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