Cost of capital

Ashutosh Dash

Fundamental Enterprise
Value

Two Propositions
Value

the enterprise and allocate

When target will have ordinary amounts of

debt outstanding
A relatively unchanging capital structure
WACC and APV valuation take this
approach
Value

the debt and equity, and add

Good for LBOs as interest tax Shield Varies

Violation of WACC and APV assumptions

What info do we need???

Free

Cash Flow:

FCEE or ECF or CCF

WACC:

KE , KD , Weights and Tax Rate

CAPM

Model

Discount

Rate if not WACC

Valuation Ratios A
Review

You

have been asked to assess whether Midway

Banks, a small banking company, is being valued
correctly by the market. There are 10 million shares
outstanding, trading at $ 20 per share but the book
value of equity in the company is $250 million. The
bank is expected to have net income of $ 20 million
next year and this income is expected to grow 3% a
year in perpetuity. The risk free rate is 5%, the beta
for small banks is 1.0 and the market risk premium is
4%.
a. Based upon the fundamentals, what price to book
ratio should Midway Banks be trading at?
b. If the market is correct in pricing this stock,
estimate the cost of equity that the market is
assuming for this bank.

Solution
a. Intrinsic price to book ratio =

0.833333333

Stock is undervalued slightly.

b. if the market is correct
Price to book ratio = .8 = (.08-.03)/(r-.03)
Solving for r, Cost of equity =

9.25%

(ROE - g)/ (COE -g); ROE =8%, Cost of equity = 5+4% = 9%)

CoC
Some More
Granular
Questions???

CoC - Characteristics
Forward

Looking

Risk Free Rate, Risk Premium & Cash

Flow
Based

on Market Value

Stated

in Nominal Terms

Equals

the Discount Rate

Capital Structure Ratios

Formulation
On

of Ratios be on Market Value

Target Capital Structure

Corresponding to future cash flow

A

GAAP Balance Sheet for debt and

equity
Separation of operating and financial accounts
Long term accruals netted against long term
assets
Excess liquidity should be netted against debt

Reorganized B/S Implications

Should

Excess Cash be Considered

in FCF
Non-Operating Asset
May be added to operating cash flow
value
May be considered for net value of
debt

Firm Value Bifurcated Approach

Assets

Liabilities

NWC (CA CL)

Debt

NFA

Equity

(Gross Block
Accumulated
Depreciation)

NOA (OA OL)

Total

Total

Midland - Reorganized Balance Sheet

Assets

Amoun
t

NWC

19681+7286+2226-26576-

(2846)

5642
NFA
Other 34205+9294-9473-4839s
14179-2725
Liabilities
Debt 20767+81078-19206-3131
Equit
y

167350
12284

79508
97280

COST OF
EQUITY
A Glimpse

Risk Free Rate

Follow

Duration Matching Strategy

Cash flow Horizon

Equity Risk Premium
Risk

Free Rate should include

Real Rate
Inflation Risk (Expected + Inflation Risk)
Maturity Risk (Reinvestment + Default)
YTM

of a long term treasury bond

Calculation of Beta
Risk

Sharing Method

Un-levering

and Re-levering
Method (risk Factors are Known)

MM

Proposition when Return on

Capital is known

Approach II
Asset

= (WD * D) + (WE * E)

Helps

in un-levering and re-

levering Beta
Weights

are based on value

Tax may be considered if the debt
outstanding is perpetual
Asset

= (WD * D) + (WE * E)(1-t)

An Alternative.
MM

Proposition II:
RE = RA + (D/E)*(RA RD )

Tax

effect should be considered

in case of perpetual debt

RD

< WACC < RA < RE

CoE Build-Up Model

2

Primary components

A risk-free rate
A premium for risk

subcomponents of Premium:
A general equity risk premium
A small-company risk premium
A company-specific risk premium

Contd.

COST OF
DEBT
A Hint

How to Calculate
CAPM

Model
Based on Interest Charges
Whether floating rate or fixed???
Using

Spreads over treasury rate

Why tax rate in WACC?

Interest
Not

provided tax shield

a good explanation

For unlevered cash flow WACC

includes tax effect
For levered cash flow WACC excludes
tax effect

COST OF
CAPITAL
A tip-off

Corporate Vs Divisional Cost of Capital

Should

WACC be calculated for divisions?

Yes, each division demands a level playing
field
No, debt is a pass-through arrangement

None

of the arguments take value max view

Cost should be opportunity cost not funds
cost
Divisions with different risks have different
opportunity cost

Use

of corporate cost leads to type I & II error

A word of caution
In

calculating Beta:

Comparable Firm based on

characteristics
Anomalous asset beta excluded as
outlier
Range of asset betas in sensitivity
analysis