As we discussed in a previous article, firms create value for their shareholders when they invest in projects which earn returns in excess of their capital costs. Capital costs, particularly equity costs, are highly subjective. For firms, the total cost of capital is based on the mix of financing sources. In this article, we discuss how firms measure capital costs and choose financing sources which enhance firm value.
- CAPITAL STRUCTURE
A firm’s capital structure refers to the mix of the firm’s sources of financing. The value of the firm is the present value of the firm’s future cash flows discounted at the firm’s cost of capital. Thus, the goal of corporate finance decision makers relating to the firm’s cost of capital is to establish a financing mix which minimizes the cost of capital, and thus enhances the value of the firm.
2.1. Weighted Average Cost of Capital (WACC)
A firm’s weighted average cost of capital (WACC) is an average of the costs of each of the firm’s capital sources, weighted by the proportion of each capital source to the firm’s total capital. A generalized WACC calculation recognizes the costs from three capital sources: debt (Kd), preferred equity (Kp), and common equity (Ke). The basic WACC formula is as follows:
WACC = (Kd x D/(D+P+E)) + (Kp x P/(D+P+E) + (Ke x E/(D+P+E))
Where D is the firm’s outstanding debt, P is the firm’s outstanding preferred stock, and E is the firm’s outstanding common equity. Corporate managers and investors should use market values for the outstanding amounts of these capital sources when possible.
2.2. Optimal Capital Structure
A firm’s optimal capital structure is the mix of capital sources which yields the lowest WACC. Optimal capital structures will differ by industry, as some industries have stable cash flows and thus can support higher debt levels. As a firm increases debt levels, the firm’s risk increases and thus debt and equity costs will increase. Firms can only decrease the WACC by increasing debt up to a certain level, which will differ by firm and industry as mentioned above. In practice, the optimal capital structure is a range rather than a single figure.
Since debt is lower in cost (both pre-tax and after-tax) than equity, a firm’s optimal capital structure will include some level of debt. However, firms should weigh the trade-offs of achieving an optimal capital structure with the benefits of a more conservative capital structure. Firms with high debt levels will have less operational and financial flexibility than less leveraged firms. A strong balance sheet is one with both relatively liquid assets and low debt levels. A firm with a strong balance sheet will have more opportunities for value-enhancing initiatives. This is especially true during industry downturns, where less-leveraged firms can take business from or acquire weaker competitors.
- COST OF DEBT FINANCING
Most firms will issue multiple forms of debt. In general, debt sources with the shortest maturities will have the lowest interest rates. Similarly, senior bank financing will have a lower interest rate than junior bonds. A corporate manager should try to match the duration of the project with the duration of the debt source. Investors and security analysts should be conservative and use the firm’s longest-maturity and highest-cost debt when calculating WACC (used as the discount rate in firm valuation).
The market interest rate for a firm’s debt can differ substantially from the effective interest rate on the firm’s outstanding bonds. Since the cost of debt should reflect the cost of issuing new debt, corporate analysts and investors should use the yield-to-maturity (YTM) on outstanding bonds. The YTM is the rate which equates a debt instrument’s price, which fluctuates based on changing interest rates, with the present value of the debt instrument’s future cash flows.
The firm’s debt cost, Kd, should also reflect the tax-deductibility of interest expense (the “tax shield”). Debt costs can be tax-adjusted using the following formula:
Kd = YTM x (1 – Tc)
Where Tc is the firm’s marginal tax rate.
- COST OF EQUITY FINANCING
Equity represents the most junior claim of any security on the company’s cash flows and assets. Thus, a company’s cost of equity will always be higher than its cost of debt. What the premium should be, however, is highly subjective. In general, the firm’s equity cost will be:
Ke = Kd + Equity Risk Premium
4.2. The Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is the most widely used method of calculating equity costs. With the CAPM, equity cost (Ke) is a function of: the risk-free rate (Rf), the return premium of stocks over the risk-free rate (E(Rm) – Rf), and the firm’s “systematic” risk (Be). The CAPM formula is thus:
Ke = Rf + Be[E(Re) – Rf]
The CAPM theorem is an extension of Harry Markowitz’s portfolio theory. The CAPM assumes that all investors follow portfolio optimization and have thus diversified away all the risk specific to an individual stock (referred to as non-systematic risk). The CAPM only recognizes risk common to all stocks, known as systematic risk. In practice, this systematic risk is calculated as the correlation of a stock’s past returns to a market portfolio, usually proxied by the S&P 500. This risk measure is referred to as a stock’s “beta” (Be). If a stock’s beta is greater than 1, it is considered riskier than the market and will have a higher equity cost. If a stock’s beta is less than 1, it is considered less risky than the market and will have a lower equity cost. Betas are easily obtainable, as they are published by various popular financial data services. For non-publicly traded firms, betas must be estimated from publicly-traded competitors.
4.3. Some Criticisms of CAPM
The idea that risk can be described by a single number is highly controversial. Numerous academic studies have been authored which show a poor relationship between beta and actual stock returns. As a result, many academics and finance practitioners have advocated using “multi-factor” models, which recognize other statistical factors in the equity risk premium. However, these multi-factor models strike many as awkward and no-less subjective than the traditional CAPM.
A thorough discuss of the merits and flaws in the CAPM is beyond the scope of this article. However, investors and corporate analysts should recognize that equity costs should be at some premium to debt costs. What that premium should be will likely continue to be a source of discussion in finance. Absent a viable formulaic alternative, many investors and corporate finance managers continue to use the CAPM.
Asquith, Paul, and Lawrence A. Weiss. Lessons in Corporate Finance: A Case Studies Approach to Financial Tools, Financial Policies, and Valuation. Hoboken: Wiley, 2016.
Clayman, Michelle R., Martin S. Fridson, and George H. Troughton, Corporate Finance: A Practical Approach, 2nd ed. (Hoboken: Wiley, 2012)