Session 13: Estimating Hurdle Rates- Financing Weights & Cost of Capital

Summary

In this finance class session, the focus is on raising capital through borrowing, specifically discussing the importance of using market values instead of book values to compute the cost of capital. The instructor illustrates how to estimate the market value of debt using Disney as a case study, emphasizing the need to include lease commitments in debt calculations. By analyzing the costs of equity and debt, the session concludes with guidance on determining appropriate hurdle rates for investments, highlighting the significance of accurate measurement of cash flows and risk assessment in decision-making.

Takeaways

• 😀 Debt financing is one of the ways to raise money for a business, with the cost of debt playing a significant role in estimating the cost of capital.
• 😀 When calculating the cost of capital, it is essential to use market values for both equity and debt, rather than relying on book values, which can be misleading.
• 😀 Some companies still use book value weights for the cost of capital, but this can result in a lower cost of capital, which is less accurate.
• 😀 The market value of equity is easy to calculate for publicly traded companies, but the market value of debt is more complex, especially when dealing with non-traded debt like bank loans.
• 😀 Market value of debt can be estimated by treating the company's debt as a large coupon bond, using information about the interest expense and maturity of the debt.
• 😀 Leases should be treated as debt when estimating the cost of capital, as they represent significant liabilities that affect a company's overall debt load.
• 😀 To estimate the total market value of a company's debt, both interest-bearing debt and lease commitments should be considered.
• 😀 Once the market value of debt and equity are determined, they can be used to calculate the weightings of debt and equity in the cost of capital calculation.
• 😀 The cost of equity is derived from the risk-free rate, beta, and risk premium, while the cost of debt is based on the risk-free rate and company-specific factors such as credit rating and tax benefits.
• 😀 The cost of capital represents the minimum acceptable return for a business, and it is determined by the mix of debt and equity used to finance the business and the risk associated with the investment.

Q & A

What is the primary focus of this session in the corporate finance class?

The primary focus is on raising money through borrowing, specifically discussing the cost of debt and the cost of capital. The session aims to explain how to calculate and understand the cost of capital, incorporating both the cost of equity and the cost of debt.

Why is it important to use market value instead of book value when calculating the cost of capital?

Market values provide a more accurate reflection of a company's financial standing and borrowing capacity as they are updated regularly, unlike book values, which are more static and infrequent. Using market value ensures that the cost of capital reflects the current economic conditions.

What are some common reasons CFOs use book value instead of market value to calculate cost of capital?

Some CFOs argue that book value is more reliable and less volatile than market value, offering a conservative approach. Others claim that since returns in capital are based on book value, the cost of capital should be as well. However, these reasons are criticized as inconsistent and outdated.

How do you calculate the market value of debt for a company like Disney?

To calculate the market value of debt, you treat the company's debt as a large coupon bond, discounting both the annual interest payments and the face value of the debt back to the present using the company's cost of debt. The market value of debt is then computed as the present value of these cash flows.

Why should lease commitments be included in the calculation of a company's debt?

Lease commitments should be considered debt because they represent future financial obligations. For companies like Disney, leases make up a significant portion of total debt, and excluding them would provide an incomplete picture of the company's borrowing.

What is the cost of capital for Disney, and how is it determined?

The cost of capital for Disney is 7.81%. It is calculated by weighting the cost of equity and the cost of debt based on their respective market values, incorporating Disney's specific cost of equity (8.52%) and cost of debt (2.4%) after taxes.

How does the cost of capital differ for companies with different financing structures?

For companies with a higher proportion of equity financing, like Baidu (95% equity, 5% debt), the cost of capital is more influenced by the cost of equity. For companies with a significant amount of debt financing, like Tata Motors (70% equity, 30% debt), both the cost of equity and debt play a larger role in determining the overall cost of capital.

What is the main reason why private businesses, like Bookscape, may have a higher cost of capital compared to public companies?

Private businesses often have higher costs of capital due to the owner's lower level of diversification, which increases their risk. This risk is reflected in a higher cost of equity, which subsequently raises the overall cost of capital for the business.

Why do companies use different hurdle rates for various types of returns?

The appropriate hurdle rate depends on how returns are measured. If the returns are calculated for equity investors (after debt payments), the cost of equity is used. If the returns represent the entire business (pre-debt earnings), the cost of capital is used. This distinction ensures the correct rate is applied based on the cash flows being analyzed.

What is the key takeaway regarding the risk of investments and the cost of capital?

The cost of capital should reflect the risk associated with an investment. Riskier investments will have higher hurdle rates, and the cost of capital captures this risk through the mix of debt and equity used to fund the business. It ensures that companies are adequately compensated for the risks they take on.