Essay About Little Risk And Equity Cost Of Capital

Corporate Finance – Module 4 – Cost of Capital
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Corporate FinanceModule 4Cost of capitalThe cost of capital of a firm is the minimum acceptable rate of return required by the firms’ investors to provide funds. Also known as “required rate of return” or the “hurdle rate” The firm raises found using a mixture of debt and equity:Equity cost of capital and the debt cost of capital The weighted average cost of capital (WACC) Given estimates of the cost of debt and equity capital[pic 1]Debt cost of capitalIs very often estimated using the interest rate that would be charged on newly issued debt. If there is little risk the firm will default, this approach yields reasonable estimates of the cost of debt. Equity cost of capitalIt is an opportunity cost: Expected rate of return on available alternative investments with similar risk Typically, the riskier the business of a firm, the higher its cost of equityTwo main issues while estimating: How do we measure risk? A common measure of risk of an investment along these lines is the standard deviation (SD) of its return Two kind of risk:Individual risks (idiosyncratic, firm-specific, diversifiable)Common risks (systematic, market-wide, non-diversifiable)The exposure to individual risks can be reduced by holding diversified portfolios and should not matter. However, the exposure to common risks cannot be diversified and is therefore important Estimating the Equity cost of capitalCapital Asset Pricing Model (CAPM): attempts to measure non-diversifiable risk and estimate the corresponding risk premium. Idiosyncratic risks are irrelevant because they can be eliminated in well diversified portfolio. Hence, only market-wide risks matter and require a risk premium Dividend Discount Model: uses dividend yields to estimate the equity cost of capital, thus avoiding the difficulty of measuring non-diversifiable risk. CAPM model[pic 2]The equity beta of a firm is the expected percentage change in the firm’s equity returns associated with a 1% change in the return of the market portfolio. Because the market portfolio only contains market risk, the equity beta of a company measures to what extent the firm’s equity holders are exposed to market risk. In other words, the systematic risk of a firm’s equity can be measured by its equity betaThe use of historical data to estimate future betas is problematic: Betas appear to be time-varyingBetas are hard to forecastBetas are less stable for individual securities Clearly, a project’s beta cannot be estimated from its historical returns, but [pic 3]A difficulty: comparable firms may have different capital structures, i.e., may be using debt and equity in different proportions than we do in our business. We can use an unlevered Beta (with no debt) or levered Bet (with debt)Unlevered betaMeasures the systematic risk of unlevered equity Given the absence of debt, the unlevered equity beta also measures the risk of the firm’s assets [pic 4]Levered BetaDebt financing adds financial risk to equity returns The beta of levered equity no longer measures assets risk. However, the asset risk and returns are replicated by the portfolio of the firm’s debt and equity [pic 5]Unlevered and levered cost of capitalUnlevered cost of capital.If the comparable firm were 100% equity financed A first approach consists in estimating the cost of “levered equity” using CAPM[pic 6]Then obtain: [pic 7]An alternative approach is “un-lever” the equity Beta[pic 8]Then use the CAPM to estimate the unlevered cost of [pic 9]The Dividend Discount Model (Gordon-Shapiro) Provides an alternative method to estimate the cost of equity. In general, the current price of a share of stock is:[pic 10]If dividends are expected to grow:[pic 11]Problems Not applicable to non-dividend paying stocksA constant g might be unreasonableg can be difficult to estimate. The divided discount model can be useful to estimate the expected return of large portfolios