COST OF CAPITAL

CHETAN SUKHDEO RANPISE

DPGD/JA10/0052

SPECIALIZATION: FINANCE

WELINGKAR INSTITUTE OF MANAGEMENT DEVELOPMENT & RESEARCH

YEAR OF SUBMISSION: -NOVEMBER 2011

ACKNOWLEDGEMENT

With immense pleasure I would like to present this report on COST OF CAPITAL I would like to thanks Welingkar Institute of Management for providing me opportunity to Present this project. My special thanks to Mr. Permeshwar Welekar (project Guide) for his invaluable guidance, co-operation and for taking time out his busy schedule to help me. Acknowledgments due to my parents, family members, friends and all those people who have helped me directly or indirectly in the successful completion of the project.

Chetan Sukhdeo Ranpise

CERTIFICATE FROM THE GUIDE

This is to certify that the project work titled COST OF CAPITAL is a bonafide work carried out by CHETAN SUKHDEO RANPISE

(Admission No.) DPGD/JA10/0052

A candidate for the Post Graduate Diploma examination of the Welingkar Institute of Management under my guidance and direction.

SIGNATURE OF THE GUIDE NAME: Mr. PERMESHWAR WELEKAR DESIGNATION: DEPUTY MANAGER (FINANCE) ADDRESS: INDIAN OIL CORPORATION LTD. NEAR RAILWAY GOODS SHED, BHIALI-3, DIST. DURG. CHHATISGARH.

DATE:

PLACE: 3

TABLE OF CONTENTS

TITLE PAGE........1 ACKNOLEDGMENT..........2 CERTIFICATE FROM GUIDE..3

A. INTRODUCTION Objective11 Motivation..12 Cost of Component..13 Application of the Cost of Capital...14

B. BACKGROUND Cost of capital for MNC15 Cost of capital across countries..16 The cost of capital background for a firm..17 Required rate of return on project..18 Effect of debt on required returns..19 Cost of capital issues...19 Relationship between implied cost of capital and realized returns24 Adjusting forecasts for predictable errors.....27

C. METHDOLODGY Weighted average cost of capital(WACC)34 Cost of debts.37 Cost of preferred stock.41 Cost of equity.42

D. CONCLUSION53 E. RECOMMENDATIONS.56 F. LIMITATIONS..58 BIBLIOGRAPHY.60

INTRODUCTION
In the context of financial management, the term cost of capital refers to the remuneration required by the investors or lenders to induce them to provide funding for an ongoing business. If the firms goal is to remain profitable and to increase value to its shareholders, any use of capital must return at least its cost of capital, and optimally, an amount greater than its cost of capital. The Weighted Average Cost of Capital (WACC) is often used as benchmarks, or hurdle rate when evaluating new project and business that would require use of the scare resources of funding.

The cost of capital is the required rate of return that a firm must achieve in order to cover the cost of generating funds in the marketplace. Based on their evaluations of the riskiness of each firm, investors will supply new funds to a firm only if it pays them the required rate of return to compensate them for taking the risk of investing in the firms bonds and stocks. If, indeed, the cost of capital is the required rate of return that the firm must pay to generate funds, becomes a guidelines for measuring the profitabilitys of different investments. When there are differences in the degree of risk between the firm and its divisions, a risk-adjusted discount-rate approach should be used to determine their profitability.

Cost of capital plays a central role in valuations, portfolio selections, and capital budgeting. Therefore, measuring and validating the cost of capital metrics has been the subject of much research. While cost of debt is usually directly observable, the cost of equity capital is not and needs to be inferred. Researchers have attempted to validate the inferred measures of cost of equity capital in two ways: (1) correlations with ex-ante proxies for risk such as beta, earnings variability, leverage and growth, and (2) correlations with realized returns [see Gebhardt, Lee and Swaminathan (2001) and Gode and Mohanram (2003) among others]. Prior research has

demonstrated that while implied cost of capital estimates correlate well with ex-ante proxies for risk, but correlate poorly with realized returns. Such low correlations can be attributed to four factors: (1) realized returns are affected by economic surprises regarding future cash flows or discount rates [Vuolteenaho (2002)], (2) market inefficiencies, e.g., the market consistently overestimates or underestimates future earnings [e.g. the accrual anomaly documented in sloan (1996)], (3) researchers measurement of market expectations are incorrect, e.g., analyst earnings forecasts are a poor proxy of market expectations of earnings [see Hughes, Liu and Su (2008)]. and (4) researches have used an incorrect model of earnings dynamics to estimate extrapolate earnings beyond the analyst forecast horizon, i.e., researchers have measured terminal value at the end of analyst forecast horizon incorrectly. In this paper, we focus on the third aspect and show that errors in analyst earnings forecasts contribute to the low correlation between implied cost of capital and realized returns. We then use insight from recent research that demonstrates that the errors in analyst forecasts are predictable. Correcting the forecasts to better measure markets expectations of earnings leads to significantly improved correlation between implied cost of capital and realized returns. Without the corrections, the difference in mean implied cost of capital estimates between the top and bottom quintile of portfolios formed on the basis of implied cost of capital is 7.8%, but the difference in mean realized returns is a statistically insignificant 0.35%. Moreover, the relationship between implied cost of capital and realized returns is not even monotonic across the quintiles. After correcting earnings forecasts, the difference in mean implied cost of capital between the top and bottom quintiles is 6% and the difference in mean realized returns is 6.6% with a strong monotonic progression across quintiles. We use the abnormal earnings growth model or the OJ model developed in Ohlson and Juettner-Nauroth (2005) because it is theoretically rigorous yet parsimonious, and provides a simple closed form solution for the implied cost of capital. 1 Further, prior research has documented that while the OJ model provides cost of capital estimates that are highly correlated with ex-ante risk factors [Gode and Mohanram (2003)], they are weakly correlated with realized

returns [Easton and Monahan (2005)]. We also use the PEG model, a restricted and simplified version of the OJ model, as prior research has suggested that the simple version may outperform the full version [Easton (2004), Easton and Monahan (2005)]. The risk premiums derived from the full OJ and the abbreviated PEG model are denoted as RPOJ and RPPEG respectively. We begin our analysis by replicating prior results that demonstrate a strong association between risk premiums and risk factors, but a weak and non-monotonic association between risk premium and realized returns. Consistent with prior research, we observe a strong positive monotonic relationship between implied risk premium and risk factors such as beta, standard deviation of returns and standard deviation of analysts EPS forecasts, and a strong negative monotonic relationship between risk premium and firm size and analyst following. further, the relationship between implied risk premium and ex-post realized returns are weak and nonmonotonic. As mentioned earlier, the spread in returns between firms in the highest and lowest quintile of RPOJ is merely 0.35% compared to 7.8% spread in risk premium.

We then explore how predictable forecast errors may bias implied cost of capital. We find that the highest RP quintile also has the highest negative ex-post earnings surprise, which suggests that the relationship between risk premiums and realized returns may be weak due to errors in measuring expected earnings. Hughes, Liu and Su (2008) show that while analyst forecast errors are predictable, one cannot generate excess returns by predicting forecast errors, which suggests that the market does not use the forecasts at face value, but corrects them. Therefore, one can more reliably estimate implied cost of capital by using adjusted analyst forecasts, and this more reliable estimate may exhibit a higher correlation with realized returns. In the context of our paper, the analyst forecasts may be overly optimistic for the highest RPOJ Quintile but the market may well be aware of the overstated forecast and may be using a lower forecasts. The resulting lower stock price when compared with inflated analyst expectations Would yield a spuriously high implied cost of capital. Consistent with Hughes,Liu and Su (2008),

We choose the following factors to predict forecast errors: accruals (ACCR),book-to-market ratio (BM), earnings-to-price ratio (EP), long-term growth (LTG), sales growth (SGR), changes in PP&E (CH_PPE) trailing return (RETO) and revision in analyst forecasts (REV), we run annual regressions to predict surprises in one year-ahead and two-year-ahead EPS. Using the coefficients from once-lagged (twice-lagged) annual regressions to avoid look-ahead bias, we estimate the predictable errors in EPS1 (EPS2) forecasts. We then remove the predictable error component of analyst forecasts of EPS1 and EPS2, recomputed the cost of capital based on the adjusted forecasts and analyze their relationship with realized returns. The results demonstrate the central point of our paper-the cost of capital implied by the corrected analyst forecasts shows a must stronger relationship with realized returns. Quintiles formed on the basis of implied cost of capital show monotonically increasing realized returns.The difference in adjusted RPOJ (RPPEG) between the top and bottom quintiles is 7% (7.3%) while the difference in realized returns is 4.2% (4.7%).Finally, we include the initial estimate of implied cost of capital in our prediction of forecast errors. Instead of reflecting risk, a very high RP estimate might reflect that the markets expectations are much lower than analyst forecasts. Therefore, we use lagged RPOJ(RPPEG) as an additional explanatory variable in the regression to predict forecast errors. We then use these adjusted forecasts to infer the new cost of capital. This results in a stronger association between implied cost of capital and realized returns. The spread between the top and bottom quintile of adjusted RPOJ (RPPEG) is 6.0 %( 6.6%) while the realized returns differ by 6.6 %(6.7%). To summarize, our paper makes two contributions to the literature. First, it shows that correcting analyst forecasts to remove predictable errors leads to implied cost of capital measures that have much higher association with realized returns than has been documented before. Second, it shows that, in additions to the well known factors used to predict forecast errors, one should use the implied cost of capital itself to predict surprises, as a very high cost of capital estimate suggests that the markets true earnings expectations are lower then analysts. Section 2 summarizes the prior research related to implied cost of capital as well

as the predictability of analyst forecasts errors. Section 3 outlines the theory underlying the OJ model, our empirical execution of the OJ Model to calculate implied cost of capital estimates. and the sample selection procedure. Section 4 analyzes the relationship between the cost of capital estimates and returns and sheds light on the significant role of analysts forecasts errors. Section 5 outlines a procedure to correct the predictable errors in analysts forecasts and demonstrates that doing so strengthens the relationship between implied cost of capital and realized returns, section 6 concludes the paper. . Most firms do not rely on only one type of financing, but seek to maintain an acceptable capital structure using a mix of various elements. These sources of financing include long term debt. common stock preferred stock & retained earnings.

What impacts the cost of capital?

RISK IN ESS OF EARNINGS E THE DEBIT TO EQUITY MIX OF THE FIRM

FINANCIAL SOUNDNESS OF THE FIRM

INTEREST RATE LEVELS IN THE US/GLOBAL MARKETPLACE

The cost of capital becomes a guideline for measuring the profitabilities of different investments.

Another way to think of the cost of capital is as the opportunity cost of funds, since this represents the opportunity cost for investing in assets with the same risk as the firm. When investors are shopping for places in which to invest their funds, they have an opportunity cost. the firm, given its riskiness, must strive to earn the investors opportunity cost. If the firm does not achieve the return investors expect (i.e. the investors opportunity cost), investors will not invest in the firms debt and equity. As a result, the firms value (both their debt and equity) will decline.

Lets Takes an Example

The managers of Rocky Mountain Motors (RMM) are considering the purchase of a new tract of Land which will be held for one year. The purchase price of the land is $10,000. RMMs capital structure is currently made up to 40% debt, 10% preferred stock, and 50% common equity. This capital structure is considered to be optimal, so any new funds will need to be raised in the same proportions. Before making the decision, RMMs managers must determine the appropriate require rate of return. What minimum rate of return will simultaneously satisfy all of the firms capital providers?

Because the current capital structure is optimal, the firm raises funds as follows Sources of Funds Debt Preferred Common TOTAL Amount $4000 $1000 $5000 $10000 Dollar cost $280 $100 $600 $980 After tax cost 7% 10% 12% 9.8%

10

The following table shows three possible scenarios: Rate of Return Total Funds Available Less: Debt Cost Less: Preferred Cost =Remainder to common 8% $10800 $4280 $1100 $5420 9.8% $10980 $4280 $1100 $5600 11% $11100 $4280 $1100 $5720

Obviously, the firm must earn at least 9.8%. Any less, and the common shareholders will not be satisfied.

1. Objective The objectives of cost of Capital are as follows.

I.

Managing the right-hand side of the Balance Sheet:

For making a valuable & strong balance sheet the cost of capital is very important. It reflects the ability & it surviving life in the industries & create trust in the mind of the shareholders.

II.

By now, for valuation analysis, we know:

Criteria for NPV, IRR, Payback. What the relevant Cost of Financing is How to compute net cost of Financing How to introduce forecasts error in Cost of Financing.

11

III.

Source of Financing:

Debt, equity, retained earnings, preferred stock, warrants, venture Capital and bank loans, strategic alliances. Bank loans, venture capital, and warrants not discussed. To simplify, we concentrate only on debt, equity, and retained earnings.

IV.

Cost of financing=Cost of Capital=? The rate that must be earned to satisfy the required rate of return of the firms investors. What is the cost of each source of financing? What is a projects cost of capital?

Definition:

2. I.

Motivation Why cost of capital is important?

The cost of capital is important in its Net Present Value term as follows.

If financing cost is reduced Y NPV increases Y more projects end up with NPV>0 Y more wealth created to shareholders.

12

II.

Some preliminaries

Minimum required return / cost of capital=that particular discount rate k that makes NPV=0 The return generated by a security is the cost of that security to the company that issued it. Cost of capital to the firm = reward to investors. The cost of capital depends primarily on the use of funds i.e. the risk of the CFs not on the source.

I. II.

Risk of CFs (systematic risk) Company capital structure

3. Case 1

Cost of Components:

Assume firm has no debt & has retained earnings. Remember from the chapter performance Measures;

Net income = total dividend + retained earnings If a company cannot find profitable projects, i.e. projects with return at least equal to ks, then the firm should distribute retained earnings to shareholders as dividends. Thus, if the company is retaining your money, then the minimum acceptable rewards to you (an average investor) is the required return on equity = required return on retained earnings = ks/ required return on equity.

But reward to investor = cost of capital to the firm.

Required return on equity = cost of retained earnings.

13

Case 2 Now suppose firm needs to issue new equity for an expansion project obviously Ke>ks (cost of new equity) > (Cost of retained earnings) = (required return on new equity)> (required return on retained earnings) Since some transactions (floatation) costs have to be paid to investment banks for assisting firm In selling the new securities. Case 3 If a company has a good project (NPV>0), should it be financed using equity? Not necessarily, firm should consider using debt. 4. Application of the Cost of Capital

The cost of capital is a measure of the opportunity cost of capital in an economy. A companys cost of capital should equal the marginal return available to investors in the next best investment opportunity of similar risk available in the capital. The cost of capital should reflect: The return available to investors in the economy on risk-free instruments. The return that investors require for taking systematic risk over and above the risk-free rate Systematic risk is at which cannot be diversified away. Traditionally measured as the weighted average of the cost of equity and debt, known as the weighted Average Cost of capital (WACC). Basically Cost of capital have four applications system which for the management for careful decision on investment in cost of capital. Capital budgeting decisions and value-based management Company valuation Mergers & acquisitions Goodwill write-off 14

BACKGROUND

As investors desire to obtain the best/highest return on their investments in securities such as share (Equity) and loans to companies such as debentures (debt), these returns are costs to companies paying these dividends (on equity) and interest (on debt)! It all depends on the perspective from which we close to view the calculation (are we Earning or paying?)

Cost of capital for MNC

A firms capital consists of equity (retained earnings and funds obtained by issuing stock) and debt (borrowed funds). The firms cost of retained earnings reflect an opportunity cost what the existing shareholders could have earned if they had received the earnings as dividends and invested the funds themselves. The firms cost of new common equity (issuing new stock) also reflects an opportunity cost. What the new shareholders could have earned if they had invested their funds elsewhere instead of in the stock. This cost exceeds that of retained earnings because it also includes the expenses associated with selling the new stock (flotation costs).

The firms cost of debt is easier to measure because that if firms incurs interest expenses as a result of borrowing funds. Firms attempt to use a specific capital structure or mix of capital components that will minimize their cost of capital. The lower a firms cost of capital, the lower is its required rate of return on a given proposed project. Firms estimate their cost of capital before they conduct capital budgeting because the net present value of any project is partially dependent on the cost of capital.

15

Costs of capital across Countries

An understanding of why the cost of capital can vary among countries is relevant for three reasons. First, it can explain why MNCs based in some countries may have a competitive advantage over others. Just as technology and resources differ across countries, so does the cost of capital. MNCs based in some countries will have a larger set of feasible (positive net present value) projects because their cost of capital is lower, thus these MNCs can more early increase their world market share. MNCs operating in countries with a high cost of capital will be forced to decline projects that might be feasible for MNCs operating in countries with a low cost of capital. Second MNCs may be able to adjust their international operations and sources of funds to capitalize on differences in the cost of capital among countries. Third, differences in the costs of each capital component (debt and equity) can help explain why MNCs based in some countries tend to use a more debt-intensive capital structure than MNCs based elsewhere. Country differences in the cost of debt are discussed next, followed by country differences in the cost of equity

A firm capital consists of equity (retained earnings and funds obtained by issuing stock)and debt (borrowed fund).There is an advantage to using debt rather than equity as capital because the interest payments on debt are tax deductable. The tradeoff between debts advantage and its disadvantage. It is favorable to increase the use of debt financing until the point at which the bankruptcy becomes large enough to offset the tax advantage of using debt.

Companies MUST consider the cost of financing they receive in the form of equity or debt if they are to manage their finances better, cheaper finance cost to the company means higher profitability and in most cases, superior cash flow. Generally the cost of EQUITY has no tax effect but the costs of DEBIT finance to companies are technically SUBSUDISED by tax since

16

INTEREST (cost of debt) can be claimed for tax purposes in so for as it is wholly exclusively and necessarily incurred for business purposes.

The Cost of Capital Background for a firm: Cost of capital is a major standard of comparison used in financial analysis and is vital company statistic needing careful calculation. The return on capital resources must equal or exceed the cost of that capital. Although zero or negative returns are acceptable in special cases. The necessary subsidies may lead to costs in another form.

The realities of commercial life have caused the cost of capital to be very complex subject. Any comparisons must be made between like numbers. A percentage profit before tax made on a hotel in Bermuda bears no relationship to the same figure made after tax on a farm in Scotland. A profit expressed as a percentage of capital employed should not be compared with a discounted cash flow internal rate of return. Capital investment analysis aims to discover the financial truth about the plan under investigation. If it does not meet the survival standard of the organization, that fact should be stated clearly before the discussion as to its desirability begins. In practice, many apparently unprofitable activities which, of course, should out number them.

Most. companies raises funds from many sources- related earnings, new equity, grants and many forms of loans. The overall cost of capital to the new firm is the return it must earn on its assets to meet the requirements of all those providing it with financing. Lenders require interest payments and shareholders expect to receive dividends and see capital growth. In deciding the appropriate standards for an organization. The marginal cost of capital is a vital guide. In a growing company, new capital will be needed and, therefore, the return on a project of normal risk should be judged against a standard of the weighted average cost of new capital. Companies making investment decision continuously should use this marginal cost of capital as

17

the standard for all projects with risks normal to the companys business. if a project cannot pass this test, it will diminish the companys value.

Required Rate of Return on Projects: Obviously project involves differing risks. Some such a cost saving investments and lease or buy decisions, are of low risk. Other such as research projects, involves greater than average levels of risk. A company should classify its risk categories for projects and set required returns for each. A large project of risk significantly different from normal can alter the overall character of a company. Its cost of capital, its accepted gearing and the returns expected by financiers.

The required rate of return for a project can be significantly different from the weighted average cost of capital for the company. High risk project are characterized by high fixed operating expenditure and high revenue variability. These should be expected earn high earn rate of return. The exact return required will be depending upon a judgment about the level of risk in the project compared with the average risk of the company. In the case above where weighted average cost of capital in real term is 6%, the real required return on a project twice as risky as the market should be 12% with 10% expected inflation the money required return should be 22%

By evaluating different project at different required rate of return, the company seeks to protect its shareholders. Shareholders require higher rate of return for higher level of risk, and receive compensation for high risk in capital markets. Companies undertaking high risk assets Investment decision must seek to achieve higher returns than their shareholders can earn for That level of risk in the capital market.

18

Effect of debt on required returns: Unless there are non-financial incentives, a project is acceptable only if it stands on its own feet, that is, its cash flow should at least meet the company return criterion for the risk involved. With the possibility of debt financing is the position changed? A typical case arises when new assets simply increase the total assets on a proportion of which debt is available. The total operating risk of the company remains constant as more debt financing is used, so it is unrealistic to believe that the overall cost of funds can be reduced in this way.

For better understanding we take a view of comparison of company cost VS projected cost. same has been as follows.

Cost of capital issue Price Base: WACC may be measured either in real terms or nominal terms. A nominal WACC is expressed in current terms, while a real WACC is expressed in real/constant terms. Hence, the real WACC shows the WACC excluding the impact of inflation. The choice of price base should be consistent with the regulatory pricing regime. If access and interconnection prices are regulated In real terms, the cost of capital should be expressed in real terms, whereas it should be expressed in nominal terms if prices are regulated in nominal terms. In the past, prices have been regulated in nominal terms in Sweden, and there is no indication that this will charge in the future. Hence the cost of capital should be estimated in nominal terms. By permitting a nominal return on assets, investors are compensated for both their opportunity cost of capital and expected inflation. In the view of AMI, the WACC should be stated in nominal terms.

19

Taxation: The WACC may be estimated post-tax or pre tax. The pre tax WACC is the WACC adjusted to allow for corporate tax payments. When applied to the capital base. It indicates the (pre-tax) operating profit required to finance tax and interest payments, while providing shareholders with their required return. The WACC is usually calculated on a post-tax basis, since most market information is available on this basis. Then, it is converted to a pre-tax WACC. A formula often used for converting a post-tax WACC to pre-tax WACC is.

WACCpre-tax = WACCpost-tax / (1-T).

Where T is the effective tax rate.

To estimate a pre-tax WACC, a single effective company tax rate must be estimated. This is problematic as it is difficult to accurately estimate a single effective tax rate, reflecting a companys taxation liabilities, as the taxation liabilities will inevitably vary from year to year. furthermore, forward-looking costs do not depend on the tax rate for previous years, but on the corporate tax rate can be expected in a forward looking perspective. Therefore, AMI suggests the pragmatic solution of using the corporate tax rate as a proxy for the effective tax rate of an SMP operator. Although we acknowledge that this is not theoretically correct, we note that this eliminates any uncertainty that would otherwise be introduced by attempting to estimate an effective rate, and further is in line with generally accepted practice.

20

Principle for determining the capital structure:

The relative share of debt and equity in a companys capital structure is called the debt to equity ratio. Financial gearing refers to the companys proportions of debt and equity and is defined as D/ (E+D), where D is the debt and E the equity capital 10. A highly geared company has a high ratio of debt to equity. There are a number of ways to determine the debt to equity ratio.

A ratio measured on the basis of book values - using a ratio based on the accounting value of the companys debt and equity.

A ratio measured on the basis of current market values - based on the observed market value of the companys debt and equity.

An (optimal) target ratio that a company decides to use for long term financing of its investments. Calculations of the financial gearing should be based on market values (as opposed to book Values) as these reflect the true economic value of the type of outstanding financing. The issue is therefore whether to use an operators current gearing level based on current market value or its target ratio.

21

Using Company Cost (K) Vs. Project Cost (K) K

Project risk < firms

Project risk > firms

Firms K

Risk-free

Reject good projects

Accept Bad Projects

BETA

THE Cost of Capital of a firm is the minimum rate of return which the firm must earn on its investments in order to satisfy the expectations of investors who provide funds to the firm. It is the weighted average of the cost of various sources of finance used by it. The method of computing the cost of capital is to compute the cost of each type of capital and then find the weighted average of all types of costs of capital. In other words, two steps are involved in determination of cost of capital of a firm: (I) computation of cost of different sources of capital, and (II) determining overall cost of capital of the firm. For example a companys capital structure is as follows: 14 per cent debentures of Rs.10, 00, 000, 12 per cent preference share capital Rs. 5, 00,000, Equity share capital Rs. 5, 00,000. It is assumed that equity shareholders of such companies expect 14 per cent dividend. Total capital Rs. 20, 00,000. Income tax rate 30% CDT 15% Total cost = {(98,000 debenture interest taking tax saving at the rate of 30%) + (69,000 preference dividend and corporate dividend tax) + (80500 equity dividend and corporate dividend tax)} = 2, 47,500

22

Cost of capital=

2, 47,500 20, 00,000

*100 = 12.375 %

This company should earn a minimum rate of return of 12.375 per cent on its investments in various projects in order to satisfy the expectation of investors who have provided funds to it. (Surcharge and education cess ignored)

Q. No. 1: In considering the most desirable capital structure for a company, the following estimates of cost of debt and equity capital (after tax) have made at various levels of debt-equity mix: Debt as % of total Capital Employed 0 10 20 30 40 50 60 Cost of Debt (%) 5.0 5.0 5.0 5.5 6.0 6.5 7.0 Cost of Equity (%) 12.0 12.0 12.5 13.0 14.0 16.0 20.0

You are required to determine the optimal debt equity mix by calculating composite cost of capital. Ignore corporate dividend tax.

Answer: Debt as % of Total CE 0 10 20 30 40 50 60 RECOMMENDATION DEBT : 30 % Overall cost of capital (Ko) (%) 12.00 0.10(5.00) + 0.90(12.00) = 11.30 0.20(5.00) + 0.80(12.50) =11.00 0.30(5.50) + 0.70(13.00) =10.75 0.40(6.00) + 0.60(14.00) =10.80 0.50(6.50) + 0.50(16.00) = 11.25 0.60(7.00) + 0.40(20.00) = 12.20

23

Relationship between implied Cost of Capital and Realized Returns:

I.

Replicating Prior Results Regarding the Association between implied cost of Capital, Risk, measures, and Realized Returns:

In this section, we replicate prior research to validate our approach. Prior research has Shown a strong positive relationship between RPOJ and other measures of firm risk such as systematic risk, return volatility and forecast dispersion, and a strong inverse relationship with the quality of a firms information environment captured by proxies such as firm size and analyst following. However, prior research has not shown a strong association between RPOJ and realized returns. Each year, we partition our sample into five quintiles based on the level of risk premium. We then compare the mean values of risk metrics as well as future realized returns across these five quintiles. We consider the following risk and information asymmetry measures systematic risk measured as calculated using monthly returns over the lagged five years (ensuring that least 12 months returns are available), idiosyncratic risk calculated as the standard deviation of the past years monthly returns (STDRET), and finally analyst forecast dispersion calculated as the standard deviation amongst individual analysts of the EPS1 forecast (EPS1STD). The quality of the firms information environment is captured by firm size as measured by market capitalization (MCAP) at the time of the analysts forecast, and the number of analysts following a firm (NUMEST). Table 3, panel A presents the results for quintiles based on RPOJ. The results confirm a strong relationship between RPOJ and risk and information asymmetry measures. Across the five quintiles ranging from lowest RPOJ to highest RPOJ, increases from 1 to 1.23, STDRET increases from 9.7% to 12.9%, and forecast dispersion increases from 7.2% to 15.3%. Firms with the highest RPOJ are also the smallest and least followed while firms with the lowest RPOJ are the largest and most actively followed panel B presents the results for quintiles based on REEEG and shows that the differences across the groups are even greater for most of the variables. Overall, the results confirm prior 24

finding that OJ based implied risk premium metrics are strongly related with other risk metrics. Table 3, panel A also presents the relationship between the implied risk premium measures and future returns. To mirror the definition of risk premium, we subtract the risk-free rate from buy and-hold return realized over the 12 month following the forecast to arrive at our return measure (RET1). The relationship between RPOJ and RET1 is not monotonic. RET1 increases from quintiles. 1 through 3 and then declines. The difference in returns between the top and bottom quintiles of risk premium is positive but insignificant 0.35 % and is a fraction of the 7.8% spread in RPOJ across the top bottom quintile. Table 3, Panel B shows a similar no monotonic relationship between RPPEG and RET1. RET1 increases from 5.58% to 8.40% from the first to the third quintile and then declines to 6.63% for the top quintile. The difference across the top and bottom quintiles in returns is a little stronger at 1.05%, but it is still insignificant, and is only a fraction of the 8% spread in RPPEG.Table 3, panel C presents the results of a simple univariate regression with RET 1 as the dependent variable and either RPOJ or RPPEG as the independent variable. Regressions are run at the firm level, both pooled across the entire sample as well annually using the Fama-MacBeth procedure. The results indicate a weak or even non-existent relationship between realized returns and implied cost of capital. For RPOJ the coefficient is an insignificant 0.0939 for the pooled regression and -0.0280 for the annual regression. For RPPEG, the coefficient is significant for the pooled regression at 0.1947, but an insignificant 0.0286 for the annual regressions. All the coefficients are significantly below the benchmark of 1, which would indicate a perfect relationship between implied cost of capital and realized returns. Thus the regressions results confirm the weak relationship between risk and return seen across quintiles.

25

II.

Why Do High Implied RP Firms Not Earn High Realized Returns?

What might explain the reversal in returns from the middle quintiles to the top quintiles of risk premium? Is there a systematic trend in realized bad news across the groups that causes firms with high implied risk premium to have substantially lower realized returns? To examine this, we compare the realized earnings surprise across the five quintiles. We define SURP1 as the difference between realized EPS1 and expected EPS1 scaled by stock price. Table 3, panels A and B shows a strong inverse trend between earnings surprise and implied risk premium, i.e. firms with high implied risk premium are far more likely to have negative earnings surprises. this could be due to two different sets of reasons with widely different consequences for empirical analysis. The first possibility is that the market expectations are being measured with error Suppose, for some firms, market expectations are lower than IBES forecasts. For these firms, The stock price will appear low relative to IBES earnings forecasts, which will inflate the implied Cost of capital. These firms will have a negative earnings surprise rather than a higher realized return. The second possibility is that the market is inefficient and has unreasonably high growth expectations for firms that are perceived to be high risk. It may then be surprised when the firms do not meet those expectations, which will cause the realized return to be low. We focus on the first possibility and examine how errors in measuring market expectations bias implied cost of capital.

III.

The Impact of Forecast Accuracy on the Association between OJ Based

Implied Cost of capital and Realized Returns Prior research has shown that when analyst forecasts are likely to be more accurate, implied risk premium is stronger related with realized returns (Easton and Monahan (2005)). We test this in our sample by using the realized absolute forecast error (absolute value of SURP1) as our metric of forecast accuracy. Each year, we partition our sample into quintiles based on absolute forecasts error and study the relationship

26

between risk premium and returns within each quintile. Table 4 presents the results for quintiles based on RPOJ. For the first error quintile (most accurate forecasts) we see a strong monotonic relationship between risk premium and return, with a return difference of 16.6% when the difference in RPOJ is 6.86% between high and low RPOJ quintiles. For the next two quintiles, the monotonic relationship continues with return spreads around 10% as against a difference in RPOJ of 7% across RPOJ quintiles. For the fourth quintile, the relationship is much weaker with a return difference of only 3.38% and ceases to be monotonic. Finally, for the fifth quintile with the greatest ex-post forecast error, the relationship is inverted with firms with the highest risk premium earning 9.18% less than firms with the lowest risk premium. The results for RPPEG in the columns to the right are almost identical. A couple of points are noteworthy. First high absolute error groups have high negative SURP1. In other words, when analysts get it really wrong. They are more likely to be extremely optimistic than extremely pessimistic. Second, the high RP firms are far more likely to be in the quintiles with the greatest absolute forecast error. For instance, almost half of the top quintile of RPOJ observations (4,896 out of 10, 896) lie in the least accurate quintile with most negative surprise. These results show that forecast errors weaken the relationship between implied cost of capital and realized returns.

Adjusting Forecasts for Predictable Errors: Identifying Factors that May Predict Forecast Errors Forecast errors weaken the association between implied cost of capital and realized returns, either because of market expectations are biased, i.e., market inefficiency, or due to errors in measuring market expectations, i.e., predictable errors in analyst forecasts, or both. Hughes, Liu and Su (2008) shows that predicting forecast errors cannot be used to generate excess returns. Which suggests that the market is aware of analyst forecast errors and corrects for them. Thus we focus on adjusting analysts forecasts to arrive at better proxies of market expectations, which, in turn, improve inference of cost of capital. We draw upon prior research to identify

27

factors that could help us predict analyst forecast errors. As discussed in the literature review section, systematic trends in forecast bias and accuracy have been the subject of much research. We synthesize these results to identify the following factors to predict forecast errors (# represents Compustat Annual Data Item, represents change in).

Accruals (ACCR): accruals for prior fiscal year, defined as the change in non-cash current assets ( (#4 - #1)) minus depreciation (#14 and the change in current liabilities excluding the current portion of long term debt and tax payable ( (# 5 - #34 - #71)), scaled by prior year total assets (#6)

Book to-market ratio (BM): the ratio of book value at prior fiscal year end (#60), scaled by market capitalization measured at the time of the forecasts.

Earnings-to-price ratio (EP): ratio of EPS1 to PRICE

Long term growth (LTG): from IBES

Sales growth (SGR): annual growth in sales (#12) as of the prior fiscal year end

Changes in gross PP&E (CH_PPE): change in gross PPE (#7), scaled by prior year total assets (#6) Trailing return (RET0): contemporaneous raw buy-and-hold return for the 12 months ending at Six months after prior fiscal year end. Revision in analyst forecasts (REV): revision in EPS1 forecasts from three months after prior Fiscal year end to six months after prior fiscal year end, scaled by PRICE

28

Given that we use both one-year-ahead as well as two -year -ahead EPS estimates, we examine Two measures of errors: SURP1 (SURP2), which is the difference between realized EPS1 (EPS2) and expected EPS1 (EPS2) scaled by stock price. Table 5, panel A provide the average of annual correlation between the error variables and the factors used in predicting errors. Figures above/below diagonal are Pearson/Spearman correlations. For SURP1, the factors ranked from the highest to lowest absolute correlation are as follows: REV, RETO, BM, EP, LTG, SGR, ACCR, and CH_PPE. The ranking of factors for SURP2 is virtually identical. This suggests a strong role for prior revisions, returns, and valuation ratios. To avoid look-ahead bias, we run annual regression of SURP1 (SURP2) at the end of year n on these factors as of the end of year n-1 (n-2).

Table 5, Panel B presents the summary of annual regressions. Coefficients are mean coefficients from annual regressions. T-statistics are calculated from the distribution of annual coefficients using the Fama and MacBeth (1973) methodology. Overall, the adjusted R2 is fairly high at around 22% for SURP1 and 17% for SURP2. As expected from the correlation table. REV, RETO, EP, BM and LTG are significant.

To avoid loss of observations, we run a reduced regression with these fewer variables by excluding the variables pertaining to accruals, sales growth and book-to-market. The results are essentially unchanged. Table 5, panels C and D presents the details of annual regressions for the reduced model for SURP1 and SURP2, respectively. Overall, the predictability of forecast errors lends strong support to the hypothesis that implied cost of capital estimates are biased by the errors in measurement of market expectations.

29

Predicting Forecast Errors:

We multiply the coefficients from one- year lagged regressions of SURP1 on EP, LTG, CH_PPE RET0, and REV with the realized values of these variables to arrive at predicted SURP1 (PREDSURP1). That is, we regress the realized earnings forecasts errors at the end of 1982 on the observable factors at the end of 1981. We then use these regression coefficients and the observable factors as of the end of 1982 to predict the forecast error for earnings expected at the end of 1983, and so on, Similarly, we use twice lagged regressions to predict the forecast errors PREDSURP2 in EPS2

Table 6, panel A summarizes the correlations between predicted and actual earnings surprises scaled by price. As shown the pearson correlation is about 30%, while the Spearman rank correlation is slightly higher. Table 6, panel B shows the summary of pooled and annual regressions of SURP1 on PREDSURP1. The adjusted r-squared is 14% for pooled data and 15% for year-by-year regressions. The r-squared for PREDSURP2 is about 11% and 12% for pooled and annual regressions, respectively. These results confirm that one can predict forecast errors with some degree of accuracy and the market is likely to be using these cleaned up forecasts.

Using Adjusted forecasts to infer Cost of Capital:

We now re-compute the implied cost of capital after removing predicted errors from EPS1 and EPS2, Table 7, Panel A shows the results. Corrected mean (median) EPS1 is only 88% (85%) of uncorrected EPS1,Corrected mean (median) EPS2 is only 77%(72%) of the uncorrected EPS2 short-term growth is not affected much because both EPS1 and EPS2 are revised

30

downward. Mean (median) PE ratios rise by about 18% (18%) while the mean (median) PEG ratios rise by About 21% (26%).

This suggests significant changes in forecasts and valuation metrics. The lowered forecasts naturally lead to lower estimates of risk premium. Mean RPOJ declines from 6.4% to 5.3%, while mean RPPEG declines from 4.4% to 3.3%.This decline is consistent with lowered aggregate RP estimated by Easton and Sommers (2007) after adjusting for forecast bias. Table 7, Panel B, shows that the adjusted RP measures have a correlation of only about 70% with the old RP measures corroborating the fact that the adjustment to earnings forecast significantly impact the implied cost of capital.

Table 7, panel C highlights the main contributions of our paper. It shows that the adjusted cost of Capital measures have a much stronger and monotonic association with the realized returns. Quintiles formed on the basis of adjusted implied cost of capital show monotonically increasing realized returns. The difference in ARPOJ between the top and bottom quintiles is 7 % while the difference in realized returns is 4.2%. The PEG model shows slightly better results the difference in ARPPEG between the top and bottom quintile is 7.3% while the difference in realized returns is 4.66%.

The strong relationship between the adjusted RP measures and returns is reinforced by the firm level regressions in Table7, Panel D. Recall that the coefficients on the RP measures were mostly insignificant when we compute RP using unadjusted analyst forecasts (Table 3, panel C) In contrast, the coefficients on the adjusted RP measures are all significant and are in the 0.4 to 0.6 range. To illustrate, the coefficient on ARPOJ is 0.4479 for the pooled regressions and 0.5232 for the annual regressions, while the coefficient for ARPPEG is 0.5030 for the pooled regression and 0.5918 for the annual regressions.

31

Table 7, panel E shows that we have been largely successful in eliminating the bias due to predictable errors in analyst earnings forecasts. In sharp contrast to Table 4, when we form quintiles based on realized errors and examine the relationship between implied cost of capital and realized return within quintile, we find a monotonic and significant relationship for each quintile. The difference in particularly striking for the fifth quintile of forecast accuracy, where the return difference across RP quintiles is now 5.87% for ARPOJ quintiles and 5.73% for ARPPEG quintiles (compared with -9.18% and -9.69% respectively for the unadjusted RPOJ and RPPEG quintiles within the fifth accuracy quintile in Table4)

Using Implied Cost of Capital to predict Forecast Errors:

In addition to the factors that we have discussed so far, one can also use the implied cost of capital itself as a predictor of analyst forecast errors. Consider a firm with high implied cost of capital. Rather than reflecting risk, this could simply reflect that the market expects lower earnings. Had one used the lower forecast, the implied cost of capital would have been lower.

Table 8, Panel A confirms our intuition that the implied cost of capital may help predict the forecast errors. There is a negative correlation of about 30 % between forecasts errors (SURP1 And SURP2) and risk premiums (RPOJ and RPPEG). We therefore us ROPJ (and RPPEG) as additional explanatory variables in the regression to predict SURP1 and SURP2 Table 8, panel B repeats the analysis in Table 5, Panel B except that we now add unadjusted RPOJ and RPPEG as explanatory variables. The adjusted R2 for the SURP1 regression increases from 20.50% in Table 5, panel B to 22.6% in Table 8, Panel B if we add RPOJ as an explanatory variable. If we use RPPEG instead of RPOJ, then the adjusted R2 is even higher at 23.2% Results for SURP2 are similar.

32

Table 8, panel C repeats the analysis in Table 7, Panel C except that we now use RPOJ and RPPEG as additional variables to clean the analyst forecasts for expected errors. In Table 7 Panel C, the difference in adjusted RPOJ between the top and bottom quintile is 7 % while the realized returns differ by 4.2%. In contrast, in Table 8, panel C, the difference in RPOJ between the top and bottom quintile is 6% while the difference in realized returns is 6.24%. With RPPEG the difference in expected returns between the top and bottom quintile is 6.6% while the difference in realized returns 6.69%, which is also a dramatic improvement over Table 7, Panel C Thus the addition of implied cost of capital as a predictor of forecast errors significantly Improves the correlation with realized returns. To confirm the stronger relationship between the adjusted RP measures and returns, we repeat the firm-level regressions. Recall that the coefficients on the RP measures were in the 0.4 to 0.6 range when we made the first-stage adjustments (Table 7, Panel C) when we incorporate the initial estimate of RP in our error prediction regression, the coefficients improve still further to reach the 0.8 level. The coefficient on ARPOJ is 0.8002 for the pooled regressions and 0.8411 for the annual regressions, while the coefficient for ARPPEG is 0.7904 for the pooled regression and 0.9456 for the annual regressions. The coefficients from the annual regressions are insignificantly different from the theoretical benchmark of 1, which represents a perfect relationship between expected and realized returns. Our results show that removing predictable errors in analyst forecasts increases the accuracy of measuring market expectations and significantly strengthens the association between implied derived from the OJ model (and the simplified PEG model) and realized returns. Thus the weak results found in prior research were potentially caused not by a flaw in the valuation model, but by errors in measuring markets expectations of earnings.

33

METHDOLOGY
The cost of capital allowed by a regulator in setting price limits should reflect the opportunity cost of the funds invested in assets. It represents the rate of return that an investor would be likely to require in order to invest in a company, given its risk profile compared with other potential investments. It can also be thought of as the discount rate which an investor would use in evaluating the income stream to be expected from investing in the company.

1)

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The weighted average cost of capital (WACC) is computed from (a) the average cost of debt for the various forms of debt held by the company, and (b) the cost of equity. This is the return that investors (shareholders and lenders of various types) require in order to invest in the company.

The firms WACC is the cost of capital for the firms mixture of debt and stock in their capital structure.

WACC= Wd ( Cost of debt) + Ws (cost of stock/RE) + Wp (cost of pf stock)

So now we need to calculate these to find the WACC!

34

Wd = Weight of debt (i.e. fraction of debt in the firms capital structure) Ws = Weight of stock Wp = Weight of preferred stock

THE FIRMS CAPITAL STRUCTURE IS THE MIX OF Ws Wd

Think of the firms capital structure as a pie that you can slice into different shaped pieces. The firm strives to pick the weights of debt and equity (i.e. slice the pie) to minimize the cost of capital.

Calculating Company WACC Example Given:

Optimal proportions are 30% Debt, 10% preferred, 60 % common equity

Retained Earnings = $300,000

T= 40%: Value of k from above examples is used.

$ Financing needed = $200,000

Solution:

If retained earnings are to be used to finance projects, as in this example,

35

WACC

= = = =

Wdkd (1-T)

WpsKps

WeKe + 0 8.4%

0.3(10%) (0.6)+ 0.1(9%)+0.6(14%) 1.8% 11.1% + 0.9% +

Where do the weights come from? Possibilities include.

Proportional current book value of each component

Proportional current market value of each component

Target capital structure

Should short-term debt be included in wd?

Limitations of WACC If we use the existing WACC as the hurdle rate in NPV computations (benchmark), we are assuming that when new funds are raised to finance new projects, the cost of capital will be unchanged, i.e.

The proportion of debt and equity remain unchanged.

The operating risk of the firm is unchanged.

The finance is not project specific.

36

2) COST OF DEBT (Kd) The cost of debt measure the combination of interest rates changed by banks to the company and the return paid by the company on any corporate bonds or other loan instruments issued. It is standard practice to conceive of this as being made up of a risk free component and a company specific risk premium.

We use the after tax cost of debt because interest payments are tax deductible for the firm.

Kd after taxes = Kd (1-tax rate)

EXAMPLE

A company raised a debt of Rs 1, 00,000 on 1.1.2001, issue expressed Rs. 10,000, interest rate 20 per cent, debt repayable in five equal installments with interest issue expenses allowed out of taxable income of first year, interest allowed as deduction out of taxable income of relevant year. Tax rate 50 per cent. Cash flows as follows.

01.01.2001 10,000)

Rs.90, 000 inflow (Received Rs. 1, 00,000 as loan minus issue expenses Rs.

31.12.2001

Rs. 25000 outflow (Repayment Rs. 20,000 plus interest Rs. 20,000 minus tax Saving on issued expenses Rs. 5,000 minus tax saving on interest Rs.10,000

31.12.2002

Rs.28, 000 outflow (Repayment Rs. 20,000 plus interest Rs.16,000 minus tax Saving on interest Rs.8,000)

1.12.2003 31.12.2004

Rs. 26,000 outflow (Repayment plus interest minus tax saving on it) Rs.24, 000 outflows do37

31.12.2005

Rs. 22,000 Outflow do-

Here cost of capital is that discount rate at which present value of all future cash outflows (Rs.25, 000 of 31.12.2001, Rs. 28,000 of 31.12.2002, Rs. 26,000 of 31.12.2003, Rs. 24,000 of 31.12.2004 and Rs.22, 000 of 31.12.2005) would be equal to Rs. 90,000. Finding of this rate Involves following steps.

(i) Find fake payback period on the basis of average cash outflows. Average cash flow= (25,000 +28,000+26,000+22,000) divided by 5= Rs 25,000.Fake payback period = 90,000/25000 = 3.60

(ii) Locate the figure of fake payback period in annually table against loan repayment period which is 5 years in this example. The corresponding rate is 12 per cent.

(iii) Discount future cash flows at the rate locate under (ii) if the present value of future cash flows is more than net cash inflow at the time of raising the loan (i.e. Rs.90, 000 in this example) discount future cash flows at higher rate than the rate located under (ii) if the present value of future cash flows is less than net cash inflow at the time of raising the loan, discount the future cash flows at a rate lower than the rate located under (ii) above.

Present value of future cash flows at 12 percent. 25,000 * .893 28,000* .797 26,000* .712 24,000* .636 22,000*. 567 90,891

38

As present value of future net cash outflows is more than net cash flow at the time of raising the loan, we shall go for a higher rate. Late the rate be 17 per cent. 25,000*.855 28,000*.731 26,000*.624 24,000*.534 22,000*.456 80915

(iv) Cost of debt Lower rate NPV =Lower rate + Lower rate NPV Higher rate NPV * Diff. in rates

-891 = 12 + -891- 9085 *5 = 12.45 per cent

There are three difference situations regarding computations of cost of debt. (1) Irredeemable debts. (2) Debts redeemable after certain period in lump sum, (3) Debts redeemable in installments. The above explained method of calculation of cost of debt is quite lengthy and

39

complicated. It is unavoidable in third situation, i.e. debts redeemable in installments. In first two situations, almost similar results can be obtained by simple formula given below.

Irredeemable debt: Annual Interest (1 Tax rate) Cost of debt = Net proceeds of debt * 100

Debt redeemable after certain period : (RV NP) Annual int. (I -- T) + N Kd = NP + RV * 100

Kd = Cost of debt T = Tax rate RV = Redeemable value of debt NP = Net proceeds of debt issue N = Term of debt, i.e., numbers of years for which debt would be outstanding after issue.

Duration of Cost of Debt

40

160 140 120 100

Duration
80 60 40 20 0 1 2 3 4 5 6 7 8

3) COST OF PREFERRED STOCK (Kp) Preferred Stock has a higher return than bonds, but is less costly than common stock. WHY? In case of default, preferred stockholders get paid before common stock holders. However, in the case of bankruptcy, the holders of preferred stock get paid only after short and long term debt holder claims are satisfied. Preferred stock holders receive a fixed dividend and usually cannot vote on the firms affairs Preferred stock dividend Kp = Market price of preferred stock

<OR if issuing of new preferred stock

Preferred stock dividend Kp = Market price of preferred stock (1- flotation cost) 41

Unlike the situation with bonds, no adjustment is made for taxes, because preferred stock dividends are paid after a corporation pays income taxes. Consequently, a firm assumes the full market cost of financing by using preferred stock. In other words, the firm cannot deduct dividends paid as an expenses, like they can for interest expenses.

Example If cowboy Energy Service is issuing a preferred stock at $100 per share, with a stated Dividend of $ 12, and a flotation cost of 3% then:

Preferred stock dividend Kp = Market price of preferred stock (1- flotation cost)

$ 12 = $100 (1-0.03) =12.4 %

Note: No tax adjustment is needed since preferred dividends are paid from after-tax income.

4) COST OF EQUITY (i.e. Common Stock & Retained Earnings) The cost of equity is the rate of return that investors require to make an equity investment in a firm. Common stock does not generate a tax benefit as debt does because dividends are paid after taxes.

42

The cost of common stock is the highest Why?

Retained earnings are considered to have the same cost of capital as new common stock. Their cost is calculated in the same way, EXCEPT that no adjustment is made for flotation costs.

The capital asset pricing model (CAPM) is used to determine the cost of equity, rE, applying the following equation.

Flotation costs (F) are not part of capital budgeting CFS. Thus, if existing shareholders finance Project using new equity, they require a higher return to cover this cost Ke >Ks

If PO = $ 50 and F = 15 % of issue price , then additional cost per share = (50) (15%) = $7.5 %

Example: Given:

Calculating Component Cost of New Equity

F = 15% of issue price, Dividend = 4.19, g = 5%, PO = $50%

Ke =?

Solution:

Using equation (4), Chapter 7, and including F, we have: Accounting vs. Financial / Economic Valuation

Ke =

Dividend1 Net Value of new equity per share

+g

43

Dividend 1 Issue price floatation cost

+g

Dividend 1 P0 - (P0) (F)

+g

Dividend0 * (1 + g) P0 (1 - F)

+g

$4.19 * (1.05) $50 (1- .15)

+ .05

= 15.4%

3 Ways to Calculate 1. Use CAPM 2. (GORDON MODEL) The constant dividend growth model same as DCF method 3. Bond yield plus risk premium

1.

Ks using CAPM (capital asset pricing model)

The CAPM is one of the most commonly used ways to determine the cost of common stock The cost is the discount rate for valuing common stock, and provides an estimate of the cost of issuing common stock.

44

Ks =

Where: Krf is the risk free rate

is the firms beta

Km

is the return on the market

EXAMPLE

Cowboy Energy Services has a B = 1.6. The risk free rate on

T-bills are currently 4% and the market return has averaged 15%

Ks = Krf +

(Km- Krf)

= 4 + 1.6 (15 -4) = 21.6%

Thus in the standard CAPM there are three determinants of the expected return on any asset the return on a riskless asset; the market premium over that riskless rate that is earned by investors as a whole. reflecting systematic risk; and the particular companys exposure to systematic risk. As discussed further below, company specific risk do not enter the cost of capital, as they can, by definition, be diversified away by investors.

45

2. DCF Approach: Given: dividend 0 = & 4.19, g= 5%, p0 = $ 50 Ks=? Solution:

From equation (4) chapter 7, we have: Ks = Dividend1 P0 +g

Dividend0 * (1 + g) + g P0

4.19

(1.05) $50

+ .05

0.088 + 0.05 =

13.8 %

You can use the average of these two approaches = 14%.

WACC: PUTTING IT ALL TOGETHER

RECALL:

WACC = Wd (Cost of debt after tax) + Ws (Cost of stock / RE) + Wp (Cost of PS)

46

EXAMPLE Cowboy Energy Services maintains a mix of 40% debt, 10% preferred stock, and 50% common Stock in its capital structure. The WACC is:

WACC = 0.4(6%) + 0.1 (12.4) + 0.5(21.6) = 2.4 + 1.24 + 10.8 = 14.4 % Reminder: Read the article Best practices In Estimating the cost of capital: Survey and synthesis. It provides excellent information on how some of the most financially sophisticated companies and financial advisers estimate capital costs.

The Gordon growth model If a large proportion of earnings is retained and reinvested now rather than being paid out as dividend then the company will grow. Thus by forgoing dividends now the shareholders will receive higher dividends in future.

Estimating growth from the Gordon model If given profit and loss and balance sheet information growth can be estimated as follows. First we calculate the retention or plough back rate from the profit and loss account. (If 100% profit is retained = 100 % retention rate)

Retention rate = retained profit Profit after tax

* 100

Secondly we calculate the return on capital employed (ROCE) from the profit and loss account and balance sheet (as normally done in Ratio analysis or interpretation of Accounts)

47

ROCE = Profit after tax

* 100%

Opening net assets Finally, multiply the two ratio together to estimate dividend growth, g = retention rate * ROCE

Limitation of this method The accounting ratios calculated are assumed to remain constant over time (which is illogical in reality) The model uses accounting data (which can be manipulated to suit management objectives) The model only works correctly if the company is all equity finances (assumes the company has no debt, this is not practical in most cases)

Determine the weights to be used

My example above gives you the weights to use in calculating the WACC. How do you calculate the weights yourself? The firms balance sheet shows the book values of the common stock, preferred stock, and long-term bonds. You can use the balance sheet figures to calculate book value weights. though it is more practicable to work with market weights. Basically, market value weights represents current conditions and take into account the effects of changing market condition and the current prices of each security. Book value weights, however , are based on accounting procedure that employ the par values of the securities to calculate balance sheet values and represents past conditions. The table on the next page illustrates the difference between book value and market value weights and demonstrate how they are calculated.

48

Value

Dollar Amount

Weights or % of total value

Assumed cost of capital (%)

Book value Debt 0 2,000,00 40.4 10

2,000 bonds at par, or $ 1000 Preferred stock 4,500 shares at $ 100 par value 450,000 9.1 12

Common equity 500,000 shares outstanding at $ 5.00 per value Total book value of capital

2,500,00 0

50.5

13.5

4,950,00 0

100

11.24 is the WACC

Market value 1,800,00 0 30.2 10

Debt 2,000 bonds at $ 900 current Market price

405,000 Preferred stock 4,500 shares at $90 current market price 3,75,000 Common equity 5,00,000 shares outstanding at $ 75 current market

6.8

12

63.0

13.5

Total market value of capital

5,955,00 0

100

What is the WACC?

49

Note that the book value that appear on the balance sheet are usually different from the market values. Also, the price of common stock is normally substantially higher than its book value This increases the weight of this capital component over other capital structure components (Such as preferred stock and long term debt). The desirable practice is to employ market weights to compute the firms cost of capital. This rationale rests on the fact that the cost of capital measures the cost of issuing securities stocks as well as bonds to finance projects and that these securities are issued at market value, not at book value.

Target weights can also be used. These weights indicate the distribution of external financing that the firm believes will produce optimal results. Some corporate managers establish these weights subjectively, others will use that best companies in their industry as guidelines and still others will look at the financing mix of companies with characteristics comparable to those of their own firms. Generally speaking, target weights will approximate market weights. If they dont, the firm will attempt to finance in such a way as to make the market weights move closer to target weights.

Hurdle rates: Hurdle rates are the required rate of return used in capital budgeting. Simply put, hurdle rates are based on the firms WACC. To understand the concept of hurdle rates, I like to think of it this way. A runner in track jumps over a hurdle. A project the firm is considering must Jump the hurdle or in other words exceed the firms borrowing costs (i.e. WACC). If the project does not clear the hurdle, the firm will lose money on the project if they invest in it and decrease the value of the firm. The hurdle rate is used by firms in capital budgeting analysis (one of the next topics we will be studying). Large companies, with divisions that have different levels of risk, may choose to have divisional hurdle rates.

50

Divisional hurdle rates are sometimes used because firms are not internally homogeneous in terms of risk. Finance theory and practice tells us that us that investors require higher returns as risk increase. For example, do the following investment projects have the same level of risks? Engineering projects such as highway construction, market-expansion projects into foreign market, new product introductions, E-commerce startups, etc.

Breakpoints (BP) in the WACC: Breakpoints are defined as the total financing that can be done before the firm is forced to sell new debt or equity capital. Once the firm reaches this breakpoint, if they choose to raise additional capital their WACC increases. For example, the formula for the retained earnings breakpoint below demonstrates how to calculate the point at which the firms cost of equity financing will increase because they must sell new common stock. (Note: The formula for the BP for debt or preferred stock is basically the same, by replacing retained earnings for debt and using the weight of debt.)

BPre = Retained earnings Weight of equity Example: Cowboy Energy Services expects to have total earnings of $840,000 for the year, and it has a policy of paying out half of its earnings as dividends. Thus the addition to retained earnings will be $420,000 during the year. We now want to know how much total new capital debt preferred and retained earnings can be raised before the $420,000 of retained earnings is exhausted and the company is forced to sell new common stock. We are seeking the amount of capital which represents the total financing that can be done before Cowboy Energy Services is forced to sell new common stock to maintain their target weights in their WACC, Lets assume

51

that cowboy Energy services maintains a capital structure of 60% equity, 40% debt. Using the formula above. BPre = Retained earnings Weight of equity

= $420,000/0.60 = $700,000

Thus, Cowboy Energy Services can raise a total of $700,000 in new financing, consisting of 0.6 ($700,000) = $ 420,000 of retained earnings and 0.40($700,000) = $280,000 of debt, Without altering its capital structure. The BPre = $700,000 is defined as the retained earnings break point or the amount of total capital at which a break, or jump, occurs in the marginal cost of Capital. Can there be other breaks? Yes, there can depending on if there is some point at which the firm must raise additional capital at a higher cost.

52

CONCLUSION
The careful approximation of a firms specific financing and WACC is essential to good financial management. When the WACC is applied to specific investment decisions, it can make the difference between accretion and erosion of shareholder value. This chapter develops an alternative approach to discounted cash flow valuation. The cash flow to the firm are discounted at weighted average cost of capital to obtain the value of the firm, which when reduced by the market value of outstanding debt, yields the value of equity. Since the cash flow to the firm is a cash flow prior to debt payments, this approach is more straightforward to use when there is significant leverage or when leverage changes over time, though the weighted average cost of capital, used to discount free cash flow to the firm, has to be adjusted for changes in leverage. Finally, the cost of capital can be estimated at different debt ratios and used to estimate the optimal debt ratio for the firm. The alternative approach to the firm valuation is the APV approach, where we add the effect on value of debt (tax benefits bankruptcy costs) to the unlevered firm value. This approach can be used to estimate the optimal debt ratio for the firm.

Traditionally, researchers in finance and accounting have used measures of risk, such as , Which use realized returns to infer risk? Inferring cost of capital from realized returns has been Problematic because the correlation between expected returns and realized returns is weak (Elton, 1996). This has led to attempts to infer the implied cost of capital using an ex-ante approach that essentially solves for the discount rate that equates current stock price to present value of expected future dividends. While implied cost of capital metrics have been shown to have a strong correlation with other risk factors, they display weak correlations with realized returns This weak correlation has been the subject of much research [see Easton and Monahan (2005) amongst others]. The general conclusion has been to attribute the lack of association. 53

Either to the fact that realized returns are affected by future events that are not predictable, or to Inadequacies of the valuation models used to calculate the implied cost of capital. Our paper is focused on identifying another source of such low correlation, notably the error in measuring market expectations. Prior research has shown that analysts systematically make prediction errors and the market recognizes this [see Hughes, Liu and Su (2008)]. Hence analysts forecasts are often poor proxies for the markets expectations. To the extent these forecasts are biased or error-prone, so will be the implied cost of capital. We focus on the implied cost of capital estimates derived from the abnormal earnings growth model or OJ model developed in ohison and Juettner-Nauroth(2005). The OJ model provides an elegant closed form solution for the implied cost of capital that is strongly correlated in the expected direction with other risk factors, but shows the weakest correlation with realized returns. We test to see whether adjusting analysts forecasts for predictable errors improves the association between implied cost of capital and realized returns. The main contribution of the this paper is to show that adjusting the analyst forecasts by removing predictable errors leads to a dramatically improved association between implied cost of capital and realized returns. While there will always be a large unpredictable component to realized returns due to economic surprises. It is reassuring to know that the theoretical relationship between ex-ante risk and realized returns holds up when one takes careful measures to remove predictable errors in analyst forecast to get a better estimate of market expectations. Our paper shows that if a stock looks too cheap relative to analyst earnings forecasts, then the explanation may not be high perceived risk but high perceived errors in analyst earnings forecasts. One can then use the factors identified in prior research to adjust the analyst forecast to get a better handle on market perceptions. We also identify another way of assessing if the analyst forecasts are biased. An abnormally high cost of capital can itself be an indicator of overly optimistic analyst forecasts. When we use the implied cost of capital as an additional variable to de-bias the analyst forecasts, the resulting adjusted

54

implied cost of capital shows an even higher association with realized returns. At the portfolio level, we obtain almost identical spreads across quintiles of expected returns and realized returns. One implication of our results is that is unlikely that the weak relationship between risk and return shown in prior research is driven by inadequacies in the OJ valuation model. Future research can improve these estimates even further through more exhaustive or sophisticated methods of removing known biases from analyst earnings forecasts. Further research can also test whether similar dramatic improvements can be observed for implied cost of capital estimates from other valuation models.

55

RECOMMENDATION
The cost of capital should be estimated as the Weighted Average cost of Capital (WACC) using the CAPM to estimate the cost of equity. Estimation will separate for cost of capital rates for fixed and mobile system. The calculations should be undertake any company in conjunction with the more thorough reviews of the cost of capital pricing methodology. The WACC should be stated in nominal terms. The WACC should be calculated on a pre-tax basis (converted from a post-tax basis), using the corporate tax rate. Calculations should be based on a partially divisionalised approach, where the business of Providing fixed service and temporarily services are treated separately. Calculation of the cost of debt as the sum of the risk free rate and a debt premium. The debt premium should be consistent with the adopted capital structure and credit rating. Use a benchmarking approach to estimate the debt premium, ensuring consistency with the maturity period of the government bond used to estimate the risk free rate if any. Cost of equity should be estimated as the expected return required by a well-diversified swedish investor. use historic returns as a starting point for the market risk premium. The historic estimates should be combined with estimates used by market analyst in Sweden to ensure that current market expectations are factored in. The historical mean return should be estimated to be in the range between the arithmetic and geometric mean.

56

The risk premium should be calculated for a time period of at least 50 years. Ideally, a judgment should be made on the basis of different time periods to ensure that the estimate is not too sensitive to the to the selected period. Beta should be estimated on the basis of daily observations using a time period of 1-3 years. One could begin by estimating beta over 1, 2 and 3 years. If the beta estimates are fairly stable, one should use 3 years. If they are not stable, One should use the shorter periods of either 1 or 2 years. If there are signs of serial correlation, use weekly observations instead of daily observations. Beta estimates should be compared with beta estimates for comparable operators.

57

LIMITATIONS
If youre going to value something based on its discounted cash flows, youre going to need a weighted average cost of capital (or an equity cost of capital) to apply to those cash flows. Duff and Phelps recently released a paper discussing the difficulty of determining the cost of capital in todays environment. Some of the problems they address. Treasury yields (the risk free rate in CAPM) are temporarily low due to liquidity concern and a fight to quality, understanding risk. It is difficult to decompose treasury yields into components of real return, inflation expectations, and reinvestment risk. The expected equity risk premium (ERP) has increased greatly (as evidenced by the massive decline in stock prices). However, they claim the equity risk premium ranges from 3.5% to 6.0% throughout the business cycle, which seems extremely low to me. We are not in a normal business cycle here. So I think the forward-looking ERP must be higher than 6%. Declines in financial stock and companies with high leveraged have outpaced the broader market, leading to a misleading beta calculation that implies risk has actually declined. Beta measures the covariance of a stocks returns with the markets returns. The market had become overweighed with financial stocks that dragged the index down as they declined. So if you compare a non-financial companys stock covariance to the pre-cash market versus its post crash covariance. It will appear to have decreased, leading to a lower beta. They recommend using a sum beta calculation to correct for this. Highly levered companies will probably be unable to sustain their debt loads going forward. The cost of capital needs to reflect likely changes to the capital structure over time. Alternative, you could use an approach like adjusted present value(APV) which separates out the value of the tax shields. Companies operating with substantial losses may not be able to take advantage of the tax shield. On interest in the period when it is paid. So the after-tax cost of debt capital may be inappropriate. 58

Their final recommendation is that any cost of capital calculation must also pass the inappropriate. The final recommendation is that any cost of capital calculation must also pass the reasonableness test. Most of these issues stem from the fact hat finance theory attempts to use past data to predict future performance. That becomes increasingly hard to justify during times of discontinuous change. Such as the one were experiencing now. For more information, the authors of this paper have published a practitioners guide to the cost of capital, available at amazon.

59

BIBLIOGRAPHY

BOOKS: Cost of Capital Cost of Capital Teaching Note (Case studies manual in corporate finance) Working Capital Management Module Cost of Capital Note Cost of Capital Applications & Examples (Fourth Edition book in Oct 2010) - ICAI Institute - Dr. J.B.GUPTA - Shannon P. Pratt and Roger J. Grabowski - Bodie, alex Kane 3rd edition book 2008 - Dr. Betty simkins

WWBSITE:

WWW.ICAI.ORG WWW.ICWAI.ORG GOOGLE BOOK GALLERIES.

60