Cost of Capital

1.1 Basic Formula

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The Equity-Beta is the covariance of the stock-return with the market-return

1.2 Betas Non Investment Grade (< BBB)

The Equity-Beta can be analyzed as follows:

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The Equity-Beta is a function of the risk of a firm’s assets (operating risk) and the amount of financial leverage.

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An Asset-Beta (= unlevered Beta) reflects a firm’s operating risks without the effects of leverage.

The Debt-Beta is the covariance of a firm’s debt with the market.

A relevered Beta is the Equity-Beta of a firm with a new capital structure, underlying the old Asset-Beta.

1.3 Betas Investment Grade (>= BBB)

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Debt-Beta for Investment Grade firms is statistically not relevant and can be dropped.

1.4 Financial/Operating/Market Risk

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βasset = operating risk

Rest of term = financial risk (drops out when debt = 0)

Βdebt = 0 if debt carries no market risk

1.5 Cost of Debt

rD = rf + Credit Spread

1.6 Cost of Equity

CAPM: rE = rf + βE(rm-rf)

1.7 Cost of Capital (WACC)

• Capital structure components should be measured on a market value basis, not a book value or historic basis

• Use a target capital structure rather than the current or historic capital structure

• T always means the incremental tax-rate

• Debt includes long-term debt, financing leases, short-term debt, operating leases used as permanent financing, off-balance financing transactions

• If cash flows are real, first compute nominal WACC, then subtract inflation to get the real WACC (or better use transformation formula)

• Use firm or divisional capital structure not project

1.8 Divisional WACC

1. Determine capital structure of division

2. Find comparable firm (pure play) ( βequity of comparable

3. βequity of comparable: remove effects of capital structure ( βasset of comparable

4. Assume βasset of comparable = best