0:00

[MUSIC]

Â Hi, and welcome to session four of this corporate finance essentials course and

Â this is, as we said before, this is a continuation of session three.

Â Remember, sessions, one and two run into each other, sessions three and

Â four run into each other, we've spent some time in session three.

Â Thinking about the meaning of the Cost of Capital,

Â the intuition behind the different terms of the Cost of Capital.

Â And now we're going to get hands on and we're going to apply.

Â We're going to look at specific company, the specific point in time and

Â we're going to estimate that company's cost of capital.

Â And as we'll be making this much more clear in just a few minutes,

Â the company will Starbucks.

Â And the point in time will be the third quarter of 2013.

Â And we're going to be looking at what the company had in terms of

Â sources of financing.

Â And how to calculate, and the actual number for

Â the cost of capital of Starbucks at that particular point in time.

Â All right?

Â Now, before we get into that, it's important that we

Â spend a few minutes doing a quick review of what we've done so far.

Â First off, we have three ways of thinking about this

Â weighted average cost of capital, or WAC, or cost of capital for, for short.

Â the, the three ways that we discuss are one from the point of view of investors.

Â One from the point of view of the company,

Â these two being two sides of the same coin.

Â And one that is actually probably the best and

Â most intuitive way of thinking about the cost of capital.

Â All three of which, are perfectly correct.

Â So whichever is most intuitive to you.

Â That is the one that you can use.

Â But from the point of view of investors, remember, investors provide capital.

Â That capital is used for companies in order to invest,

Â in order to create the, products and services that we like to buy.

Â And investors require a return on that capital so the average of

Â those required returns is basically one way of thinking about the cost of capital.

Â As we said in session three.

Â Remember, whenever we talk about averages in finance,

Â we typically think about weighted average.

Â That means that we're only thinking in terms of the sources of financing,

Â but we're also thinking in terms of how much we're using or

Â we're providing of each source of financing.

Â So the weighed average of those required returns, or simply the average of

Â those required returns, is what we call the cost of capital.

Â If we flip the coin and

Â we think of the company as having to raise capital, having to deliver,

Â deliver returns on those different sources of capitals being raised.

Â And then basically what we have is that because each source is capital,

Â it has a cost and that cost is something that the company has to deliver.

Â The average of those costs, or the weighted average of those costs,

Â is what we call again the the cost of capital.

Â So, at the end of the day,

Â we can think of the cost of capital as the average required return for

Â investors, or as the average cost that the company has to deliver to those investors.

Â Those two things are exactly the same.

Â The third and

Â critical way of thinking about the cost of capital remember, is a hurdle rate.

Â And we call it a hurdle rate because that is the minimum required return on

Â everything that the company does.

Â And all the investment projects in which the company is engaged.

Â And remember why it is the minimum required return.

Â Because if through different sources of finances,

Â financing, I have to deliver a 5% return,

Â I will not want to invest in anything from which I expect less than 5% return.

Â If I invest in anything from which I expect less, then the cost of raising

Â the capital to invest in this particular investment opportunity, I'm basically

Â burning money, and companies that do that, sooner or later go out of business.

Â So, if my cost of raising funds is 5% I will want to

Â invest in anything that gives me at least more than 5%.

Â And in that sense the weighted average cost of

Â capital becomes the minimum required return.

Â On the company's investments.

Â We also talked about,

Â that remember, the company may be financed in many different ways.

Â There are companies that are very simple, fully financed by equity.

Â Companies that are somewhat more complicated,

Â which are financed by their own equity.

Â And, companies that are even more complicated that are financed through

Â multiple sources of financing.

Â All that doesn't really matter,

Â because we all, all we need to know for each source of financing is,

Â what is the required return and how much we're using in proportional terms.

Â Once we know those two things,

Â we can put everything together into that weighted average cost of capital.

Â So we said that we would think in terms of a company raising debt and equity,

Â because it's a very typical situation, not because every company does it.

Â As we said before, in session three, some companies are fully financed by equity.

Â Technology companies, sometimes, are these type of companies that are mostly or

Â fully financed by equity.

Â That're very large sophisticated companies that use on top of debt and

Â equity they may use convertible data and

Â preferred equity and many other sources of financing.

Â So what we're still going to be thinking in terms of debt and equity and

Â the cost of debt and the cost of equity.

Â And remember the few things that we said before in

Â session three about the cost of debt.

Â First we said that the cost of debt was both observable and objective.

Â What do we mean by that?

Â Well, observable means that there's somewhere that I

Â can actually look at that particular cost of debt.

Â It may be the yield to maturity on a bond that is trading on a market.

Â It may be the rate that a bank quotes when I ask them the amount of money that I

Â need to borrow from them.

Â But either one way or the other, then I'm observing that particular number.

Â And because I'm observing that number, it becomes subjective.

Â I may like it or not like it, but if you and I are looking at that.

Â A specific cost of debt with both of us, we'll be seeing the same number.

Â So, from that point of view,

Â remember, the cost of debt is observable and the cost of debt is objective.

Â When we consider the amount of debt, and

Â we'll discuss this by the we discuss this by the end of session three.

Â We said that typically we can see their long term debt and typically that is

Â interest bearing debt so we're not really focusing on short term debt.

Â The type of debt the company usually runs uses to run,

Â the company on a day-to-day basis.

Â We're focusing on the long-term, on the investment activities of the company and

Â therefore we're focusing on interest-bearing long-term debt.

Â And the third and important thing that we said about the cost of debt was that

Â if we have a bond trading in the market, and that bond has an interest rate, and

Â a yield to maturity, we use as the cost of debt the yield to maturity and

Â not the interest rate.

Â And remember, the reason for

Â this, throughout the life of the bond that interest rate is not going to change,

Â but during the life of the bond the yield to maturity will be changing all the time.

Â And it will be changing all the time because it depends on the market price.

Â And that market price is investors' willingness to pay for that bond.

Â And that willingness to pay is going to be changing when the riskiness of

Â the company, or the riskiness of the sector in which the company does business,

Â or the risk, riskiness of the economy changes over time.

Â And it is important that we want to capture at this particular point in

Â time everything that we know about the company, the sector, and the economy.

Â We want to put all that together into how much return we

Â should require to buy the debt of this company.

Â And remember, again, because this yield to maturity changes with

Â market conditions and company conditions, and industry conditions.

Â And the interest rate of the bond does not change,

Â then we use the yield to maturity, and not the interest rate.

Â That's a very important concept.

Â In many cases, there may be a big difference between the two.

Â If you were to look, for

Â example, at Greek bonds today, Greek bonds that were issued some time ago.

Â Well, those coupon may be very low, but those yield to maturities are huge.

Â Which means that you know, people have adjusted.

Â They do not consider these interest payments enough, and so

Â they're willing to pay a lot less for them.

Â And because they're willing to pay little,

Â the required return on that debt goes up a lot.

Â So we actually want to use the yield to maturity for

Â that reason rather than the, the interest rate.

Â In fact the,

Â the Greek example is a perfect example because if Greece had bonds That we're

Â issued a five ten years ago well those bonds were issued a time of tranquility.

Â Those coupons will reflect that at that point in

Â time people were perceiving relatively low risk from the point of

Â Greece say your bond that was issued ten years ago.

Â But now things have changed dramatically.

Â Maybe they no, surely the interest rate on those bonds is not changed but

Â the yield to maturity has gone up dramatically.

Â Well, that's the number that we want to use as the Greek company,

Â average company, cost of debt.

Â All right?

Â So bottom line the cost of debt observable, objective we need yield to

Â maturities not interest rate and we typically think in term of

Â long term interest bearing debt as oppose to short term non interest bearing debt.

Â Then we talked about the cost of equity and that cost of equity unlike the cost of

Â debt remember is not observable and because it's not observable we

Â need to estimate it and because we need to estimate it becomes subjective.

Â Why subjective?

Â Because the model that you use and I use or the inputs for

Â the model that you use and the inputs for the model that I use may be different.

Â And so your estimate and my estimate may be a different and that

Â means that neither we have an observable number, nor we have an objective number.

Â Now in terms of models there are many but there is one that is far more widely used

Â than others and that is what we for the capital assessment pricing module or for

Â short the CAPM as we show you one slide.

Â in, in session three, this is by far the most widely used model which doesn't mean

Â that it's free from controversy.

Â Some people don't like the model.

Â Some people say the model doesn't really work, but

Â at the end of the day, it's a very popular model.

Â It's a very intuitive model, and it gives you an estimate of the cost of debt or

Â the required return on debt.

Â Now what is important about the CAPM and, and what, what you need to keep in

Â mind is that although the intuition is very neat, the intuition is very clear.

Â And it seems that it's very simple that you need to throw only

Â three numbers into the right hand side of the expression in order to get the cost of

Â debt on the left hand side.

Â The problem with that is that now, everything seems to be very arguable.

Â What is a risk for rate, how we estimate the market risk premium, how we

Â estimate the beta, there are differences opi, different opinions about that.

Â And, and it's very difficult to argue that this person is right and

Â the other persons are wrong.

Â If you'll remember from session three, we actually looked for

Â the Risk-Free rate, the market risk premium and beta.

Â We looked at different possibilities.

Â And, and the use of those different possibilities.

Â So we said, well, you know, there are many possibilities for

Â the Risk-Free rate but the ten-year yield seems to be a popular option.

Â There are many possibilities for

Â the market risk premium, particularly in the case of the US,

Â we've seen that numerical possibilities with 5 to 6% being the most popular one.

Â And, finally, in terms of beta.

Â How many years we go back in order to estimate whether a company is

Â mitigating or magnifying markets fluctuations,

Â five years seems to be a popular number but by no means the only number.

Â So when you put all this together, what we arrive to is basically the idea that

Â the CAPM is intuitive, it's easy to understand.

Â It seems to be easy to apply, but it's not.

Â What we have to do is to look at the consensus.

Â What are the most widely used practicing terms of the CAPM?

Â And we may beg to disagree.

Â We may think that the situation of the company we need to deal with deserves or

Â needs a different treatment and we may go for that.

Â But it's important that unlike the cost of

Â debt in which everything seems to be more or less undisputable.

Â Just about everything that has to be,

Â has to do with the cost of equity is much more arguable.

Â And, and that is the way I will discuss it.

Â And that is the way that reality goes, unfortunately.

Â It would be very easy for me to stand before you here and say.

Â look, this is what you have to do in order to calculate very quickly the cost of

Â equity with the CAPM, but

Â that's not unfortunately where reality is going to show you.

Â And final thing, we talked about the cost.

Â We reviewed the cost of debt.

Â We reviewed the cost of equity.

Â The final thing are the proportions of debt and equity.

Â Remember we call it the weighted averaged cost of capital.

Â Although sometimes we call it the cost of capital for short.

Â But it's always a weighted average because we do need to take into account

Â how much we're using of each of these two, or any number of sources of financing.

Â And remember something that it's important when we get to the numbers a few minutes

Â from now, we're going to be dealing with a company that uses a lot of equity and

Â very little debt.

Â So we just cannot calculate the straightforward average between

Â whatever we calculate as a cost of debt and

Â whatever we calculate at the cost of equity.

Â That would give us a really wrong idea of what is this company's cost of capital,

Â particularly when a company uses, as we're going to see, over 98% equity and 2% debt.

Â We just cannot assume that this is just equal proportions of debt and equity.

Â So we need to take into account proportion of each source of financing and,

Â very important, we do that at market value, not at book value.

Â We went over the reasons for that before, but remember, the,

Â the reason is market values adjust to everything that we

Â know about the company at this particular point in time and

Â they properly reflect the current, not the historical, conditions of the company.

Â So we talked about the cost of debt.

Â We talked about the cost of equity.

Â We talked about the proportions of debt and equity.

Â And final thing, we also talked about the corporate tax rate.

Â And that is relevant simply because, remember if that you have the debt on your

Â capital structure and therefore you pay interest, then you get a tax break.

Â Whereas if you actually don't have a debt on your capital structure and

Â not by interest, but by dividends, those dividends don't get a tax break.

Â That asymmetry in just every country's tax code implies that interest payments

Â are made before taxes and therefore, when you pay those,

Â that, that interest, you reduce your profits and

Â you pay less taxes, and that's what we call a tax shield.

Â That is, if we compare as we did in session three, two identical companies

Â with the only difference that one has debt and the other doesn't have debt.

Â There was a difference in the taxes that they pay, and that tax

Â difference implies that you get a break of taxes in terms of paying interest and so

Â that's why there's a pre-tax cost of debt and after-tax cost of debt.

Â And we need to calculate those, and we're going to do that in one minute.

Â