Answer to Question #9083 in Economics of Enterprise for Harry

Question

Analyze the various ways to determine the cost of capital and determine which is the most difficult to get right. Explain your rationale.

Answer 1

The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This is the rate of return that a firm would
receive if it invested in a different vehicle with similar risk. Cost of capital = interest rate at zero level risk + premium for business risk + premium for financial risk. There are other different ways to determine the cost of capital:

1.The cost of debt is relatively simple to calculate, as it is composed of the rate of interest paid.
It is computed by taking the rate on a risk free bond whose duration matches the
term structure of the corporate debt, then adding a default premium. The formula
can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax
rate and Rf is the risk free rate.

2.The cost of equity is more challenging to calculate as equity does not pay a set return to its investors. It is therefore inferred by comparing the investment to other investments
(comparable) with similar risk profiles to determine the "market" cost of
equity. It is commonly equated using the Capital Asset Pricing Model (CAPM) formula:


An alternative to the estimation of the required return by the CAPM as above, is the use of the Fama–French three-factor
model.
r = R_f + β (K_m - R_f ) + bs * SMB + bv * HML + α.
Here r is the portfolio's rate of return, R_f is the risk-free return rate, and K_m is the return of the whole stock market. The "three factor" β is analogous to the classical β but not equal to it, since there are now two additional factors to do some of the work. SMB stands for "small (market capitalization) minus big" and HML for "high (book-to-market ratio) minus low"; they measure the historic excess
returns of small caps over big caps and of value stocks over growth stocks.


3. The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. Its calculation is an iterative procedure
which requires estimation of the fair market value of equity capital:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V = E + D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate