Defining the cost of capital
- For businesses, the cost of capital is a cost of raising financing: The first is to read the cost of capital literally as the cost of raising funding to run a business and thus build up to it by estimating the costs of raising different types of financing and the proportions used of each. This is what we do when we estimate a cost of equity, based on a beta, betas or some other risk proxy, a cost of debt, based upon what the business can borrow money at and adjusting for any tax advantages that might accrue from borrowing.
- For businesses, the cost of capital is an opportunity cost for investing in projects: The cost of capital is also an opportunity cost, i.e., the rate of return that the business can expect to make on other investments, of equivalent risk. The logic is simple. If you are considering investing in a new asset or security, you have to earn more than you could make by investing the money elsewhere. There are two subparts to this statement. The first is that it is the choices that you have today that should determine this opportunity cost, not choices that you might have had in the past. The second is that it has to be on investments of equivalent risk. Thus, the cost of capital should be higher for riskier investments than safe ones.
- For investors, the cost of capital is a discount rate to value a business: Investors looking at buying into a business are effectively buying a portfolio of investments, current and future, and to value the business, they have to make an assessment of the collective risk in the portfolio and how it may change over time.
- Investors price companies based upon a reasonable assessment of the company’s business mix (and country risk exposure) and what they can generate as expected returns on alternative choices of equivalent risk. The former requires companies to provide information on their business mixes and the latter generally is easier to do in a liquid, public market.
- A company that operates in multiple businesses and many countries cannot use a single, “company-wide” cost of capital as its hurdle rate in investments. It has to adjust the cost of capital for both the riskiness of the business in which the investment is being planned and the part of the world that it is going to be located in.
- The overall company’s cost of capital has to be a weighted average of the costs of capitals of the businesses that it operates in, and as the business mix changes, the cost of capital will, as well.
- First, I assign each company to one primary business in estimating business risk and use the unlevered beta for that business as the beta for the company. Optimally, I would compute the unlevered beta for each company, using the mix of businesses it is in, but with my sample size and data access, it is close to impossible to do.
- Second, I assume that the company gets all its revenues in the country in which it is incorporated and assign it the equity risk premium of that country. Thus, a Russian company’s cost of equity is computed using the Russian ERP (see my earlier post on country risk) and a German company’s cost of equity is computed based on the German ERP. I know that this violates my earlier point of multinational companies, and I would never make this assumption in building up an individual company’s cost of capital but I am afraid I have no choice with the larger sample.
- Third, I estimate a default spread for the company by using the variance in its stock prices. It is true that some of the companies (about 4000 or about 10% of my sample) have bond ratings available on them, but the bulk of my companies do not. In addition, if the company is incorporated in a country with sovereign default risk, I add the default spread for the country on to that of the company. I also use the marginal tax rate of the country that the company is incorporated in to estimate an after-tax cost of debt.
- Finally, to keep the numbers comparable, I compute the costs of capital for all companies in US dollars.
If you work in finance, you will run into the challenge of estimating the cost of capital for a company sometime during the course of the year. I hope that the datasets that I have created are useful to you in that endeavor and if you decide to use them, here is a simple template for arriving a company’s cost of capital in the currency of your choice.
|Step||Input||Measure||Comments/ Data sets|
|1||Risk free rate||Use the prevailing 10-year US T.Bond rate as the risk free rate in US dollars,even if you plan to compute the cost of capital in another currency.||Fight the urge to normalize, tweak or otherwise mess with this rate. It is what you can make today on a risk less investment, no matter what your views on it being too low or high.|
|2||Business Risk (Unlevered beta)||Break the company down into businesses, using an operating metric (revenues work best) and compute the weighted unlevered beta across the businesses.||Company breakdown: In company’s annual report or financial filings|
Beta of businesses: My unlevered betas by business (broad groups) or you can create your own subgroups.
|3||Financial Risk (Debt to equity and levered beta)||Lever the beta using the market debt to equity ratio for the company today. (If you prefer to use a target debt to equity ratio, make sure it is based on market values.||Market value of equity: Use the market capitalization as market value of equity.|
Market value of debt: For debt, use book value as your proxy for market value, or better still convert book value to market value. Add the present value of operating leases to debt.
|4||Equity Risk Premium||Obtain the geographical breakdown of the company’s revenues (or other operating metric, if you don’t like revenues). Take a weighted average of the ERP of the countries/regions that the company operates in.||Geographical Breakdown: The company’s revenues will be in its financial statements, though it is not always as clear and detailed as you would like it to be.|
ERP by country: My ERP by country.
|5||Cost of debt||If you can find a corporate bond rating for your company, use it to get a default spread and a cost of debt. If you cannot find a bond rating, estimate a bond rating for the company and a default spread on that basis. If you are doing the latter, add a default spread for the country to get the pre-tax cost of debt.||Bond Rating: If available, you should be able to find it at S&P or online.|
Synthetic Rating: You can use this spreadsheet to get a synthetic rating for your company.
Rating-based default spread: My lookup table of default spreads for ratings classes.
Country default spreads: My estimates
|6||Marginal tax rate||Multiply the pre-tax cost of debt by (1- marginal tax rate) to get the after-tax cost||Marginal tax rate by country: KPMG estimates of country tax rates|
|7||Debt Ratio||Use the market values of debt and equity (from step 3)||See step 3|
|8||Currency change||If you want to convert the US dollar cost of capital into another currency, add the differential inflation rate (between that currency and the US dollar) or better still, scale up the US$ cost of capital for the difference in inflation.||The inflation rate in the US can be estimated as the difference between the US 10-year T.Bond Rate and the US TIPs rate. For other countries, you can use the actual inflation rate last year as a proxy for expected inflation.|
If you are interested, I have a spreadsheet that has these steps incorporated into it. Give it a shot!
Looking at the costs of capital across sectors and companies, there are lessons that I take away for valuation and corporate finance:
- A rising (falling) tide lifts (lowers) all boats: The first reaction that most analysts and CFOs will have to my estimates of the cost of capital is that they look too low, with a median value of 7.40% for US companies and 8.32% for global companies. In fact, the longer that you have been around in markets, the lower today’s numbers will look like to you, because what you consider a normal cost of capital will reflect your experiences. The low costs of capital, though, are appropriate, given the level of risk free rates today.
- The cost of capital does not (and should not) reflect all risk faced by a business: Even if you accept the proposition that the costs of capital are lower because of low risk free rates, you may still feel that the costs of capital don’t look high enough for what you view as the riskiest companies in the market. You are right but that is because the cost of capital captures risk to a diversified investor in a going concern. Consequently, it will not reflect risks that are sector-specific but not market-wide, such as the risk to a biotechnology company that its newest drug will not be approved for production. Those risks are better reflected in the expected cash flows. The cost of capital also does not reflect truncation risk, i.e., that a firm may not survive the early stages of the life cycle or an overwhelming debt burden. That risk is better captured through decision trees and probabilistic approaches.
- Don’t sweat the small stuff: In my view, analysts spend too much time finessing and tweaking the cost of capital and not enough on the cash flows. After all, the cost of capital, even if you go with the global distribution, varies within a tight range (6% to 12%, if you use the 10th and 90th percentile) and your potential for making mistakes is therefore also restricted. In contrast, profit margins and returns on capital have a much wider distribution across companies and getting those numbers right has a much bigger pay off.
- An ERP Retrospective: Looking back (2014) and Looking forward (2015)
- Country Risk, Return and Pricing: The Global Landscape in January 2015
- The Tax Story (in January 2015): Myths, Misconceptions and Reality Checks
- Putting the D in the DCF- The Cost of Capital
- The X Factor in Business: Excess Returns and Value