In the previous volumes we covered the various types of valuation approaches and various types of value. This article will focus on cost of capital which is a key component used in deriving value under an income based approach.
Companies typically access financing through equity or debt and in some instances financing is accessed through both. Cost of capital usually refers to the weighted average cost of capital (“WACC”), this is the blended cost of equity and debt. In order to determine a firm’s cost of capital, the cost of the sources of financing must be determined. Cost of equity (Ke) and cost of debt (Kd) should be determined on a prospective basis and be reflective of the expected risks and rates of return in the future.
In order to calculate WACC, we must add the weighted Ke and the weighted after-tax Kd. This is represented by the formula below:
WACC = (Ke* We) + (Kd * (1-t) * Wd)
Ke is the cost of equity
We is the weighting of equity in the capital structure
Kd is the cost of debt
Wd is the weighting of debt in the capital structure
t is the effective corporate tax rate
Cost of equity (Ke)
The cost of equity is the rate of return required by equity investors. This is the rate of return required by shareholders to compensate them for the risk that they undertake as equity investors.
Cost of debt (Kd)
The cost of debt is the rate of return required by prudent lenders. Stated differently, the cost of debt is the market interest rate that a firm has to pay on its borrowing.
The chart above shows that at debt levels below the optimal capital structure, neither equity investors nor lenders require greater returns to compensate for this level of risk and since debt costs less than equity adding debt reduces the WACC. However, when the debt level increases beyond the optimal capital structure, both equity investors and lenders demand higher returns which increases the WACC.
The cost of capital that is used in a fair market valuation should be based on the optimal capital structure – its minimum WACC - of the firm and not its actual capital structure. Optimal capital structures are usually determined based on an analysis of the capital structures of comparable companies. The use of optimal capital structures eliminates the risk of bias of various owners in how they finance their businesses based on the percentage of debt and equity in their capital structures.
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