The Cost of Capital

Sep 28, 2019

Finance

**5 steps for creating cost of analysis reports for college students**

** **As a finance student, you must have often come across this phrase – weighted average cost of capital. Whether you are performing Net Present Value analysis or valuation of any asset, cost of capital calculations is very important. You must be thinking – Why it is so important? Is there any easy way to get it right? This article seeks to answer these questions. Read on to find out more.

Every firm needs money to run its operations. As such, it raises funds from different sources such as equity investors, debt providers, bank overdraft, etc. While some sources of funds are short-term in nature, such as bank overdraft, current liabilities, etc., other sources of funds are long-term. These long-term sources of funds define the capital structure of the company and provide the basis for sustaining operations. The providers of these funds incur opportunity costs since they chose to invest the funds in the business rather than investing them elsewhere. These opportunity costs represent the alternative return that the capital providers could have earned, had they invested their funds elsewhere. It represents the threshold return which should be earned by the organization so that the capital providers can stay invested in the business and do not pull away funds. This opportunity cost defines the cost of capital for any business. The cost of capital can thus be defined as the return required by the long-term investors of the business in exchange for commitment of funds in the business. The term ‘weighted’ is often used with cost of capital, since the opportunity costs vary for different classes of investors. As such, the opportunity costs of different classes of investors are averaged to determine the weighted average cost of capital for the business.

**Calculations and requirements**

Though cost of capital calculations can look tricky at the start, they can be performed easily if you follow these 5 basic steps:

- Identify the long-term providers of funds of the business such as debt providers, equity investors, preferred stock investors, etc.

At first glance, the liabilities of the business may appear to be the sources of capital as they finance the asset base of the company. However, for calculating cost of capital, only the long-term sources of capital are used. As such, current liabilities are excluded from calculation of cost of capital since they are short-term in nature. The long-term sources of capital are common equity and retained earnings, bonds and debentures with maturity greater than one year, and preferred stock. These are the broad components of long-term capital of any business or organization.

- Determine the current market valuation of different classes of investors, such as market value of debt, market value of equity, market value of preferred stock, etc.

The market value of equity can be obtained by multiplying the outstanding shares of the company with the current share price of the company. Since the share price is dynamic and changes every day, it is suggested that you mention the date for which you used the stock’s price. This will help you to date the report and save yourself from any major changes that may occur after you finish preparing the report. The stock price can be accessed from any financial website such as Yahoo Finance, Reuters, Bloomberg, etc. The book values of debt and preferred stock are generally used as proxy for their market values.

- Use these market values to find the proportion of each component of capital in the aggregate capital structure.

The market values of the individual components are summed up to find the total market value of the company. The market value of each individual component is divided by the total market value of the firm to obtain the proportion of the components in the capital structure.

- Find the cost of capital of individual components through application of different models. For example, apply Capital Asset Pricing Model to find cost of equity, apply Dividend Discount model to find cost of preferred stock, etc.

This is the most critical step, since the accuracy of the cost of individual components will impact on our overall WACC estimate. For finding the cost of equity, the most accepted and widely used method is the Capital Asset Pricing Model (CAPM). Application of CAPM requires 3 key inputs – risk free rate, market risk premium and beta of the stock. The 10-year Treasury yield is used as an estimate for the risk-free rate and can be accessed from Bloomberg.com as shown below.

The value of beta can be obtained from any financial website while the market risk premium can be obtained from A. Damodaran’s website. The value is updated monthly and you can access it as shown below.

There are other methods also that can be used to find cost of equity, but CAPM is the most widely used and accepted method. Investors are rewarded for bearing systematic risk and CAPM calculates return on the basis of systematic risk of the security.

The cost of debt is generally estimated by dividing the interest expense with the value of debt for the financial year. Similarly, the cost of preferred stock is obtained by dividing the preferred dividend with the market price of the preferred stock. Cost of debt is adjusted by the effective tax rate to arrive at the post-tax cost of debt for the company.

- Multiply the weights of components of capital with the return required by investors (as calculated in Step 4) to find the Weighted Average Cost of Capital (WACC).

This is the final step in which the cost of components is multiplied with their respective weights to find the weighted cost. These weighted costs are then summed up to arrive at the WACC for the company. The obtained value reflects the threshold return which is demanded by the providers of the capital for the entity and also sets the minimum level of return to be achieved on all projects of the company.

**Sources of data**

The accuracy of the calculations depends on the quality of inputs used; therefore, you must exercise extra caution when you pull data for performing these calculations.

To collect data about market value of equity and debt, it is best to refer to sites such as Bloomberg.com, Reuters.com and access the latest audited financial statements of the company. These sites are credible sources, and are updated on a real-time basis so that you can find the latest data about the company. The market capitalization of any company reflects the market value of its equity. For finding the market value of debt, you can refer to the latest audited financial statements and use the book value of debt as proxy for market value of debt. Similarly, you can also use book value of preferred stock as proxy for market value of preferred stock for the company.

**Types of companies for which this analysis can be prepared**

It is easy to conduct cost of capital analysis for public companies, since the data about their financial statements and balance sheets are readily available. However, conducting this analysis for private companies can be tricky. In that case, the method of comparable companies is used in which the cost of capital calculations is done for a public company operating in the same industry with similar product profile and risk. The calculations for the public company are then adjusted with illiquidity risk associated with private companies and are revised accordingly.

There can be cases when the capital structure of the private company differs from the capital structure of the public company. In such situations, the process of deleveraging and re-leveraging the equity beta is used. The beta of the comparable public company is first deleveraged to arrive at the asset beta so that the impact of capital structure can be isolated from the value of beta. This asset beta is again re-levered using the capital structure of the private company so that better estimations of equity beta can be obtained, and the cost of equity can be computed accordingly.

**What do professors look for in cost of capital analysis reports?**

Cost of capital calculations are objective in nature, but their values can be different from student to student depending on the type of data used and the methods applied for estimating cost of debt and equity. To ensure that you can get the maximum score, it is very important that you prepare a detailed report in which you list all your assumptions and sources of data so that the professor can be sure that you used reliable data and methods. Detailed explanations would increase the credibility of calculations and help you fetch better points.

Professors pay keen attention to the type and number of methods used for calculating cost of equity. There are several methods which can be used to calculate cost of equity such as Capital Asset Pricing Model (CAPM), dividend discount model (DDM), etc. and you can get good scores if you use weighted average method to find cost of equity using both these models. Use of multiple models increases the reliability of your metric and as such, it is highly recommended that you use multiple models to arrive at the component cost. Then you can apply weights to these models based on your estimation of accuracy and superiority of the model. Using these weights and cost of the component, you can compute the weighted average cost of the component. This value would be more robust than the values obtained through application of a single model only. Professors are always fond of using multiple models to get estimates with better accuracy.

The inclusion of tax effect is very important, and professors are very keen on the incorporation of tax rates in calculation of cost of capital. You should always ensure that the cost of debt used in calculating cost of capital should be post-tax rate, while the cost of equity and preferred stock should be pre-tax rate. This is because debt has an associated tax shield which is not available with equity and preferred stock. The interest payments that are made on debt are tax deductible and this provides the benefit of tax shield to companies. Therefore, the cost of debt is lowered by the tax rate and the post-tax cost of debt is lower than the pre-tax cost of debt. However, the dividend payments that are made on equity and preferred stock are not tax-deductible and thus these components have a relatively higher cost since the impact of tax rates is not included in the cost of equity and preferred stock computation. You need to be very cautious about including the impact of taxes on cost of capital. These are fundamental concepts and professors are very particular about this.

**What goes in a good cost of capital report?**

Now that you have understood about the major concepts of cost of capital, try to ensure that these checkpoints are addressed in your cost of capital analysis reports.

- List all sources of data, formulas and assumptions used to perform cost of capital analysis.
- Try to use multiple models to obtain robust estimates.
- Try to present the calculations in tabular format to increase visual appeal of the report.
- Use headings and sub-headings so that the report is easy to follow.
- Always explain the rationale behind application of concepts in your report.

The presentation of the cost of capital calculations is as important as the application of methods. Professors are limited on time and therefore, if your report is easy to read and follow, you can create a much stronger impression in the professor’s mind. Always try to use tables when presenting calculations. This is an example of impressive WACC calculation style.

Always remember that presentation is as important as the calculation itself. So, try to spend some time on formatting the report to make it presentable and easy to follow. When you prepare the report, do not think that you are preparing it for the professor. Always think that you are preparing it for a first-timer student who would understand the concept of cost of capital by reading your report. That will help you to present and detail your report in a comprehensive manner. There are no right or wrong answers in this. Your style of writing and methods used will help you earn top scores.

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