Cost of Capital.
13. Using Ibbotson Associates Cost of Capital Data (Michael W. Barad and Tara McDowell).
14. Arbitrage Pricing Model.
Part III: Other Topics Related to Cost of Capital.
15. Minority versus Control Implications of Cost of Capital Data.
16. Handling the Discount for Lack of Marketability.
17. How Cost of Capital Relates to the Excess Earnings Method of Valuation.
18. Common Errors in Estimation and Use of Cost of Capital.
19. Cost of Capital in the Courts.
20. Cost of Capital in Ad Valorem Taxation (Carl R.E. Hoemke).
21. Capital Budgeting and Feasibility Studies.
22. Central Role of Cost of Capital in Economic Value Added (Joel M. Stern, G. Bennett Stewart III, and Donald H. Chew Jr.).
Appendix A: Bibliography.
Appendix B: Courses and Conferences.
Appendix C: Data Resources.
Appendix D: Developing Cost of Capital (Capitalization Rates and Discount Rates) Using ValuSource PRO Software (Z. Christopher Mercer, ASA, CFA).
Appendix E: Iterative Process Using CAPM to Calculate the Cost of Equity Component of the Weighted Average Cost of Capital (Harold G. Martin, Jr., MBA, CPA/ABV, ASA, CFE).
Appendix F: International Glossary of Business Valuation Terms.
Appendix G: Converting After-tax Discount Rates to Pretax Discount Rates.
CPE Self-study Examination.