Cost of Capital

We evaluate projects by determining the cash flows for the

project and then discounting them to get the NPV.

What is the discount rate we use?
The new project will only have a positive NPV if its return

exceeds what the market is offering on similar investments.

Therefore, our discount rate should be tied to the returns offered

by investments with similar risks in the market.

Calculating Cost of Capital

Cost of capital represents minimum return we need from

projects given the capital we have:

i.e. Are you using your capital productively?
If not, shareholders are better off investing their money

somewhere else.
Need to calculate productive return for each element of capital:

common equity, prefs and debt.

Calculating Cost of Capital

Capital costs should reflect current market

conditions, not historical, sunk costs.

Weights should be market weights, not historical

book values.
Cost of debt should reflect tax deductibility of

interest payments.

Cost of Debt

The cost of debt is the return the firms lenders require.

Remember that were only interested in after-tax values in capital

budgeting though.
Interest on debt is tax-deductible, dividends paid to shareholders are

not.
This means that the interest we pay is actually a little less because we

get some of it back in the form of the tax deduction. This needs to be
taken into account in our cost of debt calculation.
Cost of debt = RD

After-tax cost of debt = RD x (1-TC)

Practical Considerations: Rd

The interest rate at which the company can issue new

debt
Not the coupon on existing debt
Also the YTM on new debt (e.g. Bonds)

Cost of Equity

The return that shareholders require from the company.

How do we observe this? Impossible to ask each individual

investor what the return is that they expect from the

company.
Need to approximate the return somehow.
Does open us up to estimation errors.

Dividend Growth Model

Method for evaluating share price against required

return

D1
P0
RE g
Where
P0 = the price at the beginning of the year.
D1 = the dividend paid during the year
RE = the expected return on the share
g = the expected growth in the dividends paid each year.

Dividend Growth Model

We can use this to approximate the return required by

shareholders by rearranging the terms:

D1
RE
g
P0
The method is simple, but what about shares that do not pay

dividends?
The method is very sensitive to changes in the growth rate.
Does not actually link the expected returns to risk in anyway.

Using Market Estimates

The dividend growth method uses information about the firm to

determine what shareholders expect.

What about determining the expected return based on expectations in

the market?
We know that total returns = risk-free return + risk premium
We also know we are only rewarded for systematic risk.
If we want to know the expected return for our project in the market

place we need to know the risk-free rate, the risk premium of the market
and the beta (systematic risk).

SML method

RE R f E ( RM R f )
Where

Rf = risk-free rate
E = Beta of the firms equity
RM = Return on the market as a whole
(RM - Rf) = Risk premium on the market

Practical Considerations

Problems with this technique are that we need to

estimate the beta and market risk premium.

It is a good method, however, in that it specifically

takes risk into account and can be used even when

the company does not pay dividends.

Practical Considerations rf (US)

Which risk-free rate is appropriate?

Evidence in US suggests 90-day T-Bill or long-term Treasury Bond yield

most used.

Difference between rates can be up to 150 basis points so will have a

significant impact on WACC calculation.

T-Bills reflect more accurately the riskless nature of CAPM requirement but

T-Bonds reflect more accurately the investment periods companies exposed

to.

Bruner, et al (1998) find 70% of practitioners in their US sample use T-

Bonds.

Practical Considerations rf (SA)

Correia and Cramer (2008) find that 55% of firms used the R153,

15% used the R157 and the remaining 30% used a variety of other
rates such as the R186, R194, ALBI, R201 and the average bond
yield.
A PWC survey in 2003 found that all respondents used the R153

while a follow-up in 2005 indicated an equal split between the

R153 and R157.
Do such long-term rates really reflect a risk-free return,

however?

Practical Considerations -
Betas should be forward-looking to reflect risk of expected cash flows.
Unfortunately, must rely on proxies, most often historical betas.

Rit = i + i(Rmt)
How long should the time period be?

Longer period more robust but may include irrelevant/outdated information.

Shorter period may not be normally distributed or contain unwanted noise.

What is our market portfolio?

CAPM says unobservable portfolio of all publically traded assets

Can we use a broad index as an accurate proxy?

Practical Considerations -

What if the company is not publically traded?

Cannot calculate beta without price data.

Alternative is to identify publically-traded company in same

industry which is as similar to our company as possible.

Approximately same size, industry, product lines, sales volumes,

etc.
Can then use that companys beta as proxy for ours.

Practical Considerations -

One factor that influences beta but is frequently overlooked is operating

leverage.
Operating Leverage: the relationship between sales and operating cash

flow
The higher the fixed costs, the higher the DOL
All else constant, higher fixed costs leads to more volatile cash flows and

higher betas.
This means that similar firms in the same industry can have

significantly different betas depending on their reliance on fixed costs.

Practical Considerations (SA)

Difficulties in calculating betas for smaller firms due to liquidity

problems.
Carreia and Cramer (2008) find that 77% of companies use the ALSI for

calculating beta while 23% use the FINDI.

Many companies prefer to employ published betas.
Most used in order are Cadiz/UCT Financial Risk Services, Bloomberg

and McGregors.
44% of companies made adjustments to published betas while 56% did

not

Practical Considerations (Rm-rf) (US)

Ideally require estimates of future returns but for practical reasons

historical figures typically used.

Do we use geometric or arithmetic figures, however?
Geometric average always less than arithmetic and gap bigger when

returns more volatile.

Evidence from US indicates difference can be as much as 2% in returns

depending on method chosen.

Bruner, et al (1998) indicate roughly 71% of participants in survey use

arithmetic returns.

Practical Considerations (Rm-rf) (SA)

Analysts differ on appropriate market risk premium for SA.

Dimson ,et al (2003) 6.8% (over the period 1900 2002)

Kantor (2005) -4%.

Kruger (2005) - 5 to 5.5%

Much of the difference is due to the time period analyzed. How long is

appropriate?

Market respondents typically within this range:

PWC survey (2005) found 50% used a premium of 6%, 35% used a premium of 5% and
less than 10% used a premium of 7%.

Carreia and Cramer (2008) found 45% used a premium of 5%, 15% used a premium
between 3% and 4% and 40% used a premium between 6% and 7%.

Preference Share Capital

Preference shares are closer to debt than equity in

many respects.

Preference shareholders expect fixed dividends in

return for their investment.

The cost of prefs is therefore simply the preference

dividend yield they are entitled to based on their

holdings.

Preference Share Capital

Value of a share P = Dps/kps

Dps

Dps

Dps

Dps

Rearranging,
kps = Dps/P
Dps = Preferred dividend
P = market price of preferred stock

Hurdle Rates

WACC only applies to projects or investments of the same risk as

the firm.

Should this differ it is necessary to adjust the WACC up/down to

reflect the higher/lower risk.

This can be done by adjusting:

Adding or subtracting a premium to reflect the risk differential

(thumb-suck)

Determining the beta for the project/investment and recalculating RE

and then WACC.

Practical Experience

Bruner, et al (1998) find that all US analysts polled calculate

hurdle rates for firm divisions individually.

Only 26% of companies polled always adjust cost of capital to

reflect different risk profiles.

Carreia and Cramer (2008) find that 83% of SA companies use

the company beta when evaluating projects, 11% use a sectoral

beta and only 6% use project betas.

Economic Value Added (EVA)

Widely used in various valuations including capital budgeting, M&A,

incentive compensation schemes, etc.

Measures the economic profit of the firm as the difference between

NOPAT and cost of funds (measured by total cost of capital).

EVA = NOPAT (WACC x Capital)

NOPAT = adjusted operating profit before taxes cash operating taxes

Positive EVA indicates value creation and vice versa.

EVA

Disconnect exists between valuations on cash basis and

accountings accrual basis.

Adjustments typically made to reconcile the two:

Exclude reserves and provisions

Exclude abnormal or unusual items
Exclude non-operating items

According to research up to 160 adjustments could be made

(Erasmus, 2006) in practice.

Calculating EVA

Computing Cash Operating Taxes

Income tax expense (I/S)
- Change in deferred taxes
+ Tax benefit from interest expense
- Tax benefit from interest on lease
- Taxes on non-operating income
= Cash Operating Taxes

Calculating EVA

Computing Adjusted Operating Profits Before Tax

Sales
+Increase in LIFO reserve
+Implied interest expense on operating leases
+Other Income
- Cost of Goods Sold
- Selling, General and Administrative Costs
- Depreciation
= Adjusted Operating Profit before Taxes

Calculating EVA

Capital
Book Value of Common Equity
+Preferred Stock
+Minority Interests
+Deferred income tax reserve
+LIFO reserve
+Accumulated goodwill amortization
+Interest-bearing short term debt
+Long-term debt
+Capitalized lease obligations
+PV of operating leases
= Adjusted Operating Profit before Taxes

MVA an alternative to EVA

Change in MVA used to assess performance of

management.

Measured as market value of firms capital minus

book value of capital employed.

MVA = MV of firms capital invested capital

Should equal present value of all future EVAs

discounted at cost of capital.

Is EVA or MVA useful?

Bernstein and Pigler (1997) formed portfolios of 50 stocks with

highest EVA and MVA over 10-year period.

Portfolio Return
ROE

EPS Surprise
MVA

S&P 500

EVA

Rf

Portfolio Risk

Is EVA or MVA useful?

Bernstein and Pigler (1997) formed portfolios of 50 stocks with

highest percentage change EVA and MVA over same 10-year

period.
Portfolio Return
ROE

EPS Surprise

MVA

S&P 500

Rf

EVA

Portfolio Risk

References

Bernstein, R and Pigler, C (1997) "An Analysis of EVA" Quantitative Viewpoint, Merrill Lynch & Co.

Bruner, R.F., Eades K.M., Harris, R.H. & Higgins, R.C. 1998. Best practices in estimating the cost of
capital: survey and synthesis. Journal of Financial Practice and Education, Spring/Summer

Carreia, C and Cramer, P (208). An analysis of cost of capital, capital structure and capital budgeting
practices: a survey of South African listed companies, Meditari Accountancy Research Vol. 16 No. 2 2008 :
31-52

Dimson, E., Marsh, P. & Staunton, M. 2003. Global evidence on the equity risk premium. Journal of Applied
Corporate Finance, 15(4):9-19.

Kantor, B. 2005. Risk and return in equity markets: what should we expect? Cost of Capital Conference,
Investec Securities, Cape Town, 15 July.

Kruger, G. 2005. Case study: First Rand Cost of Capital Conference, Investec Securities, Cape Town, 15 July.

PriceWaterhouseCoopers Corporate Finance. 2003. Business Enterprise Valuation Survey,

PriceWaterhouseCoopers (2003 edition).

PriceWaterhouseCoopers Corporate Finance. 2005. Valuation Methodology Survey,

PriceWaterhouseCoopers (2005 edition).