Gicts Presentation

8/7/2019 Gicts Presentation

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INTRODUCTIONINTRODUCTION

Cost of Capital


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Cost of Capital: IntroductionCost of Capital: Introduction

y The projects cost of capital is the minimum required rate of return

on funds committed to the project, which depends on the riskinessof its cash flows

y The opportunity cost of capital or simply cost of capital for a project

is the Discount rate for discounting its cash flows


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Significance of the cost of capitalSignificance of the cost of capital

y Evaluating investment decisions

y Designing a firms debt policy

y Appraising the financial performance of top

management


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Component of Cost of CapitalComponent of Cost of Capital

y Cost ofEquity capital

y Cost of Retain earning

y Cost of Debt

y Cost of preference share capital


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Cost ofEquityCost ofEquity

y Is it free?......Absolutely Not.!!!!

y

Why do we need to go to Public?y Why one should Invest in this company?


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Cost of EquityCost of Equity

y What are the two ways that companies can raise

common equity?

Companies can issue new shares of common stock.

Companies can retain earnings for the reinvestment.


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y Is there a cost for the retained earnings?

yesx Earnings can be reinvested or paid out as dividends.

x Investors could buy other securities, earn a return.

x Thus, there is an opportunity cost if earnings are reinvested.

y The opportunity cost of retained earnings is the rate of

return, which the ordinary shareholders would have

earned on these funds if they had been distributed asdividends to them.


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Three ways to determine the cost of equity, Ke

1. CAPM:

2. DCF (Dividend Discount Model) and its variants:

1

0

D

PK = + g

e


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NumericalNumerical

y Whats the cost of equity based on the CAPM?

Krf = 7%, RPM = 6%, beta = 1.2.

y Ke = Krf + (Km - Krf )b = 7.0% + (6.0%)1.2 = 14.2%.


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Cost ofEquity: CAPM Vs. DividendCost ofEquity: CAPM Vs. Dividend

Growth ModelGrowth Model

y The dividend-growth approach has limited application in

practice

It assumes that the dividend per share will grow at a constant

rate,g, forever.

The expected dividend growth rate, g, should be less than the

cost of equity, ke, to arrive at the simple growth formula.

The dividendgrowth approach also fails to deal with risk

directly.


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Cost ofEquity: CAPM Vs. DividendCost ofEquity: CAPM Vs. DividendGrowthGrowth

ModelModel

y CAPM has a wider application although it is

based on restrictive assumptions:

The only condition for its use is that the companys share isquoted on the stock exchange.

All variables in the CAPM are market determined and except the

company specific share price data, they are common to all

companies.

The value of beta is determined in an objective manner by usingsound statistical methods. One practical problem with the use of

beta, however, is that it does not probably remain stable over

time.


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Issues in using CAPMIssues in using CAPM

y Deciding Risk free rate of return

y

Measurement of Market Risk Premium

y Knowing beta


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Deciding Risk free rate of returnDeciding Risk free rate of return

y Returns from an investment are said to be risk free if the actual returnsfrom it are equal to the expected returns. Therefore, there is zero variancearound the expected return.

y Therefore, an investment is risk free if it has:

Zero default risk: There has to be no default risk, which generally implies thatthe security has to be issued by the government. Note, however, that not allgovernments can be viewed as default free.

Zero reinvestment risk: There is no uncertaintyaboutreinvestmentrates,which implies that there are no cash flows prior to the end of your time horizon,since these cash flows have to be reinvested at rates that are unknown today..


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y So what should be our risk free rate of return?

Short-term government fixed-income securities (T-Bills)?

Long-term government fixed-income securities (T-Bonds)?

Bullet bond or zero-coupon bonds?


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y A simpler approach is to match the duration of the analysis (long term invaluation as firms are assumed to have infinite lives) to the duration of therisk free rate (also long term)

Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash flows in a long term analysis will yield aclose approximation of the true value.

For short term analysis, it is entirely appropriate to use a short termgovernment security rate as the riskfree rate. It may be noted that ininvestment analysis, where we look at projects, these durations areusually between 3 and 10 years.

y Essentially it has to be Zero-coupon government securities as bulletedsecurities face the reinvestment risk.


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y Risk Free Rate of Interest in Emerging Markets:

In emerging markets, there are two problems:

x Problem 1:

x

The government might not be

viewed as risk free (Thailand,Indonesia, Malaysia, Pakistan etc.)

x Problem 2:

x There might be no market-based long term government rate (China)

as government issues only the short term debt. Many governments

do not borrow long term locally, there are scenarios where

obtaining a risk free rate in the local currency, especially for thelong term, becomes difficult.


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y Risk Free Rate of Interest in Emerging Markets:

Problem 1:

x The government might not be viewed as risk free (Brazil, Indonesia)

x One can adjust the local currency government borrowing rate bythe estimated default spread on the government bonds (based on the

assigned country rating) to arrive at a risk-free local currency rate.The default spread on the government bond can be estimated using

the local currency ratings that are available for many countries.

x For instance, assume that the Brazilian government bond rate (innominal Brazilian Reals (BR)) is 14% and that the local currencyrating assigned to the Brazilian government is B2. If the default

spread for B2 rated bonds is 7.5%, the risk-free BR rate would be6.5%.

x Risk-free BR rate = Brazil Government Bond rate DefaultSpread = 14% -7.5% = 6.5%


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The Historical Premium ApproachThe Historical Premium Approach

y This is the default approach used by most to arrive at the premium to usein the model

y Steps in estimating the historical premium:

Define a time period for the estimation (1926-Present, 1962-Present....)

Calculate average returns on a stock index during the period

Calculate average returns on a risk-free security over the period

Calculate the difference between the above two averages

Use the above as a market risk premium in your analysis

y The limitations of this approach are:

it assumes that there are no trends in the risk premium, and that investors todaydemand similar premiums to those that they used to demand two, four or six

decades ago (T

he risk aversion may change from year to year, but it reverts backto historical averages) it assumes that the riskiness of the risky portfolio (stock index) has not

changed in a systematic way across time.

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Gicts Presentation