Cost of Capital

The basic principle for weighting equity and debt in cost of capital is that weights should always be market value numbers as opposed to book value numbers. Most companies and Valuers still often use book value weights for estimating cost of capital due to the following specious reasons:

 

1.      Book Value seems more reliable than market value since book values are not as volatile as market value. While this is true, this is only because book value is estimated only every quarter or every year. The fact that something does not move does not make it more reliable.

 

2.      Taking book value is a more conservative approach. However, this reasoning does not withstand any logical scrutiny. Book value weights are usually less conservative than market value weights and it gives a lower cost of capital. Book value weights tend to weigh debt more (not taking in account the improved or existing repayment capacity of the company and weigh equity less (not taking in account the going concern value of the company). The cost of debt is usually lower than cost of equity, thereby giving a lower cost of capital.

 

3.      The return on capital, i.e. the accounting return on capital, is based on book value. While this is true, the cost of capital has no relation with the return on capital. The cost of capital is the cost at which new funding can be raised from the market today. The book value is completely irrelevant when estimating cost of capital.

 

Hence, for computing cost of capital, we need market value of equity and market value of debt.

 

For a publicly traded company, the market value of equity is relatively simple. The market value of equity is simply the market capitalization of the company. The market value of debt is somewhat trickier as many publicly traded companies have debt that is not rated. So most Valuers and analysts use the book value of debt as a proxy for market value of debt while using market value of equity to compute cost of capital. This is highly inconsistent.

 

The market value of debt can be computed very simply. The inputs we require are (i) the book value of debt, (ii) interest expense, (iii) tenure of the debt. Having these 3 parameters, we can compute the present value of the debt by discounting the cashflow to present terms at the cost of debt. This gives the cost of debt for the company. We can make the same calculation for the company’s lease commitments to estimate the total market value of debt for the company. Some Valuers argue the logic behind converting lease commitments into debt. However, in case of businesses like retailers or restaurants, a bulk of debt takes the form of lease commitments. This changes the cost of capital for the company and the value of the operating assets of the company.

 

So when we’re valuing a company, we take the market value of equity, estimate the market value of debt, and now with the cost of equity and cost of debt, we’re in a position to compute the cost of capital.

 

Some people ask whether to use cost of equity or the cost of capital as the hurdle rate or discounting rate. The answer depends on how we compute returns. If returns mean the returns to equity investors, i.e. cashflows leftover after debt payments, then the appropriate discount rate will be the cost of equity. If returns are measured to the entire business, i.e. return on capital using pre-debt earnings, the appropriate hurdle rate is cost of capital. This goes back to the basic principle of discount rates, i.e. the discount rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.