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:

Table 4.17: Cost of capital for Disney's 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:

Table 4.18: Cost of Capital for Aracruz: Real and US Dollars
Money Attraction Secrets

Money Attraction Secrets

Discovering The Laws Of The Right Financial Blueprint. I bet you're scared, angry and maybe even confused. These are perfectly rational and appropriate reactions to the worldwide credit crisis that erupted in 2008 and sends shudders through every home in the United States.

Get My Free Ebook


Post a comment