Chapter 17: Cost of Capital PDF

Chapter 17: Cost of Capital BASIC PRINCIPLES OF CORPORATE FINANCE M. Dallocchio and A. Salvi EGEA, 2023 Agenda 17 Introduction 17.1 General Principles 17.2 Methods for Estimating the Cost of Equity 17.3 Cost of Debt 17.4 Cost of Equity...

Chapter 17: Cost of Capital BASIC PRINCIPLES OF CORPORATE FINANCE M. Dallocchio and A. Salvi EGEA, 2023 Agenda 17 Introduction 17.1 General Principles 17.2 Methods for Estimating the Cost of Equity 17.3 Cost of Debt 17.4 Cost of Equity 2 Introduction  Alternative but perfectly equivalent assumptions about the cost of capital: “Cost of capital”: the return expected by investors for allocating their resources to the company, or as a cost to those it must finance. “Cost of capital”: the weighted average cost of the various resources that a functioning firm can draw on, which in turn is composed of the cost of equity and the cost of debt in non- complex corporate financial structures. “Cost of capital”: the minimum rate of return the company must earn on its investments to meet the expectations of its lenders, whether shareholders (cost of equity) or financial creditors (cost of debt).  Fundamentals of Cost of Capital Calculation: General principles Methods for estimating the cost of equity Cost of debt Cost of equity 3 Agenda 17 Introduction 17.1 General Principles 17.2 Methods for Estimating the Cost of Equity 17.3 Cost of Debt 17.4 Cost of Equity 4 General Principles (1/2)  The "cost of capital" is related to two types of risk: Volatility generated by the company's expected operating results. The driving force behind the volatility of operating risk is the incidence of fixed costs relative to the Operational company's operating cost structure and the cyclicality of the business. The greater risk the uncertainty about expected operating results, the greater the company's operating risk. It arises from the Company's reliance on debt in addition to equity. Financial risk is Financial related to the company's ability to repay borrowing costs and debt under a given risk financial structure. This risk falls primarily on the company and its shareholders, resulting in an increase in the minimum required rate of return.  The minimum expected joint return to financial creditors and shareholders is not affected by the composition of the financing structure, as it is solely a function of the firm's operational risk. 5 General Principles (2/2)  The cost structure (incidence of fixed and variable costs or operating leverage) and the cyclicality of the business are the main factors that contribute to defining the overall cost of capital, amplifying or dampening the volatility of operating cash flows.  Steps for constructing the cost of capital: (1) Operational risk analysis (2) Estimation of minimum required return from the set of financing sources (3) Financial structure decision (4) Estimating the cost of each financing source  It is important to note that the cost of capital is usually estimated indirectly, i.e., starting with an analysis of the cost of individual sources of financing, and then "combining" them to obtain a weighted average of the total cost of capital. 6 Agenda 17 Introduction 17.1 General Principles 17.2 Methods for Estimating the Cost of Equity 17.3 Cost of Debt 17.4 Cost of Equity 7  Methods for Estimating the Cost of Equity Direct Method  The minimum rate of return required by lenders to compensate them for the risk they collectively assume can be set equal to the rate of return that investors would earn by investing in "risk-free" assets, plus a risk premium that is a function of the operational risk of the business being conducted by the firm. k is the expected return from the set of 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 𝒐𝒐𝒐𝒐 𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪 = 𝒌𝒌 = 𝒓𝒓𝑭𝑭 + 𝒓𝒓𝑴𝑴 − 𝒓𝒓𝑭𝑭 × 𝜷𝜷𝑨𝑨 corporate lenders rF is the risk-free rate βD measures the rM is the market portfolio return correlation of debt yields to 𝜷𝜷𝑨𝑨 is the beta of the asset (beta asset o market yields. When debt unlevered) is low, it tends to zero. βA measures the correlation There is a relationship between the Company's between βAsset and βEquity in operating cash flows and that as the former increases, expected market cash the latter will also increase. βE measures the flows. correlation between its returns and those of the market portfolio. 8 Metodologia di stima del costo del capitale aziendale Metodo diretto  La formula di Hamada serva ad ottenere dato un βEquity (levered) un βAsset (unlevered). Tale formula è valida se sono soddisfatte 2 ipotesi: l’azienda può indebitarsi al tasso risk-free, a prescindere dalla sua struttura finanziaria sono assenti costi attesi del dissesto finanziario βE βA= 𝟏𝟏+ 𝟏𝟏−𝑻𝑻𝑻𝑻 𝑽𝑽𝑫𝑫/𝑽𝑽𝑬𝑬 La presenza di indebitamento e di correlato effetto leva porta ad avere un βEquity (L) > βAsset (U) 9  Methods for Estimating the Cost of Equity Indirect Method  The indirect method is based on estimating the cost of capital as a weighted average of the costs of the funding sources. k𝑬𝑬 is the cost of equity k𝒅𝒅 is the cost of debt 𝑽𝑽𝑬𝑬 𝑽𝑽𝑫𝑫 𝒌𝒌 = 𝑾𝑾𝑾𝑾𝑾𝑾𝑾𝑾 = 𝒌𝒌𝒆𝒆 + (𝟏𝟏 − 𝑻𝑻𝑻𝑻) 𝐤𝐤𝐝𝐝 VD is the market value of debt 𝑽𝑽𝑫𝑫 + 𝑽𝑽𝑽𝑽 𝑽𝑽𝑫𝑫 + 𝑽𝑽𝑽𝑽 VE is the market value of equity Tc is the corporate income tax rate  The cost of capital represents the "price" the company would have to pay to lenders if it were to refinance its debt, regardless of the historical cost of doing so and taking into account the company's operational risk. Estimate the value of the company's operating assets when debt levels Scope of are stable. Application To calculate the net present value of investment projects with a risk similar to the "average" risk of the company.  The cost of capital reflects the rate of return expected by investors. It is not an accounting concept and should 10 not be confused with actual or historical return on capital. Agenda 17 Introduction 17.1 General Principles 17.2 Methods for Estimating the Cost of Equity 17.3 Cost of Debt 17.4 Cost of Equity 11 Cost of Debt (1/5)  The IRR of debt represents the cost to the company expected by the lenders. It indicates the return expected by lenders. Implicit assumptions in IRR All "ancillary" operations carried out with the intermediate flows take place at the IRR itself. All the ancillary operations to refinance the outflows caused by the progressive repayment of the capital take place at a cost equal to the IRR of the main operation itself.  The cost-effectiveness of two or more fundraising efforts, both using debt, based on a comparison of their IRRs. The choice should be the one with the lowest IRR as long as it is lower than the return on investment. 1. Construct the cash flow profile of the financial operations under  Stages of financial analysis: consideration. 2. Calculate the IRR. 3. Compare the IRRs of the various alternatives and select the lowest TIM