Estimating Cost of Capital

Estimating Cost of Capital

Anders Vilhelmsson

Department of Business Administration, Lund University

September 2009

Cost of Capital
 Estimating Cost of Capital

Aim of the 2 lectures

I Cover chapter 10 in the book

I Cover relevant research, particularly from 2004 (when the

book was updated) until 2009
I Slides can be found after the lecture at www.nek.lu.se/nekavi

Cost of Capital
 Estimating Cost of Capital

Valuation

I Easy in theory, the total value of a company is the present

value of all future cash ‡ows

I CF 1 CF 2 CF 3 CF 4 CF 5
V = + + + + ...
1 +k (1 +k )2 (1 +k )3 (1 +k )4 (1 +k )5
I However, k is unknown and may not be constant over time

Cost of Capital
 Estimating Cost of Capital

WACC

I WACC = VD kd (1 Tm ) + VE ke
D = Value of debt
V = Enterprise value
kd = Current borrowing rate (tax deductible)
Tm = Corporate (marginal) tax rate (e.g. 26.3% in Sweden)
E = Value of equity
ke = Cost of equity
I Example 1 on the board

Cost of Capital
 Estimating Cost of Capital

WACC

I Why do we need 2 full lectures to do the above calculations?

I kd and especially ke are unobservable
I We need theory (models) to estimate kd and ke
I D
In practice it may also be non-trivial to calculate (target) V
and VE
I We will put most e¤ort in estimating ke correctly since the
uncertainty is largest in this number.

Cost of Capital
 Estimating Cost of Capital

Cost of debt

I Primary problem, non-‡at term structure of interest rates

I In principle 1 year CF should be matched with 1 year debt
rate, 2 year CF with 2 year rate and so on
I In practice match with the duration on the company’s CFs
I Growth stocks, high duration, value stocks low duration
I The book recommends about 10 years for all companies

Cost of Capital
 Estimating Cost of Capital

Duration

I Macaulay’s Duration:
n n
PV (CF t ) CF t /(1 +r )t
D= ∑ t V = ∑ t V
t =1 t =1
I V = Enterprise Value
I Do loan example on the board
I What happens with the sum is in…nite (e.g. CF from a stock)?
n
PV (CF t )
I D= ∑ t V + (n + Dcv ) PV (VCVn )
t =1
I Dcv = 1 Duration of continuing value, derive on the board.
r g
I Do stock example on the board

Cost of Capital
Duration

Figure: Source: Own calculations

Term structure of interest rates
 Estimating Cost of Capital

Estimate cost of debt

I Use Yield to maturity (YTM) on long term bond

I YTM > kd but small di¤erence for BBB companies and better
I P= C
+ C
+ C
... C +P n
1 +ytm (1 +ytm )2 (1 +ytm )3 (1 +ytm )
I Solve for YTM but this is an n:th order equation (numerical
solution)
I Calculate YTM in Excel example

Cost of Capital
Cost of debt vs YTM

YTM as a function of Recovery rate and defualt prob. cost of debt is 6%

0.45

0.4

0.35

0.3
YTM

0.25

0.2

0.15

0.1

0.05
0.25

0.50
0.45
0.40
0.13 0.35
0.30
0.25
0.20
0.15
0.10
0.05
0 .01 0
Default probability Recovery rate

Figure: Source: Own calculations

 Estimating Cost of Capital

Estimate cost of debt

I What to do with companies that only have untraded or short

debt?
I Find credit rating
I Compare to traded long bonds with the same credit rating
I What to do with companies with <BBB rating?
I Use BBB cost of debt and add 0.5% units (motivated by 0.1
higher CAPM beta)

Cost of Capital
 Estimating Cost of Capital

Estimate cost of equity

I Estimating the cost of equity is the same thing as explaining

the cross section of stock returns
I Why do companies have di¤erent expected returns?
I Theory: Because of di¤erent exposure to systematic risk
factor(s)
I CAPM, FF3, momentum, liquidity, risk aversion (APT)

Cost of Capital
 Estimating Cost of Capital

The CAPM

I Security market line (SML) E [Ri ] = rf + βi (E [Rm ] rf )

E [Ri ] = Expected return on asset i
rf = risk free rate
E [Rm ] = Expected return on the market portfolio
cov (R i ,R m )
βi = σ2
systematic risk in asset i
m

I Problem: E [Ri ], E [Rm ] and βi are all unobservable and rf

varies with maturity

Cost of Capital
 Estimating Cost of Capital

Estimating the risk free rate

I Same thing as with the cost of debt (Match each cash ‡ow)
I Make sure cash ‡ows and cost of capital uses the same
currency

Cost of Capital
 Estimating Cost of Capital

Estimating the market risk premium

I Interesting working paper at

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1473225
I Compares the recommended market risk premium from 150
di¤erent textbooks
I CAPM actually gives the market risk premium as
E (Rm ) rf = γσ2m assuming CRRA utility
I σ2m can, at least historically, be observed but not γ (the
relative risk aversion)

Cost of Capital
Estimating the market risk premium

Figure: Source: Fernández (2009,WP)

 Estimating Cost of Capital

Estimating the market risk premium

Figure: Source: Fernández (2009,WP)

Cost of Capital
 Estimating Cost of Capital

Estimating Beta

I Lets look at the recommendations given by the book

I Use at least 60 data points
I Use monthly data
I Use SP500 or MSCI world index as market portfolio

Cost of Capital
 Estimating Cost of Capital

At least 60 data points

I Number of data points is a trade o¤ between

I Precision and possible time variation
I If you think that beta is constant over time use all data you
have
I 60 data points in not a magic number, happens to be 5 years
of monthly data

Cost of Capital
 Estimating Cost of Capital

Use monthly data

I Use monthly frequency - good idea if stock is very illiquid
(traded infrequently)
I For e.g. the 30 stocks in Dow Jones you can use daily of even
intra-daily (15-30 minute data)
I Andersen et al. (2006) (Dow Jones 30 between 15 minutes
and 1 day),
I Lewellen and Nagel (2006, JFE) daily and weekly on all NYSE
stocks
I You can also adjust (Dimson 1979, JFE) for infrequent trading
I Bid ask Bounce can be …xed by calculating returns using
midquotes instead of transaction prices
(bid price + ask price )/2
I Currently there is a shift towards use of higher frequency in
beta estimation
Cost of Capital
 Estimating Cost of Capital

Use a broad market portfolio

I Use a broad value weighted stock index to calculate betas,

otherwise their is no theoretical foundation.
I Never use a local market index, in e.g. Finland you would
basically measure a stock’s sensitivity towards Nokia

Cost of Capital
 Estimating Cost of Capital

Industry betas

I Idea: Improve precision in beta by using the mean beta of the

industry (adjusted for leverage)
I Assumes that companies in the same industry has the same
systematic operational risk
I Di¤erent betas within an industry is only due to di¤erent
leverage
I Master thesis topic: How well does this assumption hold
empirically?

Cost of Capital
 Estimating Cost of Capital

How to calculate an industry beta

I First compute betas for all companies in the industry with

regression analysis
I Unleverage beta with
Vu
+ VuV+txaVtxa βtxa = D D+E βd + D E+E βe
V u +V txa βu
) βe = βu + DE ( βu βd ) + VEtxa ( βtxa βu )
assume βd = 0 and βu = βtxa
) βe = βu (1 + DE )
I Do calculations on the board

Cost of Capital
 Estimating Cost of Capital

How to calculate an industry beta

I Average βu over all companies

I D
Relever to each companies target E ratio
I Example on the board

Cost of Capital
 Estimating Cost of Capital

Other factor models

I Eugene Fama and Kenneth French 3 factor model FF3, Fama

and French (1992, JoF)
E [Ri ] = rf + βi ,m (E [Rm ] rf ) + βi ,smb E [SMB ] + βi ,HML E [HML]
SMB is the return on a small stock portfolio minus a big stock
portfolio (small minus big)
HML is the return on a high book to market minus a low book to
market portfolio (high minus low)
I Is SMB and HML capturing risk exposure or misspricing?
I Still open research question, enough papers to be the topic for
a separate course
I Momentum, Jegadeesh and Titman (1993,RFS) and Liquidity,
Amihud (2002) are other prominent factors

Cost of Capital
Sample period is from March 1990 to April 2004
Panel A: 25 portfolios sorted on Book-to-market and size
λMKT λSMB λHML λMOM λMIM RA R2
CAPM -0.626 0.27
[-0.87]
CAPM+MIM RA -0.935 -0.020 0.64
[-1.51] [-2.07]
FF3 -1.602 0.141 0.353 0.60
[-2.92] [0.46] [1.24]
FF3+MIM RA -0.988 0.174 0.289 -0.023 0.66
[-1.41] [0.57] [1.03] [-2.61]
FF3+MOM+MIM RA -0.666 0.178 0.325 1.895 -0.025 0.68
[-0.83] [0.59] [1.16] [2.11] [-2.80]

Source: Nyberg and Wilhelmsson (forthcoming, The …nancial

review)
Sample period is from March 1990 to April 2004
Panel B: 25 portfolios sorted on Book-to-market and size and 30 industry portfolios
λMKT λSMB λHML λMOM λMIM RA R2
CAPM -0.031 0.00
[-0.06]
CAPM+MIM RA -0.202 -0.012 0.15
[-0.41] [-1.23]
FF3 -0.144 0.110 0.033 0.03
[-0.29] [0.36] [0.11]
FF3+MIM RA 0.019 0.154 -0.008 -0.027 0.31
[0.04] [0.50] [-0.03] [-3.12]
FF3+MOM+MIM RA 0.176 0.141 0.013 1.211 -0.025 0.33
[0.31] [0.46] [0.04] [1.34] [-2.93]

Source: Nyberg and Wilhelmsson (forthcoming, The …nancial

review)
 Estimating Cost of Capital

In defence of beta

I Builds on solid theory

I Assumes multivariate normal distribution or investors with
preferences for only mean and variance (both assumptions are
wrong)
I FF3 purely empirical evidence, no theory, size premium
vanishing
I rejecting FF3 does not really support CAPM we have more
than 2 competitors (evolution/creationism)
I CAPM may hold conditionally (beta should be forward
looking)
I E¤ect is too small to save CAPM according to Lewellen and
Nagel (2006, JFE)

Cost of Capital
 Estimating Cost of Capital

Importance of model selection

I How important is the selection of factor model? Lets try to

…nd out!
I Calculate cost of equity for J&J using CAPM and FF3 in
Excel.
I Is the J&J results typical or not? Possible master thesis topic.

Cost of Capital
 Estimating Cost of Capital

Is the cost of equity time varying / are stock returns

predictable ?

I E [ri ] rf = βi [E (Rm ) rf ]
I E (Rm ) rf = γσ2m

I Three possible sources of time variation

I Time varying betas
I Time varying risk aversion
I Time varying volatility

Cost of Capital
 Estimating Cost of Capital

Time varying betas

Figure: Source: Andersen et al. (2004) AA is Alcoa, ALD is Allied

capital corporation, DD is DuPont, and DIS is WaltDisney.The sample
covers theperiod from 1962:3 through 1999:3.

Cost of Capital
 Estimating Cost of Capital

Time varying betas

Figure: Source: Andersen et al. (2004)

Cost of Capital
 Estimating Cost of Capital

Time varying betas

Figure: Source: Andersen et al. (2004) The sample covers the period
from 1993:2 through 1999:3. We calculate the realized quarterly betas
from daily returns.
Cost of Capital
 Estimating Cost of Capital

Time varying betas

Figure: Source: Andersen et al. (2004) The sample covers the period
from 1993:2 through 1999:3. We calculate the realized quarterly betas
from 15 minute returns.
Cost of Capital
 Estimating Cost of Capital

How important is the increased precision from 15 minute

returns?

I Daily sampling gives uncertainty (95% CI) of about 1, 15

minute of about 0.2
I Simple illustration of e¤ect on valuation, say
E (Rm ) rf = 3%, rf = 2% Company with constant growth
in dividends of 2%, last dividend 1$. Point estimate of beta
1.5.
I Daily sampling gives beta between 1.0 and 2.0, 15 minute
sampling gives beta between 1.4 and 1.6,
I How much will this e¤ect the equity value of a company with
a constant growth of dividends of 2%, last dividend 1$.
value = 1/(k g )

Cost of Capital
 Estimating Cost of Capital

How important is the increased precision from 15 minute

returns?

I Daily beta Capital cost between 5% and 8%. Value between

1/(k g ) = 1/(0.050 0.02) : 33. 33$ and
1/(0.080 0.02) = 16. 67$
I 15 minute beta Capital cost between 6.2% and 6.8%. Value
between 1/(k g ) = 1/(0.062 0.02) = 23. 81$ and
1/(0.068 0.02) = 20. 83$

Cost of Capital
 Estimating Cost of Capital

Time varying risk aversion

Figure: Source: Bollerslev et al. (2009, JEc)

Cost of Capital
 Estimating Cost of Capital

Time varying risk aversion

Figure: Source: Bollerslev et al. (2009, JEc)

I Conclusion - yes (not everyone agrees)

Cost of Capital
 Estimating Cost of Capital

Time varying variance

Figure: Variance from 1960-2000

I Conclusion - Yes clear consensus

Cost of Capital
 Estimating Cost of Capital

Stock return predictability

I Emerging consensus that stock returns are predictable (a

change since the book was written)
I Taken as evidence of time varying risk premium, not as
evidence against EMH
I Remember EMH says risk adjusted returns are
unpredictable, not regular returns
I Conclusion: The cost of equity is time-varying but it is
extremely hard to estimate over short periods of time so we
may be better of using a constant cost of equity

Cost of Capital
 Estimating Cost of Capital

Hybrid …nancing

I Mix of debt and equity such as convertible bonds, options,

CDS instruments etc.
I Can be broken down to basic parts using replicating portfolios
I E.g. Convertible bond = Corporate bond + Call option, Call
option = Risk free bond + company stock
I More on this on the real option lectures

Cost of Capital