Gicts Presentation

INTRODUCTION
Cost of Capital
Cost of Capital: Introduction
 The project’s cost of capital is the minimum required rate of return

on funds committed to the project, which depends on the riskiness
of its cash flows
 The opportunity cost of capital or simply cost of capital for a
project is the Discount rate for discounting its cash flows
Significance of the cost of capital
 Evaluating investment decisions
 Designing a firm’s debt policy
 Appraising
the financial performance of top
management
Component of Cost of Capital
 Cost of Equity capital
 Cost of Retain earning
 Cost of Debt
 Cost of preference share capital

Cost of Equity
Is
it free?......Absolutely Not….!!!!
Why do we need to go to Public?
Why one should Invest in this company?
Cost of Equity
 What
are the two ways that companies can raise
common equity?
◦ Companies can issue new shares of common stock.
◦ Companies can retain earnings for the reinvestment.

Cost of Equity
 Isthere a cost for the retained earnings?
◦ yes
 Earnings can be reinvested or paid out as dividends.
 Investors could buy other securities, earn a return.
 Thus, there is an opportunity cost if earnings are reinvested.
 The opportunity cost of retained earnings is the rate of

return, which the ordinary shareholders would have
earned on these funds if they had been distributed as
dividends to them.
Cost of Equity
Three ways to determine the cost of equity, Ke
1. CAPM:
2. DCF (Dividend Discount Model) and its variants:
D1
K = P0 + g
e
Numerical
 What’s the cost of equity based on the CAPM?

Krf = 7%, RPM = 6%, beta = 1.2.
 Ke = Krf + (Km - Krf )b = 7.0% + (6.0%)1.2 = 14.2%.

Cost of Equity: CAPM Vs. Dividend—
Growth Model
 The dividend-growth approach has limited application

in practice
◦ It assumes that the dividend per share will grow at a constant
rate, g, forever.
◦ The expected dividend growth rate, g, should be less than the
cost of equity, ke, to arrive at the simple growth formula.
◦ The dividend–growth approach also fails to deal with risk
directly.
Cost of Equity: CAPM Vs. Dividend—Growth Model
CAPM has a wider application although it is

based on restrictive assumptions:
◦ The only condition for its use is that the company’s share is
quoted on the stock exchange.
◦ All variables in the CAPM are market determined and except the
company specific share price data, they are common to all
companies.
◦ The value of beta is determined in an objective manner by using
sound statistical methods. One practical problem with the use of
beta, however, is that it does not probably remain stable over
time.
Issues in using CAPM
 Deciding Risk free rate of return
 Measurement of Market Risk Premium
 Knowing beta
Deciding Risk free rate of return
 Returns from an investment are said to be risk free if the actual returns
from it are equal to the expected returns. Therefore, there is zero variance
around the expected return.
 Therefore, an investment is risk free if it has:
◦ Zero default risk: There has to be no default risk, which generally implies that
the security has to be issued by the government. Note, however, that not all
governments can be viewed as default free.
◦ Zero reinvestment risk: There is no uncertainty about reinvestment rates,

which implies that there are no cash flows prior to the end of your time horizon,
since these cash flows have to be reinvested at rates that are unknown today..
 So what should be our risk free rate of return?
◦ Short-term government fixed-income securities (T-Bills)?
◦ Long-term government fixed-income securities (T-Bonds)?
◦ Bullet bond or zero-coupon bonds?

 A simpler approach is to match the ‘duration’ of the analysis (long term in

valuation as firms are assumed to have infinite lives) to the duration of the
risk free rate (also long term)
◦ Using a long term government rate (even on a coupon bond) as the

riskfree rate on all of the cash flows in a long term analysis will yield a
close approximation of the true value.
◦ For short term analysis, it is entirely appropriate to use a short term

government security rate as the riskfree rate. It may be noted that in
investment analysis, where we look at projects, these durations are
usually between 3 and 10 years.
 Essentially it has to be Zero-coupon government securities as bulleted

securities face the reinvestment risk.
 Risk Free Rate of Interest in Emerging Markets:

◦ In emerging markets, there are two problems:
 Problem 1:
 The government might not be viewed as risk free (Thailand,
Indonesia, Malaysia, Pakistan etc.)
 Problem 2:
 There might be no market-based long term government rate
(China) as government issues only the short term debt. Many
governments do not borrow long term locally, there are scenarios
where obtaining a risk free rate in the local currency, especially for
the long term, becomes difficult.
 Risk Free Rate of Interest in Emerging Markets:
◦ Problem 1:
 The government might not be viewed as risk free (Brazil, Indonesia)
 One can adjust the local currency government borrowing rate by
the estimated default spread on the government bonds (based on
the assigned country rating) to arrive at a risk-free local currency
rate. The default spread on the government bond can be estimated
using the local currency ratings that are available for many
countries.
 For instance, assume that the Brazilian government bond rate (in
nominal Brazilian Reals (BR)) is 14% and that the local currency
rating assigned to the Brazilian government is B2. If the default
spread for B2 rated bonds is 7.5%, the risk-free BR rate would be
6.5%.
 Risk-free BR rate = Brazil Government Bond rate – Default

Spread = 14% -7.5% = 6.5%
The Historical Premium Approach
 This is the default approach used by most to arrive at the premium to use in
the model
 Steps in estimating the historical premium:
◦ Define a time period for the estimation (1926-Present, 1962-Present....)
◦ Calculate average returns on a stock index during the period
◦ Calculate average returns on a risk-free security over the period
◦ Calculate the difference between the above two averages
◦ Use the above as a market risk premium in your analysis
 The limitations of this approach are:
◦ it assumes that there are no trends in the risk premium, and that investors today
demand similar premiums to those that they used to demand two, four or six
decades ago (The risk aversion may change from year to year, but it reverts back
to historical averages)
◦ it assumes that the riskiness of the “risky” portfolio (stock index) has not changed
in a systematic way across time.

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INTRODUCTION

 The project’s cost of capital is the minimum required rate of return

 Designing a firm’s debt policy

 Cost of Equity capital

 Cost of Retain earning

 Cost of preference share capital

◦ Companies can issue new shares of common stock.

◦ Companies can retain earnings for the reinvestment.

 The opportunity cost of retained earnings is the rate of

2. DCF (Dividend Discount Model) and its variants:

 What’s the cost of equity based on the CAPM?

 Ke = Krf + (Km - Krf )b = 7.0% + (6.0%)1.2 = 14.2%.

 The dividend-growth approach has limited application

CAPM has a wider application although it is

 Deciding Risk free rate of return

 Measurement of Market Risk Premium

 Therefore, an investment is risk free if it has:

◦ Zero reinvestment risk: There is no uncertainty about reinvestment rates,

 So what should be our risk free rate of return?

◦ Short-term government fixed-income securities (T-Bills)?

◦ Long-term government fixed-income securities (T-Bonds)?

◦ Bullet bond or zero-coupon bonds?

 A simpler approach is to match the ‘duration’ of the analysis (long term in

◦ Using a long term government rate (even on a coupon bond) as the

◦ For short term analysis, it is entirely appropriate to use a short term

 Essentially it has to be Zero-coupon government securities as bulleted

 Risk Free Rate of Interest in Emerging Markets:

 Risk-free BR rate = Brazil Government Bond rate – Default

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