LECTURE 6 – FINANCIAL ARCHITECTURE

The problems to estimate the cost of capital

Before starting to describe the problems associated to the estimation of the cost of capital, it is extremely relevant to describe its meaning: according to Investopedia, it is “the cost of funds used for financing a business”. In order to carry out this process, the companies can only be financed through equity; only through debt; or using a “combination of debt and equity” - in this particular case it is a “overall cost of capital derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC) (...)” (Investopedia, 2013). The estimation of the cost of capital depends on several factors, such as the “operating history, profitability, credit worthiness, etc.”. It means, of course, the most recent companies will face higher costs of capital because their risk is higher when compared to solid companies (Investopedia, 2013).

It is now important to describe a few and the most important problems regarding the estimation of the cost of capital:

(i) Assumptions about the costs of equity and debt: these assumptions deeply affect “the type and the value of the investments a company makes.” (Jacobs and Shivdasani , 2012). It will make the managers decide whether they invest or not in a project and also if a company will be successful financially. Thus, if the company has made an underestimation to its capital cost, it will may see “a flashing green light” in terms of the Net Present Value; on the other hand, if there is an overassumption regarding the capital cost, the project might “be cast aside”, as it will show a loss or a lower Net Present Value than the real one (Jacobs and Shivdasani, 2012). In a more precise way, there are two main problems regarding the assumptions done: - The first one is about estimating the cost of equity in which two different methods can be used (CAPM Model and Dividend Discount Model). The problem is that in each of those models, at least one of the variables is an estimation. Due to this variations, the cost of capital will also vary;

- Concerning the estimation of the cost of debt, there is a risk-free rate and a risk premium. There is a problem with both, but the risk-free rate's problems will be explained at a further stage. In terms of the risk premium, it depends on the debt and it should be higher as the amount of debt raises (Finance Train, 2013).

(ii) Treasury Yields (the risk-free rate): A risk-free rate “is equivalent to the return available on a security that the market generally perceives as free of the risk of default as of the valuation date” (Grabowski, 2009, p. 2). The rate mentioned above, reflects a return on three main components: rental rate, inflation and maturity risk or investment rate risk.

Diogo Ramalheira – 200804594

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MASTER IN MANAGEMENT – FINANCIAL MANAGEMENT

LECTURE 6 – FINANCIAL ARCHITECTURE

One problem concerning this point is the difficulty of decomposing treasury yields into the components mentioned before.

Furthermore, there is a second problem to state: nowadays, and since 31 st December 2008, the risk-free rate is particularly low (corresponding then to higher prices) as there are liquidity concerns and a “flight to quality” (Grabowski, 2009) due to the financial crisis witnessed. It means that a high volatility in the market can affect significantly the expectations and the estimations done, bringing most of the times a biased analysis on the cost of capital if these fluctuations are not taken into account. The third problem felt when calculating the estimation of risk-free rate is concerned to its maturity; it should be the same as the company's debt. The problem is that most of the times there are only certain maturities, such as 2, 5, 10 and 30 years. All the maturities in-between have to be estimated which can be not so easy (Finance Train, 2013).

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