COST OF CAPITAL PRIMER: JANUARY 2018 DATA UPDATE 6

Aswath Damodaran

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The Cost of Capital as Swiss Army Knife

¨ In corporate finance, it is not only the cost of raising funding for a business but also the hurdle rate to use in capital budgeting and an optimizing tool for capital structure & dividend policy.

¨ In valuation, it is the discount rate that we use to value a business, and the primary mechanism to bring in the risk of a business into its value.

¨ Along the way, it picks up a variety of other names that are used to describe it and gets confused or used interchangeably with the cost of equity and the cost of debt.

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The Problem with the “Cost of Funding” Definition

¨ It is unfortunate that the name that we have attached to this ubiquitous number is the cost of capital, since it seems to suggest that it is the cost of raising funding for a company.

¨ While that definition may sometimes fit, it often leads to destructive consequences, where companies that are safe and can borrow money at low rates (and hence have a low cost of funding) think that they are adding value when they go out and take risky investments that earn more than that cost.

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The Cost of Capital – A Healthier Definition

¨ A healthier definition of the cost of capital is to think of it as an opportunity cost, i.e., a rate of return that you (as an investor or by extension, a company that the investor has put money in) can make on an investment of equivalent risk.

¨ The key words in this definition are "equivalent risk", because that effectively eliminates the subsidy mistake that occurs when a safe company’s cost of capital is used to justify taking a risky investment.

¨ This is, of course, one of the first principles of finance and it is astonishing that it is open for debate and that so many companies violate it, in their practices.

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Manifestations of Violations (of Cost of Capital first principles)1. Many multi-business companies continue to have a "single" hurdle rate in

capital budgeting: In a survey of "best" practices across companies and advisors, the authors note that almost half of all companies (and advisors) surveyed used a single cost of capital across all investments.

2. In acquisitions, it is routine for companies (and bankers) to use the acquiring company's cost of capital to value the target company: Thee logic being that it is the acquiring firm that raises the capital and that its costs will lead safe firms to find any risky firm that they look at to be cheap is glossed over.

3. Cash is viewed as a value destroying asset: Cash and short term investments, it has to be invested in liquid and close to riskless assets, earning extraordinarily low returns. There are analysts, and I use the word loosely, who compare the returns generated on cash to the cost of capital of the firm to conclude that cash is a value-destroying asset.

4. A company that earns a higher return on its projects (higher ROIC) should be valued more highly than a company that earns a lower return on its projects: Without controlling for risk, this is not true.

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The Cost of Capital – Estimation Set Up

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Cost of Equity – Standard Model

Aswath Damodaran

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The Rate of Return required by your stockholders, given the risk that they perceive in your equity.

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Cost of Equity- An Alternative

¨ Agnostic about models: For those who are truly disturbed my the CAPM's limitations, there is an alternative approach worth considering that is agnostic in its assumptions about investor diversification and risk aversion.

¨ Implied Cost of Equity: It is to back out the "implied" cost of equity for stocks within a sector and to use that implied number as the cost of equity in individual companies. ¤ Take the implied equity risk premium for the S&P 500 in my

second data post from a couple of weeks ago and consider extending that approach to the banking index, to get an implied cost of equity for banks, and the energy sector, to estimate the cost of equity for oil companies.

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Cost of Debt

¨ It is the rate at which a firm can borrow money, long term, today. ¤ Pre-tax cost of debt = Risk free Rate + Default Spread for the Company

¨ To estimate the default spread, you can use one of three approaches, in order of ease.¤ Use the interest rate on the bond as your pre-tax cost of debt for the firm

since it is a current, market-set rate.¤ If a firm has corporate bonds and they are not traded ate, you can use the

bond rating for the company to estimate a default spread.¤ You can assess a "synthetic rating" for the company, based upon the

strength of its financials and its capacity to repay debt.

¨ To bring the tax benefit of debt into the after-tax cost of debt, you should use the marginal tax rate, since interest expenses save you taxes at the margin:¤ After-tax cost of debt = (Risk free Rate + Default Spread) (1- Marginal Tax

Rate)

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Weights on Debt and Equity

¨ Market or Book: This choice, at least for me, is an easy one. The cost of capital is a proxy for what it will cost you to raise money to fund the investment or project in question today, and since you can raise money only at market value, it is the only relevant number.

¨ Current or Target: It is true that the debt ratio for a company can change over time, and if management does have a target, the actual debt ratio may move to the target. Unless this change is instantaneous, it is likely to occur over time and my answer to the question is to use the current debt ratio to estimate the cost of capital at the start of the investment and as the debt ratio is changed over time to the optimal, to change the cost of capital as well.

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Estimation Choices

Estimation Approach used Possible limitationsRisk Free Rate US T.Bond Rate Cost of equity estimated in US dollars.

Beta

Started with unlevered beta for sector (using global averages) & levered up using company's D/E (including leases as debt).

Used only the primary business that the company was in. With multi-business companies, I am missing the effect of oither businesses on beta.

ERP

ERP of country that the company is incorporated in. If company operates in other countries, the ERP should be a weighted average.

Default Spread

Used bond rating, if available, to estimate the default spread. Used interest coverage ratio to estimate ratings and default spread, otherwise.

Interest coverage ratios may not capture default risk fully, Bringing in other ratios might have provided more refined estimate.

Marginal tax rateUse the statutory tax rate of the country in which the company is incorporated.

If company operates in many countries, it may be able to place its debt in a country with the higher marginal tax rae.

Weights

Current market value of equity and debt (including leases) used for weights.

Insufficient information to estimate market value of interest-bearing debt.

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Cost of Capital – Going Concern versus Truncation Risk

A DCF is a going-concern concept where we either assume that the firm is going forever or that is has a scheduled and orderly liquidation.

You have to estimate the likelihood of the truncation (distress, nationalization) will happen and what you will receive if it happens.

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Cost of Capital – Importance of Perspective¨ Rules of thumb: The cost of capital discussion is permeated with

rules of thumb about what comprises a reasonable, high or low number, many developed in a different time and for a different market.

¨ Skew values: These rules of thumb skew estimates, since analysts feel the urge to adjust the costs of capitals that they get from models or metrics to match their preconceptions about what they should be.

¨ Build up? It is my primary objection to the build-up approach, where analysts add multiple premiums to arrive at a cost of capital that matches what they would have liked to see in the first place. It is to counter this temptation that I will compute costs of capital for US and global companies and present both sector averages as well as the entire distributions for the market.

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A US Cost of Capital – January 2018

¨ To provide perspective on what the cost of capital for the median US company will look like, start with the US 10-year T.Bond rate of 2.41% on January 1, 2018, as the risk free rate and my estimate of the implied ERP of 5.08% for the US on the same date.

¨ For an average risk stock, with a beta of one, that would translate into a cost of equity of 7.49%.

¨ Bringing in the debt ratio of 23.51% for the typical US firm and a pre-tax cost of debt of 3.91% (1.5% higher than the risk free rate), results in a cost of capital of 6.43%, if we use the marginal tax rate of 24%, post tax reform:

Cost of capital for median US firm = (2.41%+5.08%)(1-.2351)+3.91%(1-.24) (.2351) = 6.43%

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Cost of Capital: Sector Differences in US

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Cost of Capital – US (Histogram)

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A Global Cost of Capital

¨ I estimate the costs of capital for global companies, in US dollars, and using the same template that I use for the US. There are a few key differences.

¤ I shift from using the US ERP of 5.08% to a GDP-weighted global average ERP of 6.20%.

¤ From a US-average debt ratio of 23.51% to to a global-average debt to capital ratio of 26.67%, from a pre-tax cost of debt of 3.91% to 4.91% (reflecting country default risk)

¤ From a marginal tax rate of 24% to a weighted average of 24.63%. The resulting cost of capital for a median global firm is higher than for the US:

n Cost of capital for median global firm = (2.41%+6.20%)(1-.2667)+4.91%(1-.2463) (.2667) = 7.30%

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Cost of Capital: Sector Differences Globally

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Cost of Capital – Global (Histogram)