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

2. 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

3. - Introduction to the cost of equity

4. 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)

5. 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.

6. 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

7. 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%

8. 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 % differs slightly from Nestlé’s global required return of %

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

10. 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

11. 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

12. 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

13. Introduction to the cost of debt

14. 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.)

15. Standard & Poor's ratings

16. Sample mapping of default probabilities to ratings

17. Weighted average cost of capital, or WACC

18. 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)

19. 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%

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