Estimating and using the cost of capital

With the estimates of the costs of the individual components - debt, equity and preferred stock (if any) - and the market value weights of each of the components, the cost of capital can be computed. Thus if E, D and PS are the market values of equity, debt and preferred stock respectively, the cost of capital can be written as follows:

Cost of Capital = ke ( E/ (D+E+PS)) + kd ( D/ (D+E+PS)) + kps ( PS/ (D+E+PS)) The cost of capital is a measure of the composite cost of raising money that a firm faces. It will generally be lower than the cost of equity, which is the cost of just equity funding.

62 While many companies outside the United States do no provide details on lease commitments in future years, Aracruz publishes financial statements that use US accounting standards for its ADR listing.

It is a source of confusion to many analysts that both the cost of equity and the cost of capital are used as hurdle rates in investment analysis. The way to resolve this confusion is to recognize when it is appropriate to use each one.

• If we want to adopt the perspective of just the equity investors in a business or a project and measure the returns earned just by these investors on their investment, the cost of equity is the correct hurdle rate to use. In measuring the returns to equity investors then, we have to consider only the income or cashflows left over after all other claimholders needs (interest payments on debt and preferred dividends, for instance) have been met.

• If the returns that we are measuring are composite returns to all claimholders, based upon earnings before payments to debt and preferred stockholders, the comparison should be to the cost of capital.

While these principles are abstract, we will consider them in more detail in the next chapter when we look at examples of projects.

Illustration 4.16: Estimating Cost of Capital

Culminating the analysis in this chapter, we first estimate the costs of capital for each of Disney's divisions, In making these estimates, we use the costs of equity that we obtained for the divisions in illustration 4.11 and Disney's cost of debt from illustration 4.12. We also assume that all of the divisions are funded with the same mix of debt and equity as the parent company. Table 4.17 provides estimates of the costs of capital for the divisions:

 Business Cost of Equity After-tax cost of debt E/(D+E) D/(D+E) Cost of capital Media Networks 10.10% 3.29% 78.98% 21.02% 8.67% Parks and Resorts 9.12% 3.29% 78.98% 21.02% 7.90% Studio Entertainment 10.43% 3.29% 78.98% 21.02% 8.93% Consumer Products 10.39% 3.29% 78.98% 21.02% 8.89% Disney 10.00% 3.29% 78.98% 21.02% 8.59%

The cost of capital for Disney as a company is 8.59% but the costs of capitals vary across divisions with a low of 7.90% for the parks and resorts division to a high or 8.93% for studio entertainment.

To estimate the cost of capital in both real and nominal US dollar terms for Aracruz in real terms, we use the cost of equity (from illustration 4.11) and the after-tax cost of debt (from illustration 4.12) and the estimates are reported in table 4.18:

The Force Of Fulcrums

Learning About The Force Of Fulcrums Can Have Amazing Benefits For Your Life And Success! How simple shifts in your thinking will make you rich forever! If you wish to grow beyond your current state of being, you'll need to learn about the fulcrum precept. A fulcrum is the pivot point for a lever. Therefore, whenever you wish to properly utilize leverage, then, you'll need to place the fulcrum in the right place. Many people have never heard if this and have no idea how to go about figuring out where they are or how to change it.

Get My Free Ebook