UNSW Business School

FINS3625 Applied Corporate Finance

Cost of Capital
Recap from last week

When putting up a 3-way financial model, what are the three statements?

What are the order? Ie, which one is on top, middle and then bottom?

What are the 4 key analysis (or supporting schedules)?

If the company buys a large equipment, where in the statements would we see this
acquisition?

Where else in which statements would we see the changes?

In forecasting, how do we know we need financing in the future?

Recap from last week

Some observations:

• Outputs are NOT exactly the same as Exhibits - Why?

• Tax schedules – Tax Accrual = the tax expense for the year (Income Statement); Tax
Payment is the actual tax paid (accrued from last year); Ending Accrued – Beg accrued +
this year accrued – payment.

• Financing schedules
• Create an input for increase or decrease of debt (depending on the cash balance)
• Feed to Financing Activities – Cash Flow statement
• Dynamic - as little hardcoded cells as possible. Any hardcoded cells should be separated
out as input on the top (easier for users to access and change as required) ie, interest rate
(should be every year)
What is Cost of Capital?

What is it?

• A company’s average cost of financing?

• Investors’ average required return when financing a project?

• A hurdle rate?

• Minimum required return on a company’s investment projects?

• Or something else?

“It is the minimum acceptable rate of return on new investments based on the rate investors
can expect to earn by investing in alternative, identically risk securities”
Cost of Capital from Different Perspectives
Figure 2: The Cost of Capital as Swiss Army Knife

Source:
Aswath Damodaran 2016 –
Swiss Army Knife of
Finance

For investors in companies, the cost of capital is an opportunity cost in the sense that it is the
rate of return that they would expect to make in other investments of equivalent risk. For the
Cost of Capital from Different Perspectives
Figure 2: The Cost of Capital as Swiss Army Knife

Source:
Aswath Damodaran 2016 –
Swiss Army Knife of
Finance

For investors in companies, the cost of capital is an opportunity cost in the sense that it is the
rate of return that they would expect to make in other investments of equivalent risk. For the
Application of Cost of Capital
Reviewing new projects/acquisitions/investments (ie, Capital Budgeting)
• ROIC > CoC; NPV – discounting cash flow by CoC; IRR > CoC

Capital structure
• Optimising financing mix between equity and debt

Dividend policy
• All projects/investments returns < CoC, return cash to investor as Div or Buyback
Managing working capital
• Carrying cost of inventory, receivables or early payment discount on payables

Valuation
• Investors uses CoC as discount rate to value the entire business
How do I find out Cost of Capital,

Cost of capital, in essence,

is the weighted average of the cost of all funds raised for the business,
the investment, the firm, the project… or aka WACC

Cost of Capital
equal
Cost of Equity X Weight of Equity + Cost of Debt X Weight of Debt

Risk Free Risk Risk Free Default

Rate
+ Premium Rate
+ Premium X (1 – tax rate)
Mechanically,

Cost of capital, in essence,

is the weighted average of the cost of all funds raised for the business,
the investment, the firm, the project… or aka WACC

Represent the “RISKS” in a business seen by the marginal investor in the

stock (shares/companies) ie, an investor who set the prices at the margin
so that a buy/sell transaction takes place.

This risk is non-diversifiable ie, Systematic. ie, beta related

How to estimate Cost of Capital

WACC = (1–tax rate) x Cost of Debt x D/(D+E) + E/(D+E) x Cost of Equity

The difficulty is the estimation of each component. Standard practice:

• Portion of Debt & Equity should be at Market or Book value?

• Debt – Short? Or Long term debt

• Cost of Debt is borrowing rate? Bond coupon rate? Market Rate?

• Cost of Equity ?
Estimating Debt & Equity weighting

This is book value

Estimating Cost of Debt
 buyout opportunities in H1. Care refinanced A$1.5 billion in facilities.

Estimating Cost of Debt

Notable H1 2021 Australian Syndicated Loan Issuances

Borrower Date Amount (A$m) Tenor (yrs.) Pricing (bps)

PEXA 1-Jul-21 335 4 Undisclosed
500 3 BBSY + 135
Ramsay Health Care 22-Jun-21 500 4 BBSY + 145
500 5 BBSY + 155
2,070 3 BBSY + 125
TPG Telecom 2-Jun-21 1,720 5 BBSY + 145
960 5 BBSY + 145
Orora 28-May-21 350 3 Undisclosed
100 3 Undisclosed
Kathmandu 26-May-21
165 3 Undisclosed
200 2 BBSY + 210
G8 Education 17-Feb-21 100 2 BBSY + 180
50 2 Undisclosed
Telstra 22-Jan-21 1,000 3 BBSY + 100
Source: LoanConnector, Bloomberg (July 2021), Debtwire
 • Highlights for the half include Wesfarmers’ issue

Estimating Cost of Debt

of the first sustainability-linked bond in the
Australian medium term note market, with an
oversubscribed total issuance of A$1,000m.

Notable H1 2021 Australian Corporate Bond Issuance

Borrower Date Amount (A$m) Tenor (yrs.) Pricing (bps)

650 7 194
Wesfarmers (A-) 23-Jun-21
350 10 255
22-Jun-21 200 6 185
NBN Co (A+)
2-Jun-21 350 7 215

Peet 4-Jun-21 75 5 487

WestConnex 31-Mar-21 650 10 315
600 7 235
Verizon
3-Mar-21 500 10 300
Communications
150 20 385
Source: Bloomberg, Thomson Reuters (July 2021)

A$ Corporate Bond Issuance

Estimating Cost of Debt
Estimating Cost of Debt (over to you)

Exercise :
Using FactSet and info in previous slides, estimate the cost of debt for a US telco
company with a BBB+ rating

Suggested answer (based on aforementioned FactSet tables):

• Verizon Communications BBB+ issued $500m 10 year Aust bond in Mar 2021
at 3%
• Now trading at 3.77% YTW (factset)
• A mix of previous and current market information
• Should examine the company’s debt market information
Estimating Cost of Equity

Various market practices:

• Constant dividend growth model:
• Price = Div1/(r-g) =è r = Div/Price + g or (Div yield + growth rate)
• Issues: irregular div and growth rate or no dividend stock; disregard capital
appreciation
• EPS or Retained earnings to Price
• Cost of Equity = EPS / Price = earnings to the market value
• Issues: No consideration of volatility or growth in earnings

• CAPM
• Re = Rf + MRP x Beta
• Intuitively, the return investors must receive for investing this company is equal to
the return for risk free investment + risk adjusted market risk premium
Component of CAPM

Re = Rf + MRP x Beta

• Rf - Risk Free Return – Long term government securities yield

Risk Free Return
Component of CAPM

Re = Rf + MRP x Beta

• Rf - Risk Free Return – Long term government securities yield

• MRP - Market Risk Premium – a premium investors demand to invest in equities on top
of Risk Free Return
• Historical estimates – long term average of equity market returns vs. Gov’t securities
• Forward view – Implied equity risk premium ie, Expected cash flow (Div + buyback),
current stock price & solve for IRR ie, http://www.market-risk-premia.com/au.html
• Practitioners use 5-6% usually for simplicity
Implied Market Risk Premium
Component of CAPM

Re = Rf + MRP x Beta

• Rf - Risk Free Return – Long term government securities yield

• MRP - Market Risk Premium – a premium investors demand to invest in equities on top
of Risk Free Return
• Historical estimates – long term average of equity market returns vs. Gov’t securities
• Forward view – Implied equity risk premium ie, Expected cash flow (Div + buyback),
current stock price & solve for IRR ie, http://www.market-risk-premia.com/au.html
• Practitioners use 5-6% usually for simplicity

• Beta – adjustment to MRP (reflects business & financial risks ie, D/E)
• Q: is Beta levered or unlevered?
• Q: how about private companies?
Beta – if listed
Beta – if unlisted?

• We need to estimate by finding proxy

 Beta – if unlisted?
evering and Re-Levering Beta

Po
• Recall that Expected return of a portfolio = Weighted Average of expected returns of
securities in the portfolio.

• Therefore, a firm’s asset return or “unlevered” return = weighted average of expected

returns of holding the securities D debt and
(both E
β =u β + βequity).
d e
V V
• Since Beta of a portfolio is the weight average of the betas of the holdings in the
portfolio, we can express the unlevered beta as the following:
βu βd βe

or
𝐷 𝐸
𝛽u = 𝛽d + 𝛽e
𝑉 𝑉
β d,
If no debt (D=0),
unlevered beta =
E
unlevered equity beta βu = βe Or 𝛽 u= 𝛽e (Unlevered Beta)
as E=V V
 βu = βd + βe
V V
Beta – if unlisted
βd βe 𝐷 𝐸
𝛽u = 𝛽d + 𝛽e

r
• If there is Debt, that means “Levered”
𝑉 𝑉
β d, •

o
In practice, we assume Debt Beta 𝛽d is “0” as it is hardly traded.

E 𝐸
βu = βe 𝛽eis now levered = 𝛽L 𝛽u = 𝛽L
V 𝑉
py
𝐸+𝐷 𝐷
𝛽L = 𝛽u 𝛽L = [1 + ]𝛽u
𝐸 𝐸
• And there is tax shield with debt

𝐷 1−𝑡 𝐷 1−𝑡
𝛽L = [1 +βu ]𝛽u or 𝛽u = 𝛽L/[1 + ] Hamada Equation
β' e = 𝐸 𝐸
⎛E⎞
Beta – Levered vs. Unlevered

• Interesting to note:

• Return (Cost) on Equity = Re = Rf + MRP x Beta of which Beta is “levered”.

• By substituting
𝐷 1−𝑡
𝛽L = [1 + ]𝛽u
𝐸
• Actually,

§ Re = Rf + MRP*Beta (U) + MRP*(1-t)(D/E)Beta (U)

Risk Free Return Return on Financial Risk

(via leverage)
Return on Business Risk
(without leverage)
Beta –

• What makes a company’s beta high?

Other issues to consider

• Current vs. historical vs. forecasted rates?

• Need to churn operating profit before there is tax benefit (Re: Cost of Debt)

• High cash holding (Gross vs. Net Debt)

• Hybrid securities

• Small cap, illiquidity, private companies

Check on understanding

• When an Acquiror acquires a Target company, which discount rate should be used to
value the acquisition?

• Acquiror’s WACC, Combined entity’s Cost of Equity, Target’s historical Cost of

Capital, Weighted average cost of financing the acquisition, the industry average cost
of capital or others…

• Example 1: Acquiror is Govt and Target is Afterpay. Whose CoC should be used for the
valuation of the acquisition?

• Implications?

• Example 2: Acquiror and Target are in similar industry. How to estimate the CoC to use
for the acquisition?
Cost of Capital
In essence,
weighted average of the cost of all funds raised for the business, the
investment, the firm, the project… or aka
WACC RWACC = (1–tc)·xD·RD + xE·RE

Cost of Capital
equal
Cost of Equity X Weight of Equity + Cost of Debt X Weight of Debt

Risk Free Risk Risk Free Default

Rate
+ Premium Rate
+ Premium X (1 – tax rate)
Burton Sensors Case Study

Week 2 –

What is the cost of capital for Burton to evaluate the acquisition of the thermowell
machine and EE?

We need to estimate WACC for the industry, Burton and EE before we can
decide

Engage online discussion early so that you can benefit from peer discussion and
learning before tutorial.

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