Cost Of Capital

The cost of capital is a term used in the field of financial investment to refer to the cost of a company's funds (both debt and equity), or, from an investor's point of view "the shareholder's required return on a portfolio of all the company's existing securities". !" #t is used to evaluate new pro$ects of a company as it is the minimum return that investors expect for providing capital to the company, thus setting a benchmar% that a new pro$ect has to meet. &or an investment to be worthwhile, the expected return on capital must be greater than the cost of capital.

Weighted average cost of capital

The '()) methodology, as defined below, is a widely accepted method for calculating the cost of capital. #t is understood by both the finance community and the industry, and is consistent with the methodology used by many regulators. The '()) for a company is a weighted average of the cost of debt and the cost of equity, with the weightings determined by the relative levels of debt and equity in the company's asset base* WACC = Cost of Debt x Gearing +Cost of equity x ( ! Gearing" The tax burden, to which operators are sub$ect to, due to the leverage effect that they cause, should be considered when calculating the weighted average cost of capital. Therefore, the post+tax '()) is* WACC = Cost of Debt x ( # t" x Gearing + (Cost of equity" x ( ! Gearing" Where$ t is the tax rate%

The weighted average cost of capital (WACC) of a firm simply refers to how much, on average, it costs the firm to raise money. That is, it is the average rate that the firm must pay on any new capital that it raises. The importance of the WACC is in its relation to the evaluation of projects.

The basis of determining WACC is to determine the costs of each of the individual sources of long term financing for the firm, weight those costs by the degree to which the firm uses the different sources, and simply add up the weighted costs.

This e uation is the same as saying! WACC " (percent of the firm that is e uity) times (cost of e uity) plus (percent of the firm that is debt) times (cost of debt)

&he gearing ratio The weighting used in the '()) formula is the company's gearing. The gearing is a measure of the ratio of debt to company value (the latter being equivalent to the sum of debt (,) and equity (-)) and is defined as* .earing / DE D + There are a number of ways to determine the gearing level, each with a direct effect on the cost of capital*

a) 0ased on boo% values* the gearing is calculated using the accounting value of the company's debt and equity. This is a transparent method, easy to chec% and audit. The downside with the use of boo% value is that it is not forward+loo%ing and does not reflect the company's true economic value. 0esides, boo% values are dependent on the operator's strategic and accounting policy and so they may vary substantially with changes in the accounting principles, provided general accounting rules are respected1 b) 0ased on mar%et values* the gearing can be calculated on the basis of the observed mar%et value of the company's debt and equity, namely its mar%et capitalisation, which in theory will reflect the true economic value of the company's capital structure. The mar%et value of equity can be obtained by multiplying the number

of shares with their current price. The mar%et value of debt can be difficult to obtain directly since besides bonds firms generally have other forms of non+traded debt, such as ban% debt. 2owever, boo% values can be converted into mar%et values by treating the entire boo% debt as one coupon bond. This coupon bond would be valued at the current cost of debt for the company. 2owever, the problem with the use of mar%et values is that they are dependent on several mar%et factors, namely volatility, investors' expectations and speculation and so they can be sub$ect to serious fluctuations, negatively affecting mar%et stability.
c" Opti'al or efficient gearing( is based on an opti'al capital structure defined by the regulator% &he reason for using this 'ethod is to ensure that fir's that over!borro) or borro) at too high a rate are not re)arded for this financial decision% &his efficiency ad*ust'ent can be done by ta+ing into account the capital structure of an efficient operator rather than the structure of actual operators%, -o)ever$ establishing an opti'al ratio is a sub*ective issue%

Determining the Costs of Financing #n order to determine the WACC, the costs of the individual sources of long term financing there are four sources of capital! $) %ebt &) 'referred (toc) *) Common (toc) +) #nternally generated funds (retained earnings)

Debt is money the company borro)s and has to pay interest on, $ust the same as we might borrow money from the ban%. The company will then have to pay interest each year which will be a set percentage of the amount they have borrowed. They need to ma%e these repayments no matter what, whether they ma%e a profit or not. 2owever the amount of debt doesn3t increase over time li%e the value of the company does.

,%, &he cost of debt The cost of debt reflects the cost the company has to sustain in order to get capital to finance its activity, either from financial institutions or through loans from other companies. #t corresponds to the weighted average of the costs of the various long+run loans of the company and it is strongly correlated to the current interest rate's level, the company's financial capacity and ris% and even to the country's fiscal policy. The cost of debt can be calculated using accounting data or the current loan boo% in order to derive the interest rate the company registers in its accounting boo%s. This is a transparent method, easy to audit, and that considers the costs the company actually paid. ( factor to be considered in calculating the cost of debt is to loo% at the firm3s credit ratings as an indication of borrowing costs. (nother method to ascertain the cost of debt is to calculate an efficient borrowing level. This could be done where firms over borrow or borrow at too high a rate and therefore the level of debt and associated interest cost are ad$usted bac% to an efficient level by the regulator so that the firm is not rewarded for this financial decision. (nother method to estimate the cost of debt is the following* )ost of ,ebt / 4is% &ree 4ate 5 )ompany 6pecific ,ebt 7remium The ris% free rate is analysed in more detail in chapter 8.9 of this document. The company specific debt premium increases with the company's gearing reflecting the company's higher financial ris%, considering that more cash flow needs to be generated in order to meet interest payments. #t can be obtained by observing published credit ratings 8 that specialist credit rating agencies assign to that company. (lthough it is more complex to calculate, this approach ensures that the cost of debt is forward+loo%ing and, therefore, avoids transitional effects, such as temporary holdings of debt

.quity is usually money obtained from selling shares in the company. (n investor will give the company money in return for a share of the company itself. The company is not usually obliged to ma%e any interest payments on this capital, but most will pay dividends to their shareholders depending on the profit they have made in a particular period. The shareholder also benefits from the value of the company (and hence the value of their shares) increasing over time.

Cost of equity
)ost of equity / 4is% free rate of return 5 7remium expected for ris% )ost of equity / 4is% free rate of return 5 0eta x (mar%et rate of return+ ris% free rate of

return) 'here 0eta/ sensitivity to movements in the relevant mar%et* 'here* Es The expected return for a security Rf The expected ris%+free return in that mar%et (government bond yield) s The sensitivity to mar%et ris% for the security RM The historical return of the stoc% mar%et: equity mar%et (RM-Rf) The ris% premium of mar%et assets over ris% free assets. The ris% free rate is ta%en from the lowest yielding bonds in the particular mar%et, such as government bonds. (or required rate of return for investors) can be calculated with the "dividend capitali;ation model", which is

The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. 6imilar to the cost of debt, the cost of equity is broadly defined as the ris%+ weighted pro$ected return required by investors, where the return is largely un%nown. The cost of equity is therefore inferred by comparing the investment to other investments (comparable) with similar ris% profiles to determine the "mar%et" cost of equity. #t is commonly equated using the )(7< formula =nce cost of debt and cost of equity have been determined, their blend, the weighted+ average cost of capital ('())), can be calculated. This '()) can then be used as a discount rate for a pro$ect's pro$ected cash flows.

*) Common (toc)! The main method used to calculate a cost of e uity capital for common stoc)!

,%/ Different 'ethodologies to calculate the cost of equity The second main component of the '()) formula is the cost of equity . -conomic theory has developed different approaches to calculate the cost of equity, for example the )apital (sset 7ricing <odel ()(7<), the ,ividend .rowth <odel (,.<), the (rbitrage 7ricing Theory ((7T), the &ama and &rench Three &actor <odel. 9 (ll these models share a common assumption about how investors ma%e financial decisions* investors are assumed to be able to reduce total ris%s by holding diversified portfolio. Total ris% is made up of two components* systematic (or undiversifiable) ris% and specific (diversifiable or idiosyncratic) ris%1 the former is a measure of how the value of an asset co+varies with the economy and cannot be diversified away by investors, since it usually has some impact on nearly all firms within the economy1 the latter is the ris% specific to a particular company that can be diversified away by investors and hence is not priced into investor3s required rates of return or cost of capital estimates. The different models are briefly analysed below. )(7< is also analysed in more detail in the next chapter.
3.4.1 The dividend growth model

The most common version of the ,.< assumes that a company will pay a dividend that grows at a constant rate over time, independent of any shoc% that might hit the economy. The cost of equity using the simplest ,.< version is* Re / D> (! 5 g) : P> 5 g 'here* Re / )ost of equity D> / The dividend paid at time ;ero P> / The current price of companies3 shares g / The expected growth rate of dividends The cost of equity is the discount factor that leaves investors indifferent between receiving the share price today and the stream of dividends that will accrue if they own the share. 'hile two of the three elements on the right hand side of the equation are easily observed, regulators using ,.< will have to form a view about investor3s expectations of future dividend growth (g).

,espite the difficulties a number of regulators have referred to results from the ,.< when estimating the cost of equity1 for example =44, =&'(T and =&.-<.
\ 3.4.2 The ar itrage !ri"ing theor#

The (7T assumes that the rate of return on any asset is a linear function of k factors (such as for example, the industrial production index, the short term real interest rate, the inflation rate and the default ris%). These factors should be common to all stoc%s and should be weighted by $%, which measures the sensitivity of security j to factor k. (s it will be shown in the next chapter, measuring beta and the factors is not straightforward, even under the )(7<. &or every additional factor introduced in the model the regulator would need to calculate an additional beta which leads usually to more practical problems than encountered when using the )(7<.
3.4.3 The "a!ital asset !ri"ing model

The )(7< is a one+factor model where systematic ris% is a function of the correlation between the returns to the firm and the returns to the stoc% mar%et. The model does not compensate investors for company specific ris%, but only for systematic ris%. The )(7< is the model most commonly used by regulators to estimate the cost of equity given that it has a clear theoretical foundation and its implementation is simple. 2owever there are different views on the use of this methodology among the finance practitioners mainly because of its simplifying assumptions
3.4.1 The dividend growth model

The most common version of the ,.< assumes that a company will pay a dividend that grows at a constant rate over time, independent of any shoc% that might hit the economy. The cost of equity using the simplest ,.< version is* Re / D> (! 5 g) : P> 5 g 'here* Re / )ost of equity D> / The dividend paid at time ;ero P> / The current price of companies3 shares g / The expected growth rate of dividends The cost of equity is the discount factor that leaves investors indifferent between receiving the share price today and the stream of dividends that will accrue if they own the share. 'hile two of the three elements on the right hand side of the equation are easily observed, regulators using ,.< will have to form a view about investor3s expectations of future dividend growth (g). ,espite the difficulties a number of regulators have referred to results from the ,.< when estimating the cost of equity1 for example =44, =&'(T and =&.-<.
3.4.2 The ar itrage !ri"ing theor#

The (7T assumes that the rate of return on any asset is a linear function of k factors (such as for example, the industrial production index, the short term real interest rate, the inflation rate and the default ris%). These factors should be common to all stoc%s and should be weighted by $%, which measures the sensitivity of security j to factor k. (s it will be shown in the next chapter, measuring beta and the factors is not straightforward, even under the )(7<. &or every additional factor introduced in the model the regulator

would need to calculate an additional beta which leads usually to more practical problems than encountered when using the )(7<.

.sti'ating the Cost of .quity under CA01

/% &he cost of equity (s illustrated in the previous chapter, the cost of equity reflects the return on equities (through dividends and through an increase in the value of shares) that is required to attract investors. ,espite its limitations, the )(7< approach is the methodology widely used by finance practitioners and regulators for determining the cost of equity. The cost of equity is a necessary input for the '()) calculation. The )(7< has a clear theoretical foundation and its implementation is relatively simple. #t asserts that the required rate of return on a ris%y asset is a function of the ris% free rate of return ( Rf) plus a ris% premium that reflects the return on a well+diversified portfolio of ris%y assets over the ris% free rate ( Rm ? Rf), scaled by the @betaA of the ris%y assetB* -(Rj) / Rf 5 j - (Rm) + Rf". &he ris+ free rate(rf" The ris% free rate is the expected return on an asset, which bears in theory no ris% at all C, i.e. whose expected returns are certain. #n practice, it is not possible to find an investment that is free of all ris%s. 2owever, freely traded investment+grade government bonds can generally be regarded as having close to ;ero default ris% and ;ero liquidity ris%. 'hen defining the ris% free rate, the relevant mar%et has to be chosen D. The relevant mar%et for the definition of the ris% free rate, may be confined to the domestic mar%et, although other country3s government bonds can also be used as a proxy for the ris% free rate. &he ris+ pre'iu' The mar%et ris% premium represents the additional return over the ris%+free rate that investors require as compensation for the ris% they expose themselves to by investing in equity mar%ets. #t is essentially a measure of investors3 appetite for ris% and it is a mar%et factor, rather than a company+specific factor. ,etermining the ris% premium can be a highly contentious issue in regulatory decisionma%ing because this forward+loo%ing measure is not directly observable. The tools available may be inadequate since they derive a forecast of what the ris% premium is expected to be based on actual equity returns rather than the premium that investors demand as compensation for investing in ris%y assets, which is the appropriate premium for the purposes of the )(7<. To estimate the ris% premium we can use ex+post estimations (based on historical investment returns) or ex+ante estimations (based only on forward+loo%ing considerations).
$istori"al eta

0eta estimates are generally obtained through regression analysis of historical evidence of the relationship between the company returns and the mar%et returns. Thus, for publicly traded firms betas can be estimated by regressing stoc%3s returns (4 j), including both dividends and price appreciation, against the mar%et returns (4 m)* 4j / a 5 b 4m 'here @aA is the #ntercept from the regression and bA is the slope of the regression, which corresponds to the covariance (4j, 4m) : EF (4m) and is the beta of the stoc%. There are a number of services that provide such estimates including Gondon 0usiness 6chool, 0loomberg, ,ata6tream, 6tandard H 7oor3s and Ialue Gine. 2owever, using historic returns to estimate future values of beta raises the question of what is the correct estimation period and frequency. #n respect to the estimation period, as we have seen before, the most recent period possible is li%ely to embody mar%et expectations about future returns. =n the other hand, the values of beta fluctuate over the business cycle. Therefore ta%ing only a recent period ris%s missing information and biasing the results, suggesting that betas should be calculated over as long a period as possible. There is therefore a trade+off between the relevance of the estimation period and the need for a sufficiently long time period to ensure the regression results are robust. <ost estimate services use period ranging from F to 9 years for the regression. The relevant frequency should be defined in order to have a data set of a reasonable si;e, which can generate a statistically significant estimate of the value of beta. ( beta calculated through regression analysis of historical information provides an approximation. 2owever, estimation errors are li%ely because betas may vary significantly over time. Therefore, the estimation of the relevant beta from historical information may need to be complemented with other forward+loo%ing approach.

2) Preferred Stock:

'referred stoc) is li)e a cross between debt and e uity as it is e uity that re uires a fi,ed dividend payment. The cost of preferred e uity is simply defined as the dividend yield on the stoc).

-et! dp" fi,ed annual preferred dividend. 'p"price of preferred rp"cost of preferred e uity

rp =

dp Pp

.ote that it is actually the net issuing price that should be used in this e uation. That is, the price of the preferred stoc) net of any flotation costs that would have to be incurred in order to issue new shares.

4.%ost of retained earnings&"ost of internal e'(it#

Jote that retained earnings are a component of equity, and therefore the cost of retained earnings (internal equity) is equal to the cost of equity as explained above. ,ividends (earnings that are paid to investors and not retained) are a component of the return on capital to equity holders, and influence the cost of capital through that mechanism.

Other practical proble's in esti'ating the cost of capital

2% 3ntroduction

There may occur circumstances in which the approaches Ksed to estimate the cost of capital cannot be used. This may be the case when the cost of capital of a non+listed firm has to be estimated1 in fact, when shares are not listed, there is no information available to estimate the company's beta. 6imilar types of problems may arise when a company has not issued debt securities, when a domestic financial mar%et is not mature enough to estimate the equity ris% premium reliably, or when the financial mar%et volatility raises concerns over the company specific parameters. 6ome alternative approaches that can be used in the aforementioned circumstances in order to alleviate the uncertainty of '()) estimation in the absence of sufficiently reliable information from the financial mar%et. #n all of these cases some additional measures can be adopted in order to avoid errors in '()) estimation. =ne option is to use good comparator companies and another one is to use the high:low+method and sensitivity analysis.

a) Comparator companies #n case some of the parameters of the '()) can not be estimated reliably as a consequence of data unavailability, a useful approach is to base the estimation of the parameters, or of the '()) itself, using comparator companies, as in the case of divisional '()) calculation. 'hen selecting companies, which have to serve as a comparison, the following aspects should be considered* The comparator company, or companies, should be comparable in si;e with the company being evaluated. The si;e can be measured for example in revenues or in total mar%et capitali;ation1 the latter is not applicable in case of unlisted firm. &urther, it is preferable that the comparator companies are selected from countries which are similar to the country of the relevant company, for example in terms of income per capita, as the ris% of telecom business is li%ely to differ depending on the income level of the country in which companies operate. #n fact, in countries with a higher income level, the use of a phone is li%ely to be less sensitive to changes in income, whereas in lower income countries, telephone services are li%ely to have higher income elasticity. The penetration rate could also be a criterion for selecting the most appropriate comparator companies. &or example, a low penetration rate could be an indication that phone services are used predominantly by businesses, since the urban population is li%ely to be more sensitive to the economy.

b) High/low scenario approach and sensitivity analysis The high:low scenario approach is useful when it is possible to produce various estimates, using different methods, but none of these estimates is clearly more reliable than the others. This is done in practice by identifying the highest and lowest level for each of the envisaged parameters and calculate a range of cost of capital outcomes. The main purpose of the high:low scenario approach is to average out errors made in individual parameter estimation. #n addition to the high:low scenario approach, sensitivity analysis could be used. This means that after ma%ing the best estimate of a parameter, one calculates the '()) using this best estimate. #n order to determine whether the '()) is vulnerable to errors in the estimation of this parameter, one can also use the highest and the lowest values of this parameter, produced in the analysis, and incorporate them in the '()) calculation as well and determine the effect on the '()). #f the effect is large, one should consider spending more time and effort to increase the reliability of the estimation of this one parameter. . Therefore ta%ing only a recent period ris%s missing information and biasing the results, suggesting that betas should be calculated over as long a period as possible. There is therefore a trade+off between the relevance of the estimation period and the need for a sufficiently long time period to ensure the regression results are robust. <ost estimate services use period ranging from F to 9 years for the regression. The relevant frequency should be defined in order to have a data set of a reasonable si;e, which can generate a statistically significant estimate of the value of beta. ( beta calculated through regression analysis of historical information provides an approximation. 2owever, estimation errors are li%ely because betas may vary significantly over time. Therefore, the estimation of the relevant beta from historical information may need to be complemented with other forward+loo%ing approach.