Cost of Equity

9 Key excerpts on "Cost of Equity"

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  eBook - PDF

  Finance for Strategic Decision-Making

  What Non-Financial Managers Need to Know

  • M. P. Narayanan, Vikram K. Nanda(Authors)
  • 2004(Publication Date)
  • Jossey-Bass

    (Publisher)

  In such years, the cost of debt will equal the rate charged by investors. Cost of Capital 59 Estimating Cost of Equity Unlike the cost of debt, the Cost of Equity is not specified con-tractually, for the simple reason that there cannot be a contract between the company and its legal owners. The owners simply receive what is left over after paying all claimants. With no con-tract, we have to estimate the Cost of Equity. We know that the Cost of Equity is essentially what the stockholders can expect to earn from alternative investments of the same risk. The lower bound on the Cost of Equity is clearly the risk-free rate, which would apply to a company with no risk at all. Therefore, the Cost of Equity of a company can be written as: Cost of Equity 5 Risk-free rate 1 Risk premium. It is customary to use the ten-year Treasury bond yield as a proxy for the risk-free rate. What about the risk premium? One can view a stock’s risk as made up of two components: one due to factors idiosyncratic to the company and another due to economy-wide factors. Ex-amples of factors that contribute to idiosyncratic risk include variations in management skills, risk of labor disputes, and risks due to inadequate operating systems (involving manufac-turing, customer service, information technology, and so on). Risks due to economy-wide factors include things such as cus-tomer confidence or recession that affect the demand for a com-pany’s product. This type of risk is also called the market risk. One might reasonably assume that stockholders would want a premium for bearing both idiosyncratic and market risks. While this is true in general, it is not true for stockholders who are well diversified. These stockholders do not bear the idiosyn-cratic risks of the companies whose stocks they own because they can diversify away these risks. The only risk that they bear is the market risk. Therefore, well-diversified investors demand

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  The Cost of Capital

  • E. Porras(Author)
  • 2010(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  The implicit cost of capital of funds raised and invested by the firm may, therefore, be defined as the rate of return of the best company project, stockholder investment opportunity, or stock- holder consumption opportunity that would be foregone, if the project pres- ently under consideration were accepted. For example, if we realize a firm can always purchase its own shares in the market, this constitutes one such opportunity, with a cost equivalent to the rate of return on the repurchased shares. 66 The Cost of Capital The fact that the primary duty of managers is to maximize the value of the company for its owners means they must look for a structure that mini- mizes the overall cost of the financial resources. Wealth is maximized because valuing future cash flows to the firm or shareholder requires the discounting of those cash flows, and the smaller the divisor, the larger the present value. In addition, the wealth maximization criterion fulfils the objective of disregard- ing individual preferences, as shareholders can adjust their income streams to their own consumption choices. How to estimate the weighted average cost of capital (WACC) A review of a typical balance sheet will provide an example of how to esti- mate the WACC. However complicated the formula looks, in reality it is just a weighted addition of the capital structure components. The model is concerned with determining the components of the structure, their relative weights and the future cost of each source of capital.

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  Understanding Financial Management

  A Practical Guide

  • H. Kent Baker, Gary Powell(Authors)
  • 2009(Publication Date)
  • Wiley-Blackwell

    (Publisher)

  This is consistent with the higher risk of preferred stock compared with bonds. Types of Common Equity The cost of common equity is the minimum rate or return required by investors to buy a firm’s common stock. Compared to estimating the cost of bonds, estimating the cost of common equity is more difficult because common equity does not represent a contractual obligation to make specific payments. The required return is an opportunity cost based on returns that investors can expect from alternative investments of equal risk. Unfortunately, no direct way exists to observe these returns. Therefore, measuring the cost of common equity requires using various estimation procedures. The choice of the appropriate method depends primarily on the type of information available for a given situation. 7 As an alternative, the compounded annual cost would be (1 + 0.02105) 4 − 1 = 0.08690 ≈ 8.69 percent. RAISING FUNDS AND COST OF CAPITAL 351 Companies can raise common equity in two ways: (1) internally by retaining earnings and (2) externally by selling new shares. Most mature firms rely on internally generated equity and raise only a small percentage of all new corporate funds from external equity markets. Due to flotation costs, the cost of raising new equity capital in the market is more expensive than that of retaining earnings. Thus, firms typically use lower-cost retained earnings before they issue more costly new common stock. Cost of Existing Equity Various models are available for estimating the cost of existing equity or retained earnings. The opportunity cost of retained earnings does not differ from that of other existing equity accounts such as common stock or capital in excess of par. We focus on three models to estimate the cost of existing equity: (1) capital asset pricing model (CAPM), (2) dividend discount model (DDM), and the bond-yield-plus-risk-premium approach.

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  Fundamentals of Corporate Finance

  • Robert Parrino, David S. Kidwell, Thomas Bates, Stuart L. Gillan(Authors)
  • 2021(Publication Date)
  • Wiley

    (Publisher)

  How do taxes affect the cost of debt? LEARNING OBJECTIVE 3. Calculate the cost of common stock and the cost of preferred stock for a firm. The Cost of Equity (stock) for a firm is a weighted average of the costs of the different types of stock that the firm has outstanding at a particular point in time. We saw in Chapter 9 that some firms have both preferred stock and common stock outstanding. In order to calculate the Cost of Equity for these firms, we have to know how to calculate the cost of both common stock and preferred stock. In this section, we discuss how financial analysts can estimate the costs associated with these two different types of stock. Common Stock Just as information about market rates of return is used to estimate the cost of debt, market information is also used to estimate the Cost of Equity. There are several ways to do this. The particular approach a financial analyst chooses will depend on what information is available and how reliable the analyst believes it is. In this section we discuss three alternative methods for estimating the cost of common equity (stock). It is important to remember throughout this discussion that the “cost” we are referring to is the rate of return that investors require for investing in the stock at a particular point in time, given its systematic risk. Method 1: Using the Capital Asset Pricing Model (CAPM) The first method for estimating the cost of common equity is one that we discussed in Chapter 7. This method uses Equation 7.12: E(R i ) = R rf + β i [E(R m ) − R rf ] In this equation, the expected return on an asset is a linear function of the systematic risk associated with that asset as measured by beta.

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  Financial Valuation

  Applications and Models

  • James R. Hitchner(Author)
  • 2017(Publication Date)
  • Wiley

    (Publisher)

  Often a business enterprise—particularly in the small and midsize markets—is focused on the benefit stream and growth potential variables, while too often the risk is left to chance. Assuming no change in the first two variables, reducing the risk attributes of a business will increase its value. 186 FINANCIAL VALUATION The cost of capital is also referred to as the discount rate. It equals the total expected rate of return for the investment—that is, dividends or withdrawals, plus expected capital appreciation over the life of the investment. This rate can be applied to the appropriate income or cash flow stream of a company to estimate the company’s present value. ValTip Identifying the value drivers of an enterprise and developing action steps to limit or reduce controllable (e.g., internally oriented versus external) risks can be of great benefit to many closely held businesses in terms of increasing their value. The value of a company can be expressed as the present value of the future economic benefits expected to be generated by the company. This value can be either for equity, in which case the future benefits are those directly to equity and an equity discount rate must be used, or for the overall company, including its debt, in which case a weighted average cost of capital (WACC) must be used. ValTip The cost of capital reflects investors’ return expectations, which are essentially composed of a risk-free rate and a risk premium: 1 ■ The risk-free rate captures a rental rate, inflation, and maturity risk. The rental rate represents a real return for lending funds free of default risk and forgoing current consumption. Inflation and inflation risk represent expected inflation and the risk that expected inflation will increase. Maturity risk represents the risk that the investment’s principal market value will change during the period to maturity as a function of changes in interest rates.

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  The Cost of Capital

  Theory and Estimation

  • Cleveland S. Patterson(Author)
  • 1995(Publication Date)
  • Praeger

    (Publisher)

  2 Theoretical Models for Estimating the Cost of Equity Capital In this chapter, we take the business risks and financial risks of a firm as given and look at several models for estimating k e , the equity investors' required rate of return, or opportunity cost of common equity capital. I. MODEL CLASSIFICATION The models that have been developed in the academic literature and/or that are used in practice to estimate k e can be classified into a number of categories according to their underlying logic and assumptions. These are summarized in Figure 2.1. On the left-hand side are a variety of accounting-based approaches that use historical averages of a firm's own earned returns as indicators of required returns on common equity or, more commonly, employ average ac- counting returns for groups of firms considered to have a similar degree of risk. The latter approach, usually referred to under the rubric of "comparable earn- ings," has been widely used over many years in public utility regulatory hear- ings. As discussed in Chapter 6, this method has the trappings of an opportu- nity cost in the sense of looking to the earnings of alternative investments but suffers seriously from a variety of theoretical and practical difficulties. The opportunity cost of capital, properly defined, relates to opportunities available to investors in capital markets. The right-hand branch of Figure 2.1 20 The Cost of Capital Figure 2.1 Classification of Cost of Capital Models shows several methods grounded in this concept. It is useful to classify them into two groups, which complement each other. First are those models, labeled "explicit," which build up an estimate of k e from separately estimated compo- nents chosen according to a given theory of equilibrium pricing in capital mar- kets. Generally, these models take the form of combining an estimate of the observed risk-free rate (NRFR) with one or more risk premiums based on the underlying theory.

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  Fundamentals of Finance

  Investments, Corporate Finance, and Financial Institutions

  • Mustafa Akan, Arman Teksin Tevfik(Authors)
  • 2020(Publication Date)
  • De Gruyter

    (Publisher)

  A simple approach will be described as follows: – Calculate geometric average returns on a stock index during the period. – Calculate geometric average returns on a riskless security over the period. – Calculate the difference between the two averages and use it as a premium looking forward. The estimate for the Cost of Equity (k e ) is: k e = E ð r i Þ = r f + β i E ð r M − r f Þ Let us calculate the Cost of Equity for company ABC stock using the capital asset pricing model: risk-free rate, r f =0.05, beta, β i =1.5, and market return, r M = 0.10. 11.3 Required Rate of Return and the Cost of Capital 229 k e = 0 . 05 + 1 . 5 ð 0 . 10 − 0 . 05 Þ = 0 . 125 = 12 . 5% Dividend Model. The constant growth dividend model, discussed in Chapter 5, is used to calculate the Cost of Equity. The price, in this case, is: ^ P 0 = D 0 1 + g ð Þ k e − g Solving this equation for the Cost of Equity; k e = D 0 ^ P 0 + g where ^ P 0 is the stock price, D 0 is the dividend in period 0 and g is the annual growth rate of the dividends. The cost of new common stock is more expensive than that of retained earnings because of flotation costs. Flotation costs include accounting, legal, printing, and commission costs. k e = D 0 ð b P 0 − f Þ + g where f represents the flotation cost, expressed as a fraction of the issue price. Why is the cost of internal equity from reinvested earnings cheaper than the cost of issuing new common stock? – When a company issues new common stock, they also have to pay flotation costs to the underwriter. – Issuing new common stock may send a negative signal to the capital markets, which may depress stock price. Let us estimate the cost of new common equity: price of stock, P 0 = € 50, dividend, D 0 = € 4.20, growth rate, g=5%, and flotation cost, f=15%.

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  CFIN

  • Scott Besley, Eugene Brigham, Scott Besley(Authors)
  • 2021(Publication Date)
  • Cengage Learning EMEA

    (Publisher)

  Throughout this chapter, we concentrate on debt, preferred stock, retained earnings, and new issues of common stock as the capital com- ponents for Unilate. 11-1 COMPONENT COSTS OF CAPITAL The items in the liability and equity sections of a firm’s bal- ance sheet—various types of debt, preferred stock, and common equity—are its capital components. Capital, which generally is described as a firm’s long-term sources of funds, is a necessary factor of production, because any increase in total assets must be financed by an increase in one or more of the capital components. Like any other fac- tor of production, capital has a cost. The cost of each type of funds is called the component cost of that particular type of capital, and the costs of capital represent the rates of return the firm pays to investors to attract various forms of capital Remember that investors provide the funds firms use to purchase assets. As a result, the returns required (demanded) by investors determine the minimum rates a firm must pay to attract the funds it uses. The average cost of these funds represents the firm’s required rate of return, r, which is also called its cost of capital. It is vitally important a firm knows its cost of capital, because this cost represents the minimum rate of return that must be earned from investments, such as capital budgeting projects, to ensure the value of the firm does not decrease. In this chapter, we discuss the concept of cost of capital, how the average cost of capital is determined, and how the cost of capital is used in financial decision making. Because a firm’s cost of funds is based on the returns demanded by investors, most of the models and formulas used in this chapter are the same ones we developed in Chapters 6 through 8, where we described how stocks and bonds are valued by investors and how investors’ required rates of return are determined.

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  Corporate Finance

  Economic Foundations and Financial Modeling

  • Michelle R. Clayman, Martin S. Fridson, George H. Troughton, Michelle R. Clayman, Martin S. Fridson, George H. Troughton(Authors)
  • 2022(Publication Date)
  • Wiley

    (Publisher)

  CHAPTER 8 COST OF CAPITAL: ADVANCED TOPICS Lee M. Dunham, PhD, CFA Creighton University (USA) Pamela Peterson Drake, PhD, CFA James Madison University (USA) LEARNING OUTCOMES The candidate should be able to: • explain top-down and bottom-up factors that impact the cost of capital • compare methods used to estimate the cost of debt • explain historical and forward-looking approaches to estimating an equity risk premium • compare methods used to estimate the required return on equity • estimate the cost of debt or required return on equity for a public company and a private company • evaluate a company’s capital structure and cost of capital relative to peers 1. INTRODUCTION A company’s weighted average cost of capital (WACC) represents the cost of debt and equity capital used by the company to finance its assets. The cost of debt is the after-tax cost to the issuer of debt, based on the return that debt investors require to finance a company. The Cost of Equity represents the return that equity investors require to own a company, also referred to as the required rate of return on equity or the required return on equity. A company’s WACC is used by the company’s internal decision makers to evaluate capital investments. For analysts and investors, it is a critical input used in company valuation. Equation 1 reminds us that a company’s WACC is driven by the proportions, or weights (the w i Þ, of the different capital sources used in its capital structure, applied to the costs of 249 each source (the r i ), with d, p, and e subscripts denoting debt, preferred equity, and common equity, respectively: WACC ¼ w d r d (1 – t) þ w p r p þ w e r e . (1) (These weights are all non-negative and sum to 1.0.) Determining a company’s WACC is an important, albeit challenging, task for an analyst given the following: • Many different methods can be used to calculate the costs of each source of capital; there is no single, “right” method.

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