Cost of Capital: Advanced Topics

The cost of capital links a company's risk to the value of its future cash flows, and small changes in it move valuations a great deal. This module explains the market-wide and company-specific forces behind the cost of capital, how to estimate the cost of debt for companies with and without traded bonds, how to estimate the equity risk premium from history and from current prices, and how to build a required return on equity for public, private and emerging-market companies. It ends by comparing a company's capital structure and cost of capital with those of its peers using pure-play betas.

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What you will learn

1. Explain the top-down (market, country and macroeconomic) and bottom-up (company-specific) factors that drive a company's cost of capital.

Top-down drivers: risk-free rates, credit spreads and the ERP, country risk, legal and tax regime, macro volatility.
Bottom-up drivers: revenue variability, operating leverage, financial leverage, asset tangibility and security features.
Higher operating leverage raises business risk and therefore both the cost of debt and the cost of equity.
Spreads widen most for weaker credits when conditions tighten, so risky companies' costs rise most.
Re-estimate the cost of capital as conditions change; it is not a fixed company attribute.

2. Compare methods of estimating the cost of debt, including for companies whose debt does not trade and for unrated or private borrowers.

Use the current YTM on long-term debt, not the coupon rate.
Without traded bonds, use matrix pricing or the rating spread; without a rating, build a synthetic rating from coverage and leverage ratios.
Private borrowers usually pay an extra premium and borrow through bank loans with covenants.
After-tax cost of debt = r_d(1 - t) at the marginal rate, only if the deduction can be used.
For distressed debt, YTM is a promised yield that overstates the expected return.

3. Contrast historical and forward-looking estimates of the equity risk premium, including the Gordon growth and macroeconomic (Grinold-Kroner) models.

Historical ERP: arithmetic mean exceeds geometric; the benchmark (bills or bonds) must match the model's risk-free rate.
Survivorship bias and rising valuations push historical ERP estimates up.
Gordon growth ERP = D1/P0 + g - long-term government yield.
Grinold-Kroner ERP = [(1 + i)(1 + rEg)(1 + dPE) - 1] + Y - rf.
Forward-looking estimates reflect current prices but rely on growth and valuation assumptions.

4. Estimate the required return on equity using CAPM, multifactor, build-up and bond-yield-plus-premium approaches, including country risk and size adjustments.

CAPM: r_e = rf + beta x ERP; adjusted beta pulls the estimate towards 1.
Build-up: rf + ERP + size premium + company-specific premium (implicitly beta = 1); expanded CAPM adds those premiums to rf + beta x ERP.
Bond yield plus risk premium: company's long-term debt yield + 3%-5%.
CRP = sovereign spread x (sigma of local equity / sigma of sovereign bond).
Be explicit about how the CRP is applied and avoid double counting with cash flow adjustments or marketability discounts.

5. Compare a company's capital structure and cost of capital with those of its peers, using unlevered and relevered (pure-play) betas.

Stable cash flows and tangible assets support more debt; volatile, intangible-heavy businesses support less.
Trade-off theory: balance tax shields against distress costs; pecking order: internal funds, then debt, then equity.
Unlever: beta_A = beta_E / [1 + (1 - t)D/E]; relever at the subject's target D/E and tax rate.
Compare D/E, net debt/EBITDA, coverage and ratings with peers to judge debt capacity.
Use target market-value weights in the WACC.

Module at a glance

The cost of capital reflects top-down conditions (rates, spreads, ERP, country, tax) and bottom-up risks (business, operating and financial leverage, assets, security features).
Cost of debt = current yield, from YTM, matrix pricing or a synthetic rating, after tax at the marginal rate.
Historical ERP depends on the mean, benchmark and sample and suffers from survivorship bias; Gordon growth and Grinold-Kroner give forward-looking estimates.
CAPM, multifactor, build-up, expanded CAPM and bond-yield-plus-premium approaches each suit different situations.
CRP = sovereign spread x equity-to-bond volatility ratio; state how it is applied.
Pure-play: unlever peers' betas with their own leverage and tax, average, relever at the target structure.
Use target market-value weights, and convert a D/E ratio to capital weights before computing WACC.

This free module has 5 lessons, 14 practice questions with full explanations.

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