Corporate Finance MLI28C060 Capital structure II: Cost of capital and its implications for capital raising Lecture 6 Monday 17 October 2016

Capital structure III: Cost of capital and its implications for capital raising Structure: - Introduction to the cost of equity - Introduction to the cost of debt - Weighted average cost of capital, or WACC. - Implications of capital raising domestic versus international Reading: Brealey & Myers: Chapter 9

- Introduction to the cost of equity

Cost of Capital in Segmented vs. Integrated Markets The cost of equity capital (Ke) of a firm is the expected return on the firm’s stock that investors require. This return is frequently estimated using the Capital Asset Pricing Model (CAPM): Ri = Rf + bi(RM – Rf) where bi= Cov(Ri , RM) Var(RM)

Cost of Capital in Segmented vs. Integrated Markets If capital markets are segmented, then investors can only invest domestically. This means that the market portfolio (M) in the CAPM formula would be the domestic portfolio instead of the world portfolio. Ri = Rf + bi (RU.S. – Rf) U.S. versus Ri = Rf + bi (RW – Rf) W Clearly integration or segmentation of international financial markets has major implications for determining the cost of capital.

Cost of Equity and Debt Cost of equity is calculated using the Capital Asset Pricing Model (CAPM) Where ke = expected rate of return on equity krf = risk free rate on bonds km = expected rate of return on the market β = coefficient of firm’s systematic risk The normal calculation for cost of debt is analyzing the various proportions of debt and their associated interest rates for the firm and calculating a before and after tax weighted average cost of debt

Worked Example: Trident’s WACC Maria Gonzales, Trident’s CFO, believes that Carlton has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations Where kWACC = weighted average cost of capital ke = Carlton’s cost of equity is 17.0% kd = Carlton’s before tax cost of debt is 8.0% t = tax rate of 35.0% E/V = equity to value ratio of Carlton is 60.0% D/V = debt to value ratio of Carlton is 40.0%

Nestlé: An Application of the International CAPM The process of calculating an international WACC differs from a domestic WACC in the selection of the appropriate market portfolio and beta Stulz (1995) suggests using a global portfolio of securities available to investors rather than the world portfolio of all securities (some of which may not be available to investors) when calculating a firm’s international cost of equity The next slide shows the domestic and international risk-free rates, market portfolios, and betas for Nestlé used to calculate required rates of return for equity In this example the domestic required return for Nestlé of 9.4065% differs slightly from Nestlé’s global required return of 9.3840%

Figure 3: Estimating the Global Cost of Equity for Nestlé (Switzerland)

Calculating Equity Risk Premia in Practice Using CAPM, there is rising debate over what numerical values should be used in its application, especially the equity risk premium The equity risk premium is the expected average annual return on the market above riskless debt Typically, the market’s return is calculated on a historical basis yet others feel that the number should be forward looking since it is being used to calculate expected returns

Calculating Equity Risk Premia in Practice The field of finance does agree that a cost of equity calculation should be forward-looking, meaning that the inputs to the equation should represent what is expected to happen over the relevant future time horizon As is typically the case, however, practitioners use historical evidence as the basis for their forward-looking projections

Market Segmentation Capital market segmentation is a financial market imperfection caused mainly by government constraints, institutional practices, and investor perceptions Other imperfections are Asymmetric information Lack of transparency High securities transaction costs Foreign exchange risks Political risks Corporate governance differences Regulatory barriers

Introduction to the cost of debt

Estimating the Cost of Debt For developed countries, the target’s local or the acquirer’s home country cost of debt. For emerging countries, the cost of debt ( ) is as follows: where Rf = Local risk free rate or U.S. treasury bond rate converted to a local nominal rate if cash flows are in the local currency; if cash flows in dollars, the U.S. treasury rate CRP = Specific country risk premium expressed as difference between the local country’s (or a similar country’s) government bond rate and the U.S. treasury bond rate of the same maturity FRP = Firm’s default risk premium (i.e., additional premium for similar firms rated by credit rating agencies or estimated by comparing interest coverage ratios used by rating agencies to the firm’s interest coverage ratios to determine how they would rate the firm.)

Standard & Poor's ratings

Sample mapping of default probabilities to ratings

Weighted average cost of capital, or WACC

Weighted Average Cost of Capital Where kWACC = weighted average cost of capital ke = risk adjusted cost of equity kd = before tax cost of debt t = tax rate E = market value of equity D = market value of debt V = market value of firm (D+E)

Worked Example: Carlton’s WACC Carlton’s CFO, believes that Carlton has access to global capital markets and because it is headquartered in the US, that the US should serve as its base for market risk and equity risk calculations Where kWACC = weighted average cost of capital ke = Carlton’s cost of equity is 17.0% kd = Carlton’s before tax cost of debt is 8.0% t = tax rate of 35.0% E/V = equity to value ratio of Carlton is 60.0% D/V = debt to value ratio of Carlton is 40.0%

Figure 2: Calculation of Trident’s Weighted Average Cost of Capital