In this series, we have already discussed the high-level considerations and the concept of stage-wise value assessment. In this post, we will discuss the assessment of the cost of capital before moving to different methods of capital investment assessment. Whatever method we use for capital investment assessment, whether an investment is feasible or not significantly depends on the cost of capital for funding the project. Please notice that I mentioned the cost of capital to fund the project not the capital structure of the firm.
The cost of capital reflects the aggregate expectations of the sources of capital depending on the market condition, the financial standing of the firm and other investment opportunities available to the funders. To arrive at the cost of capital, we need to first decide how we are going to fund a project based on the available sources of capital.
SOURCES OF CAPITAL
A project can be funded using internal capital source i.e. retained earnings or external sources i.e. issuing debt or issuing new equity or preference shares.
1. Internal - Retained Earnings
Retained earnings is the part of the income which the firm chooses to reinvest in the business after distributing dividends to preferred shareholders and common shareholders.
On the outset, it may seem like the retained earnings do not involve any cost for the firm. This notion is erroneous. By reinvesting the earnings (after paying contractual obligations to debt and preferred shareholders) the firm is effectively raising capital from the common shareholders who could otherwise claim the earnings as dividends. From a common shareholder’s point of view, the opportunity cost for the retained earnings depends in the expected market return (or return from any other comparable investment), dividend distribution tax and income tax on received dividends.
A representative opportunity cost would be = Market Return X (1 - % Distribution Tax) X (1 - %income tax on dividend)
The expected return on equity for the firm should be higher than the opportunity cost.
Debt means the sources of funds which the firm is contractually obligated to repay. A firm can raise capital using debt in various ways – bank loans, debentures & bonds, commercial papers etc. The basic idea is that the repayment amount and schedule is predefined and the firm is contractually obligated to repay.
As we are considering the cost of debt for a project, we should consider the cost lenders likely to charge for new debt issuance not the historical cost of the firm. The cost will depend on prevailing market rates, assets which can be pledged, seniority of the instrument and expected credit rating for the instrument etc.
Apart from these, we should also consider that issuance of debt costs money and the cost of debt should consider that cost of issuance as well.
As interest payments reduce the taxable income for the firm thus reducing the tax liabilities. So, the after-tax cost of debt
= Pre-tax cost of debt X ( 1 - % Income tax rate for the company)
Equity does not represent any contractual obligation to repay but involve ownership in the firm. As there is no predefined rate of return, it may seem that the equity comes for free. In reality, equity involves opportunity cost for investors.
Determination of cost of equity is based on the opportunity cost. For publicly listed companies, the capital asset pricing model is used to estimate the cost of equity. For privately held companies, CAPM should not be used. To implement CAPM we need to find the sensitivity of the market equity return of the company with the market return i.e. beta. Privately held companies have rare valuation events i.e. when the shares of the company are valued. We simply cannot estimate beta with such limited data.
Note: Valuation expert and profession at NYU Stern school of business, Dr Aswath Damodaran suggests some ways to estimate the beta for a private company link provided below the post. We are going to explore some other let theoretical options.
Many private equity investors, including venture capital firms and angel investors, are pretty upfront about their return expectations mostly expressed in terms of multiples. We can calculate the expected Internal Rate of Return (IRR) from the expected multiple based on a reasonable payback period assumption. This IRR can be used as the cost of equity.
If we do not have such expressed return expectations, we can estimate the cost of equity-based on the opportunity cost. We can calculate the average cost of equity of the publicly traded companies in the same industry and then add a liquidity premium to reflect the fact that the shares of the private company cannot be liquidated readily.
Another option is to estimate the beta based on comparable companies, calculate the cost of capital using CAPM and then add liquidity premium.
4. Preference Share Capital
Preference shares are shares which has a preference over the common shareholders over the dividends. The predefined dividend rate is generally considered as the cost of preference share capital.
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WACC represents the overall cost of capital for the project from all the sources. WACC is calculated as the weighted average of the costs for the sources of funds mentioned above.
The weights are calculated by dividing funds from an individual source by the sum of all funds. For equity we can consider either the book value or the market value for the calculation of the weights – market values are more reasonable because it represents the expectations for the investors in the market for any new fundraising.
For the debt, the after-tax cost of capital should be used to reflect the tax-saving effect of interest payments.
WACC = (Opportunity Cost of Retained Earnings) X (Retained earnings used / Total Investment)
+ (Cost of Equity ) X (Equity capital used / Total Invesment)
+ (Cost of Preference share capital) X (Preference share capital used / Total Investment)
+ (Pre-tax cost of debt) X (Debt used / Total Investment) X ( 1 - % Income tax rate)
Entrepreneurs often deal with projects without any historical comparable i.e. novel projects. To deal with the inherent ambiguity, these projects are implemented in phases and different milestones are set to be achieved. Capital is raised in stages to achieve some milestones.
It will not be proper to assume that the cost of capital will be the same for all the stages. It is better to consider each stage as a separate project and estimate the cost of capital for each stage.
Estimating Beta for private companies :