Cost of Capital Calculations - from Valuation Technologies

Section I. COST CONTRIBUTION FROM SOURCES OF CAPITAL Summary spreadsheet. Enter the market value of each source of capital, the cost of each source, compute total cost of capital. Save a case for later retrieval and analysis

Section II. COST OF CAPITAL - STOCK Use the Capital Asset Pricing Model to estimate the Cost of Capital for common stock. Enter Beta of your stock, expected returns to the stock market and riskless debt, compute cost of equity capital. You can copy cost of equity capital into summary spreadsheet.

Section III. COST OF CAPITAL - BONDS Enter coupon of bonds like yours, your marginal tax rate, compute cost of bond capital. You can copy cost of bond capital into summary spreadsheet.

Section IV. EFFECT OF LEVERAGE ON EQUITY BETA Enter current Beta, current Equity to Total Capital ratio, new Equity to Capital ratio, compute new Beta, with changed leverage. You can copy new Beta into Cost of Equity using Capital Asset Pricing Model.

Section V. EXPECTED RETURN TO STOCK WITH CONSTANT GROWTH As an alternative to the CAPM, you can compute the Cost of Equity Capital from the Gordon model. This approach assumes that the company's dividends will grow at a fixed rate indefinitely. A constant dividend growth rate is only possible if the growth rate is less than the riskless rate of return.

Section VI. STEPS IN PERFORMING A "WHAT IF?" ANALYSIS This section gives detailed instructions for computing Cost of Capital under various capital structures.

OVERVIEW

Computing the Cost of Capital is important to the management of a firm, to investors in the firm, and therefore to the Investor Relations Officer. Some uses:

1. Valuing the entire company, valuing the common stock.

2. Selecting internal projects that will add value for investors (owners) - avoiding value destroying projects

3. Determining value added by management. Is the current compensation package fair to management and shareholders?

4. Valuing mergers, acquisitions, and spin offs.

5. Evaluating planned changes in a firm's capital structure - selling bonds, retiring equity etc.

6. Understanding inadvertent changes in a firm's capital structure - Stock price rises, greater portion of capital is in stock, less in debt - Interest rates drop, bond prices increase, portion of capital from debt increases etc.

7. Estimating the effect on price of an announcement effecting earnings.

The Investor Relations Officer needs an understanding of Cost of Capital, its effects, and the firm's plans to control its capital costs. This knowledge is important in communicating with investors, and with other managers. Consider the following calculations:

1. Your company's Current Cost of Capital

2. Cost of Capital one year ago, two years ago - what is the trend?

3. Several scenarios for one year out - should investors be pleased?

4. Cost of Capital for your peers - how do you compare?

5. How do different Cost of Capital values effect total firm value and equity value, see our Discounted Cash Flow page.

6. How does your company's Economic Value Added compare with your peers? Economic Value Added as computed by Valuad.

I. COST CONTRIBUTION FROM SOURCES OF CAPITAL

First, let's assume you know the expected return to each of the assets that make up your firm's capital structure. Just enter the expected returns and the current market value of your sources of financing, Common Stock (Equity), Preferred Stock, Bonds and permanent short term borrowing.

The Expected Return to your Preferred Stock will be the preferred dividend (annualized dollars per share), divided by the current per share market price.

Since interest payments reduce corporate taxes, cost of debt needs to be corrected for the tax shield effect. The Expected Return to your bonds will be the coupon of bond of similar risk, selling at par, tax corrected, Section III. The Expected Return to short term borrowing will be the interest rate charged, tax corrected using the same shield rate as bonds.

For information on latest short term and corporate bond rates see the Federal Reserve.

Estimating the Expected Return to your stock is a little more controversial. Further down this page we will explore possible approaches. To use the Capital Asset Pricing Model, go to Section II.

To perform a "what if" calculation, changing your firm's capital mix significantly, you should consider the effect of leverage change on Equity Cost of Capital, Section IV.

The description below is to remind you of your analysis when you Restore.

The calculators below will fill in Stock value and Bond value.

I. A Equity Value

To get total current equity value, enter "Current Price" , and "Total Shares Outstanding" for your common and preferred stock; press "Common Market Cap" and "Preferred Market Cap" buttons; "Put Value of Common in C of C" and "Put Value of Preferred in C of C" to put the results into the Cost of Capital sheet.

I. B Bond Value

To compute total bond value, enter "Current Price as Percent of Par" for each issue, and "Total Par Value Outstanding" for each issue. Then press "Bond Market Cap" to compute total bond value. To put this value into the Cost of Capital calculation, press "Put Value of Bonds in C of C" button.

II. COST OF CAPITAL - STOCK

You can compute the Cost of Equity using the Capital Asset Pricing Model, or CAPM. In this model, the higher the risk associated with your stock, the higher the return investors demand. In the pure, or one factor, CAPM, the only risk that investors price is systematic, or market risk, measured with Beta. When you are ready to try the computed Expected Return to Your Company's Stock in the COST CONTRIBUTION FROM SOURCES OF CAPITAL, press the button labeled "Put Cost of Equity in C of C".

Data Downlink

BARRA's detailed explanation of the calculation of Beta

BARRA Beta

The CAPM is generally accepted as a good first approximation in computing the Cost of Capital, but is not the last word. We are trying to estimate the level of return needed to justify the current price. The CAPM assumes that the only characteristic of a company that matters is its market related risk. Studies have shown other factors that influence past return include the size of the company and the company's value versus growth position. The investors that directly influence your company's value are limited to current holders (since they can sell), and likely buyers. Thus for many firms, the expectations of a rather narrow group of investors determine price. A more refined determination of Cost of Capital considers the characteristics and behavior of current owners and likely buyers. For more information on factors that influence investors expectations, look at Targeting.

III. COST OF CAPITAL - BONDS

Next, let's look at Bonds - The return expected by a bond investor is today's coupon rate on a bond of similar maturity and risk, corrected for the probable costs of default. Since bond coupons are tax deductible, the cost to the firm is reduced by the tax shield, or the tax savings. Tax savings are based upon the marginal tax rate paid by the firm. When you are ready to try the computed Cost of Capital from Bonds in the COST CONTRIBUTION FROM SOURCES OF CAPITAL, press the button labeled "Put Cost of Bonds in C of C".

IV. EFFECT OF LEVERAGE ON EQUITY BETA

Changes in capital structure are reflected in the Section I. calculations in two ways. First, the percentage of each form of capital changes. Additionally, the Expected Return to each form of capital also changes. The most significant change is in Expected Return to common stock. As debt increases relative to common stock, the riskiness of the common increases, increasing the return required by investors. This section explores the effect of changing capital structure on the Cost of Capital contribution from common stock, aiding you in performing "what if?" analysis.

The Cost of Equity Capital calculation in Section II above assumes that you are not changing your capital structure, merely raising more capital in the current proportions. If your current capital structure is optimal, you would expect to keep it unchanged. However, practical considerations may make you change the capital mix. Issuing bonds or stock is expensive and time consuming, so most firms raise capital in relatively large, infrequent offerings, allowing the capital mix to drift. Changes in the capital markets, such as interest rate changes, or changes in the general level of stock prices may make you consider changing your capital structure.

If you choose to change the mix of equity relative to debt and preferred, you would expect the cost of equity to change. Of course the mix can change without any overt action on the firm's part. Changes in market price for your equity and debt will change the relative value in each form of capital. The more highly levered the company, resulting from less equity in proportion to the total firm's capitalization, the higher the risk of your stock. A simple calculation which approximates the effect of changing leverage is performed below. We first compute the Unlevered Beta, Beta of the company if it were fully financed with stock, then compute the new Beta, using the new leverage. When you are ready to try the computed New Beta in the COST OF EQUITY USING CAPITAL ASSET PRICING MODEL, press the "Put New Beta in CAPM" button.

The calculation of Beta with changed leverage above assumes that only stocks contribute to Beta, bonds have a zero Beta. A somewhat more realistic calculation recognizes that bonds have a Beta also, although smaller than a typical equity Beta. You can think of the total unlevered company as financed by a portfolio equity and debt. The unlevered company portfolio has a Beta computed by weighting the equity Beta and the debt Beta. The unlevered company Beta will now be somewhat higher than you got from the simple calculation above. Thus the effect of changing leverage on equity beta is somewhat lessened when bond beta is recognized.

Why should bonds have a Beta? Total return to a bond investor is, of course, the combination of coupon payments and price changes. The value of a long term bond will fluctuate with interest rates, as will the value of stocks. As interest rates go up, bond prices drop, reducing total return to the investor. Similarly, an increase in interest rates will reduce equity prices. Even though bonds and stocks may often move in opposite directions, the historical record shows a positive correlation between bond prices and stock prices, resulting in a positive Beta. An individual bond's Beta will depend upon its quality rating, years to maturity of the bond, and company leverage. Typical bond Betas range from 0.1 to 0.25. In this calculation, we recognize that bonds have a Beta greater than zero, but do not account for the change in bond Beta with leverage ( in most cases a minor effect). If you want to see the effect of bond Beta on unlevered Beta, enter a bond Beta (or leave the value at 0.15) and press the button "Compute Beta with Bond Beta".

V. EXPECTED RETURN TO STOCK WITH CONSTANT GROWTH

An alternative method to calculate the expected return to a company's stock, hence equity cost of capital, is based upon the Gordon formula for valuing a stream of dividends with a constant growth rate. Enter the current per share price, Current annual dividend, and annual rate of growth. Press the "Compute Expected Return" button to get the Equity cost of capital and the CAPM Beta implied by that Cost of Capital.

VI. STEPS IN PERFORMING A "WHAT IF?" ANALYSIS

Click on each of the links below in order. After completing each section, press the "Put.." button, then press "Back" on your browser to return to this list.

A. First, fill in current Cost of Capital, and save as a Case.

1.A Equity Value

1.B Bond Value

II. Cost of Capital - Stock

III. Cost of Capital - Bonds

1. Cost Contribution from Sources of Capital

B. Next, copy current leverage into Section IV

Under the Current Equity Percent Column, Press the "Copy from C of C"

IV. Effect of Leverage on Equity Cost of Capital

C. Modify mix of assets

1.A Equity Value

1.B Bond Value

1. Cost Contribution from Sources of Capital

D. Copy new leverage into Section IV, compute new Beta and Cost of Capital

Under the New Equity Percent Column, Press the "Copy from C of C" Then Press the "Compute Beta" and "Put New Beta into CAPM"

4. Effect of Leverage on Equity Cost of Capital

2. Cost of Capital - Stock

E. Compute new Cost of Capital, Save as a new Case

1. Cost Contribution from Sources of Capital