Question

Explain how to estimate the cost of capital. In particular, explain how to estimate the equity cost of capital, list two different methods to estimate the debt cost of capital, and how to calculate the weighted average cost of capital for a given debt-equity ratio.

Answer 1

Cost of equity can be estimated using the CAPM model. As per this model cost of equity = risk free rate + beta*(market rate of return - risk free rate).

In the above formula beta is the risk level of a stock relative to the overall market. Risk free rate is usually based on short term U.S. Treasury bills.

Two different methods to estimate cost of debt are:

(i): Using yield to maturity (YTM): This method makes use of YTM of a debt instrument/bond. It should be noted that present value of a debt instrument/bond = coupon 1/(1+YTM)^1 + coupon 2/(1+YTM)^2 + …… (coupon n + Future value)/(1+YTM)^n

(ii): Matrix pricing method based on debt ratings – The second method to compute cost of debt is the matrix pricing method. In this method credit rating of a company is looked at and then yield spread over US treasuries is determined. This yield spread is then added to risk free rate. So cost of debt = yield spread over US treasuries+risk free rate.

It should be noted that cost of debt is always after tax.

To compute weighted average cost of capital (WACC) for a given debt/equity ratio we can use the following formula: weighted average cost of capital = weight of debt/(weight of debt+equity)*after tax cost of debt + weight of equity/(weight of debt+equity). This can be explained with the help of some assumed numbers as shown below:

Assuming no other form of capital the weight of debt+weight of equity = 1 (or 100%). Suppose that for a company debt/equity ratio = 1.2. In other words debt is 1.2 times the amount of equity. We can find the weight of debt and equity from this. Total capital = 1+1.2 = 2.2 .Now again suppose that after tax cost of debt = 5% and cost of equity = 4%. So WACC = 1.2/(1+1.2)*5% + 1/(1+1.2)*4%

= 4.55%