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What Is Your Corporate Cost of Capital?

May 29, 2014 | About:
paracap

paracap

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What Is Your Company’s Cost of Capital?

In completing various advisory assignments for real estate and corporate clients, I find it amazing that many companies do not know what their cost of capital is. Cost of capital is the cost to the company of various components of its capital structure including debt, preferred stock and common stock. The weighted cost of all these components is the weighted average cost of capital (WACC). The cost to the company is the expected return to the various investors or owners who invest in each tranche of the capital structure. Apple as an example has delivered an average annual return on its common stock of 68% over the last 10 years. This is the return that investors expect in owning the common stock and is a component of Apple’s cost of capital. Cost of capital is important because it is the minimum rate of return a company must achieve on its growth investments to increase shareholder value. The WACC is calculated as follows; the percentage cost of each component in the capital structure is calculated, the weighted average cost of each component is then determined and the sum of all the weighted costs is the WACC.

The first item in the capital structure is long-term debt or bonds. The cost of debt is the current yield (not the coupon rate) on the debt, based on its market price, as most public company debt fluctuates in price, times one minus the tax rate. The after-tax cost of debt is used because interest on the debt is deductible for tax purposes and provides a tax shield. If D is the cost of debt, Y is the yield on the debt and T is the tax rate, then the formula for the cost of debt is:

D=Y(1-T)

The next item in the capital structure is preferred stock. If a company does not have preferred stock, this calculation would not be applicable. The cost of preferred stock is the dividend per share on the stock divided by the stock price. If PS is the cost of preferred stock, D is the dividend per share and P is the price per share, then the formula is:

PS=D/P

Calculating the cost of debt and preferred stock are fairly straightforward; however, the cost of common stock requires some financial formulas. There are two famous formulas or models that are used to calculate the cost of common stock, the Dividend Discount Model (DDM) and the Capital Asset Pricing Model (CAPM). Per Wikipedia, The DDM is named after Myron J. Gordon, who originally published it in 1959, although the theoretical underpinning was provided by John Burr Williams in his 1938 text "The Theory of Investment Value" and the CAPM model was introduced by Jack Treynor, William Sharpe, John Lintner and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. The DDD model formula is the dividend per share divided by the stock price plus the dividend growth rate. If C is the cost of common stock, D is the dividend, P is the stock price and G the growth rate, then the cost of common stock using the DDM is:

C=D/P +G

A company’s dividend growth rate is the expected growth in dividends over the next few years. If a company does not pay dividends then it must use the CAPM to determine the cost of common equity. The other and more popular model is the CAPM, which is the risk free rate plus Beta times the market return less the risk free rate. If C is the cost of common stock, Rrf the risk free rate, B is Beta and Rm the market return, then the cost of common stock is:

C=Rrf+B(Rm-Rrf)

The Risk Free Rate is the rate on government Treasury securities and for this article we will use the current 10-year Treasury note rate of approximately 2.5%. Beta is a statistical measure of the volatility of a company’s common stock in relation to the market. For example, if a company’s Beta is 1.5, then its stock is 50% more volatile than the market and if the market goes up 10%, this stock would go up 1.5 times or 15%. The market return is the expected return on the stock market and for this analysis we will use the expected return on the S&P 500 of approximately 10%. The term in the parentheses, the market return less the risk-free rate (Rm-Rrf) is also known as the equity risk premium or the additional return required by equity holders above the risk free rate Treasury note rate to hold risky equity securities. There is a tremendous amount of data and analysis on the equity risk premium going back to the early 1900s by Ibbotson and others and historically it has been in the range of 4% to 8%.

The following table contains data to calculate the WACC for our hypothetical company, ACME Manufacturing Inc., a Midwest based manufacture of forklifts and other equipment, traded on the Nasdaq.

Capitalization

Type

Description

Yield/Dividend

Amount at Market Value

Weight

Debt

Senior bonds

10 yr. Senior Debt

7%

$50,000,000

33%

Preferred Stock

Cumulative

$25 Par Value

$2/share

$25,000,000

17%

Common Stock

Par Value $1 & Trading at $25/share

3,000,000 Shares Outstanding

No Dividend

$75,000,000

50%

     

Totals

$100,000,000

100%

Other Information:

         

1. Tax Rate-35%

         

2. Beta-1.25

         

3. Rrf-2.5%

         

4. Rm-10%

         

Using the data on ACME above, the WACC is calculated as follows

1. Cost of Debt is 7%(1-35%) = 4.6%

2. Cost of Preferred Stock is $2/$25 = 8%

3. Cost of Common Stock is 2.5%+1.25(10%-2.5%) = 11.875%

Using the above costs and weights in the capital structure, the WACC is:

4.6% x 33%+8% x 17%+11.875% x 50%=8.8%

ACME Manufacturing Inc’s WACC is 8.8% and this is the rate that should be used to evaluate all of the firm’s investment programs. The company should only undertake corporate investments that earn a return that is greater than the WACC. All of the firm’s capital budgeting and corporate investments that yield a return in excess of the WACC or a positive net present value using 8.8% as the discount rate, will increase the value of the firm and stock price and the total return to its shareholders.

Author: Joseph Ori, Executive Managing Director, Paramount Capital Corporation, a real estate advisory firm

© Copyright Paramount Capital Corporation. All Rights Reserved.


Rating: 2.8/5 (4 votes)

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Comments

batbeer2
Batbeer2 premium member - 1 month ago

You say:

ACME Manufacturing Inc’s WACC is 8.8% and this is the rate that should be used to evaluate all of the firm’s investment programs. The company should only undertake corporate investments that earn a return that is greater than the WACC.

I take this to mean that a lower WACC makes for a better investment because it is easier for management to add value.

But you also say:

The market return is the expected return on the stock market and for this analysis we will use the expected return on the S&P 500 of approximately 10%.

So if at some point an index is expected to generate better returns, WACC goes up. This means each individual stock in the index becomes less compelling.

That's absurd.

Also you say:

The cost of debt is the current yield (not the coupon rate) on the debt, based on its market price

So if the bonds of a company drop in price, its WACC goes up. The stock becomes less attractive. There are many instances of companies buying back their debt at a lower price than it was issued because bonds had dropped in price. This is a simple and effective way to create value for the stock.

I can spit out dozens of examples of stocks that became compelling ideas as WACC (as defined here) went up. What's more, I can't think of a single practical situation, where an investor could have used this model to identify a good investment.

The model is absurd.

Having said that, it is an invaluable tool for consultants who get paid to prove that some crackpot idea adds value.

varunfriend
Varunfriend premium member - 1 month ago

There are a 10 companies per GF screener with beta less than -2 and 131 companies with negative beta ... what does that mean for their cost of equity? Does that mean that the cost of issuing equity for these companies could be negative?

dirt2624
Dirt2624 premium member - 1 month ago

WOW - text book stuff giving precise answers to how many decimal points you care to calculate to - and COMPLETELY USELESS!!! Isn't it great when academics lead the masses over the cliff - LOL.

MUNGER AND BUFFETT AGREE

I hope 99.9999% of investors use only these text book ideas so the rational thinking un-brainwashed minority of us can deal with reality. We need academic finance students on the other side of our purchases and sales.

paracap
Paracap - 1 month ago

Your comments reflect an ignorance of Corporate Finance and Modern Portfolio theory. WACC and CAPM have been the bedrocks of corporate finance for more than 40 years and are used with some variation by all the Fortune 500 and REIT CFO's I know.

A firm must know what its capital costs in order to make new investments in PP&E, acquisitions, etc. Debt is cheaper than equity because is has to be paid back and the more debt in the capital structure, the lower the WACC.

I prefer using this type of quantitative model even though it requires assumptions as to the Market Return, risk free rate etc. If you don't like the model thats fine, then use your own method or the Buffett/Munger definition of WACC.

The amount in the paranthesis (Market return minus the risk free rate) is the Equity Risk Premium or the additional return that is needed to invest in common stocks (the riskiest sercuties) above the risk free rate of US Treasury securities. The premium has averaged 4%-8% for the last century depending on which inputs are used and in my example is 7.5%.

A company's WACC will go up if its in distress because of BK risk or has no debt or preferred stock because equity is alwasys more expensive than debt. If a company has a higher WACC then it must make investments that earn a return greater than the WACC or eventually it will be out of business.

batbeer2
Batbeer2 premium member - 1 month ago

>> WACC and CAPM have been the bedrocks of corporate finance for more than 40 years.

OK, so what was the bedrock before that time?

In my view, the bedrock of corporate finance hasn't changed much since the Dutch East India company was founded in 1602.

WACC is a model. It is a feeble attempt by (some) nerd(s) to explain human (economic) behavior. As a student of human bahavior I can give you hundreds of real-life examples that the model just doesn't explain events.

FWIW, I couldn't create a better model myself. Having said that, I think it is better to accept you're ignorant than to continue using a model that is very obviously wrong.

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