The cost of equity for a company in developiong market

Country risk premium (CRP) for developing country

CRP = (sovereign bond yield - T-bond yield) x (standard deviation of developing country index / standard deviation of sovereign bonds in US currency)

The required return on equity securities:
Ks = RFR + β (E(Rmarket) – RFR +CRP)

Investment opportunity schedule and Optimal capital budget

Investment opportunity schedule
When the potential projects are ranked in descending IRR, downward slopping investment opportunity schedule is formed.

Optimal capital budget
Refer to the amount of investment capital required to fund all projects with IRR greater than
MCC.

Marginal cost of capital (MCC)

· MCC is the cost of the last dollar of capital raised.
· As more capital is raised, the marginal cost of capital rises.
· At some point, as the company continues to raise capital, the MCC can be higher than the
WACC.

The cost of capital will remain unchanged as new debt, preferred stock and retained earnings are issued until the company’s retained earnings are depleted. At a point, however, when retained earnings have been depleted and new common stock has to be used, the company’s cost of capital increases. This is known as the "breakpoint".

Breakpoint for retained earnings = retained earnings / w_s

Factors Affecting the Cost of Capital

Controllable Factors

Capital-structure policy
· As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases.

Dividend policy
· As the payout ratio of the company increases, the breakpoint between lower-cost internally generated equity and newly issued equity is lowered

Investment policy
· If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change.

Uncontrollable Factors
· Level of Interest Rates

• When interest rates increase, the cost of debt increases, which increases the cost of capital.

Tax Rates
· Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital.

Weighted average cost of capital (WACC)

WACC = w_d * k_d * (1 – t) + w_p * k_p + w_s * k_s

WACC is used to compare the after-tax cost of capital to the after-tax return.

The weights are based on company target capital structure, use bookvalue weight if they are close to the market value, otherwise use market value.

Cost of retained earning or Cost of equity captial (Ks)

If stock is in equilibrium, k_s = expected rate of return by investors E(k_s).
Where: K_s – internal equity or required rate of return for common stock.

CAPM approach:

Cost of retained earnings = RFR + (Market rate – RFR) x Beta.

Difficulties:
· don’t know whether use ST or LT treasury rate as risk free rate
· hard to estimate β
· hard to estimate risk premium

Dividend yield plus growth approach:

Required rate of return = D1/P + g.
Growth (g) = ROE(1 – dividend payout ratio)

Bond yield plus risk premium approach:

Required rate of return = (LT debt) Bond yield + Equity risk premium.

Cost of external equity (Ke)

Ke = D1/[P x (1 – % flotation cost)] + g

Where: K_e- external equity, issue new stock, usually >ks

If the firm does not earn at ke for new fund, its stock price will decrease and lead to dilutiion of earning

Cost of preferred stock (kp)

k_p- = Preferred dividends / (Net issuing price - Flotation costs)

K_p is a bit higher than the rate requried by investor due to the floating cost, i.e. k_p required > k_p

Cost of debt (kd)

After-tax cost of debt = cost of debt x (1- tax rate)
= k_d x (1 – t)

Note:
· Use interest rate on new marginal loan but not on existing or old debt.

Two methods are discussed to estimate the before-tax cost of debt (kd).
Yield-to-Maturity Approach
· This approach uses the familiar bond valuation equation. Assuming semi-annual coupon payments, the equation is

P0 = PMT₁/(1 + r_d/2) + ... PMT_n/(1 + r_d/2)ⁿ + FV / (1 + r_d/2)ⁿ

The six-month yield (r_d/2) is derived and then annualized it to arrive at the before-tax cost of debt, k_d.

Debt-Rating Approach
· This approach can be used if there isn't a reliable market price for a firm's debt.
· Based on the company's debt rating, the before-tax cost of debt is estimated by using the yield on comparably rated bonds for maturities that closely match that of the firm's existing debt.

Capital components

Capital components is the components shown in the right (liability) side of balance sheet, include:
· Debt
· Preferred stock
· Common stock

Relation between NPV and Company Value and Stock Price

In theory, positive NPV project will increase stock price by the project’s NPV per share.

In reality, the stock price reflect the investor’s expectation on the ability of the firm to identify positive NPV projects.

Relative popularity of various capital budgeting methods

Larger firms, public companies and firms with educated management:
· tend to use NPV and IRR.

Private firms and European firms:
· tend to use payback period.

Internal Rate of Return (IRR)

Please see “NET PRESENT VALUE (NPV) vs. INTERNAL RATW OF RETURN (IRR)”

Net Present Value (NPV)

Please see “NET PRESENT VALUE (NPV) vs. INTERNAL RATW OF RETURN (IRR)”

Profitability Index (PI)

PI = PV (future's cash flows)/ initial cash outlay

Rule: If greater than one, accept the project; otherwise reject.

Average accounting rate of return (AAR)

Based on accounting income but not cash flows and not account for time value of money.

AAR = Project's average net income / Project's average book value

Discounted payback period

· The number of years (including fractions) that it takes discounted cash inflows from project to equal original investment.
· Longer period than regular payback.

Rules:
If discount payback period is smaller than benchmark, accept ; otherwise, reject;

Drawbacks: not consider cash flow beyond payback period.

Payback Period (PP)

Number of years (including fractions) that it takes the nominal cash inflows equal to the original investment in a project. Payback period is a good measure for project liquidity but ignore time value of money & terminal value.

PP = full years before full recovery + unrecovered amount at the beginning of the last year/cash flow in the year

For constant cash flow
PP = project cost/ annual cash flow

Rules: If payback period is smaller than benchmark, accept; otherwise, reject.

Drawbacks: not consider the cash flow beyoung payback period and the time value of money.

Classification of projects

· Replacement decisions to maintain the business
· Replacement decisions for cost reduction
· Existing product or market expansion
· New products, markets or mandatory investments

General Concept of Capital Budgeting

Capital Budgeting
Capital budgeting can be defined simply as the process of planning for projects on assets with cash flows of a period greater than one year.

The Importance of Capital Budgeting
· The firm becomes tied to the project and loses some of its flexibility during that period.
· Managers need to forecast the revenue over the life of that asset.
· Capital-budgeting decisions ultimately define the strategic plan of the company.

Typical steps of Capital Budgeting
· Generate ideas
· Analyze projects
· Create the firm’s capital budget
· Monitor decisions and conduct a post-audit

Notes:
· Post-audit: improves future forecasts and efficiency of the operations.

Key principles of capital budgeting
· Incremental cash flows – sunk costs are not considered. Externalities including cannibalization of sales should be included.
· Opportunity costs of cash flows
· Timing of cash flow
· After-tax basis for cash flows
· Financing cost – reflected in the required rate of return but NOT in the incremental cash flows