Monday, 29 May 2017

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

  1. it includes the opportunity cost of all investors,
  2. it uses the appropriate market-based weights,
  3. it includes related costs/benefits such as the interest tax shield,
  4. it is computed after corporate taxes, 
  5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
  6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke

Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

  • the risk free rate
  • beta, and 
  • the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)

Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.

Cost of debt

The after tax cost of debt requires

  • an estimate of the required return on debt capital and 
  • an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

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