DF2-141-I

THE COST OF CAPITAL

Original text by Professor Javier Vega Fernández at IE Business School.
Original version, June 1, 1994. Last revised, September 07th 2015.
Published by IE Business Publishing, María de Molina 13, 28006 - Madrid, Spain.
©1994 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.

INTRODUCTION

The biblical character Jacob had to flee his home, having used trickery and the influence of his
mother Rebecca to win the blessing that his father had reserved for Esau, his elder brother. As
Esau was extremely angry and wanted to kill Jacob, he ran away to live with his uncle Laban, for
whom he worked as a shepherd. One day, Laban was trying to negotiate a new employment
contract with Jacob to stop him from leaving:

- "What do you want me to give you?" asked Laban

- "You don’t have to give me anything. If you agree to what I propose I will come back and
look after your sheep. I will spend the day going through your flocks putting the spotted
lambs to one side. So when it comes time to pay me, there will be no doubt about my
honesty. If you find a lamb that is not spotted in their flock, it means that I stole it.”

- "Very well, do as you say."

But Jacob used a scheme by which a lot of the sheep that were mated with white rams had spotted
offspring. Thus Jacob's flock grew faster than Laban’s. But Laban's sons were not fools and they
realized that something unnatural was going on, because their flocks were reproducing more slowly
than normal. So they said:

- "Jacob has taken over our father's property and has enriched himself at his expense."

The situation became tense and the Lord had to intervene, telling Jacob to return home to his
parents under his protection.

This story serves to introduce the idea of the Cost of Capital. Laban was wrong to agree to Jacob’s
managing the flocks as he wished; there was a rate of return of the flocks — the reproduction rate
mixed with the mortality rate and good management — that should have been respected by both of
them.

Despite progress, nothing has changed. The owners of capital can ask management for a "natural"
yield that relates to that which is obtainable in similar businesses in the market, and management
should make a commitment to obtain it. But what is that rate? Let’s try to explain.

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Let’s imagine you have been given a post as a director of a new start-up which has the following
initial balance sheet:

Cash 100 million Capital 100 million

Your task as the manager of the company –that is to say, what it is they are going to pay you your
salary for – is to invest this hundred million in a way that is entirely satisfactory to the shareholders
who have entrusted their money to you. What might “entirely satisfactory to the shareholders”
mean in this context? It would seem reasonable to suppose that they will be entirely satisfied if you
manage to invest the money in a business that produces a return equal to, or greater than, that
they could obtain without your help.

For example, if you decide to keep the money in a current account yielding 0.5%, it is likely that
your mentors will not be very happy with your management. Even if you were to look for something
more productive, such as investing the money in treasury bills at market rates, let’s say 5%, the
owners of the capital might point out that they could just as well do that for themselves, meaning
your management adds nothing that would justify their paying you your salary.

It would, therefore, seem that in order for the shareholders to consider you to be doing a job worth
paying you for, you have to invest the resources they place at your disposal in a business that
produces sufficient return for them to feel “entirely satisfied.”

What is the rate of return that satisfies the shareholders’ expectations? How can you determine it?
A first approach to the answer is very simple. You ask. Before making any investment decisions
you could bring the shareholders together and ask them how much they want to earn, as an annual
percentage, on the hundred million they have invested. As the company is a new start-up, the
shareholders probably still get along well, so you can probably reach an agreement fairly quickly.
Let’s suppose the figure that everyone accepts is 10%, which is a return they feel unable to
achieve by themselves.

The rest is either very easy or very difficult depending on your skill and market conditions. You will
have to look for investment options that turn 100 million into at least 110 at the end of the following
year. Let’s now suppose that you have found a business opportunity that will turn the invested
assets (100 million) into 110 million by the end of the year. Applying the present value formula we
obtain:

110
NPV  100   100  100  0
(1  0.10)

Although without doing the math we already knew intuitively that the operation was as profitable as
the shareholders wanted, by using the formula we can confirm that it is a good investment as it
produces an NPV equal to zero. If the investment were to produce 111 million at the end of the
year it would be even better as it surpasses the shareholders’ wishes. However, if it produced less
than 110 million, it should not be undertaken, as it would not fulfil the shareholders’ mandate, and
at the end of the day, they will be the ones judging how well we have managed their money.

From the foregoing we can deduce that the professional manager is obliged to obtain a satisfactory
return from the resources entrusted to him by the shareholders, i.e., he must make an effort to
obtain business that produces the income the shareholders want to earn on their investment. This
effort can be identified with a cost for the manager or –what is in effect the same thing– a cost for
the company. Hence, the return shareholders expect on their investment should be considered by
managers as the cost of equity.

Cost of equity (CE) = Return expected by the shareholders.

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INCLUDING DEBT

One of the characteristics of our fictitious company is that all the assets are financed by equity.
Normally, debt also plays an important part in a company’s funding. We will now add some debt by
assuming that the assets are supplemented by a further one hundred million from a long-term loan
on which we shall assume an interest rate of 6% a year. Our balance sheet would now look as
follows:

Assets 200 Capital 100

Debt 100

The cost of debt differs from that of equity in that interest is paid before tax, whereas shareholders
are paid after corporation tax (company income tax). This means that in order to treat both costs in
the same way, the cost of debt has to be converted into a cost after tax, i.e., the cost of debt with
respect to equity will be less than the nominal cost (6% in this example) as the interest paid
reduces the tax liability (i.e. the amount of tax due). The general formula for the cost of debt after
tax is:

CDAT = CD x( 1-t ),

where t is the tax rate. In our example, given a nominal cost of 6% and a tax rate of 30%, the cost
of debt would be:

CDAT = 6 x (1- 0.30) = 4.2%

WEIGHTED AVERAGE COST OF CAPITAL1 Multimedia

content *
Having introduced the cost of debt into our example, and supposing that our
shareholders want to continue earning as much as before, i.e., 10%, the cost of our
finance would have two components: the cost of equity and the cost of debt.
Normally these two costs will differ, firstly because the nominal cost of debt, i.e.,
what the bank wants to earn on the money it lends us, must be less than what the
shareholders want to earn, because the banker is running less of a risk; and,
secondly, because the tax shield reduces the cost of the debt. If the costs are different, the weight
of the sources of funding in the firm’s funding structure will influence the combination of the two.
For example, if shareholders' equity accounted for 100% of the long-term funds available, the
WACC would be 10%.

On the other hand, if it were all debt, the cost would be 4.2%. For this reason we will try to calculate
a weighted average cost of long-term finance or a weighted average cost of capital (WACC) that
takes the mix into account. The formula is:

where D and CD are the percentage of debt and its cost, respectively; E and CE the percentage of
equity and its cost, and t the tax rate1.

1
English speakers use the term “Weighted Average Cost of Capital” or WACC.

(*) Scan the QR Code in order to access multimedia content. http://multimedia.ie.edu/productos/wacc_i/wacc.mp4

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For example, using a cost of debt of 6%, a cost of equity of 10% and a funding mix of 50%, yields:

WACC = 0.06 x (1-0.30) x 50/100 + 0.10 x 50/100 =

0.042 x 0.5 + 0.10 x 0.5 = 0.071 = 7.1%

In our example, in which both debt and equity each provide 50% of the company’s capital, the
WACC is 7.1%. If the weighting were to change, for example if the share of equity increased to
70/30, the average cost would increase to 8.26%. On the other hand, if the balance shifted in favor
of debt (30/70), the average cost would fall to 5.94%. (It would not hurt to check to make sure we
have got this right.)

The investment analysis model closes with the calculation of the discount rate called WACC. This
process is carried out as follows: we start with forecasts of the free cash flows (after tax) the assets
will produce; then we estimate the cost of debt and the cost of the equity capital with which we plan
to finance the investment. A structure of debt to equity is established, and WACC is calculated. If
the NPV of the cash flows discounted at the WACC is zero or positive, the proposed investment
meets the requirements of the financial backers and can go ahead. If the NPV is negative, we
should not proceed with the investment as the results would not satisfy the investors, and they are
the ones that pay our salary.

Having defined WACC we will now look at how its various components are estimated, such as the
cost of debt and equity in their various guises, and the value assigned to the sources of finance to
calculate their weighting within the company’s capital structure.

THE COST OF DEBT

Normally the cost of debt is equated with the interest rate that the banks or bond holders require
from borrowers. However, in order to be more precise, given that lending can take various forms,
we ought to use a method that makes them uniform, based on the internal rate of return (IRR). To
calculate this we need to know:

1. How much money we are going to receive after fees and other expenses.
2. How much money we have to pay in each installment (including expenses of all types).
3. What the periodicity of the installments is (monthly, biannually, annually, etc.).
4. How many installments we have to pay.

With these data, applying the formula for the internal rate of return, we obtain:

Payment 1 Payment 2 Payment 3 Payment n

Loan     ...
(1  rd ) (1  rd ) 2
(1  rd ) 3
(1  rd ) n

By calculating rd in this formula we obtain the loan’s internal rate of return, i.e., the return obtained
by the bank, which in turn is the real cost to the company. Now we just have to turn this rd into an
annualized percentage rate (APR) if it is monthly, six-monthly or has some other frequency, as
explained in the chapter on mathematics and finance. Do you remember how?

The annual rate obtained using this method will be the cost of debt, CD. But, remember that in
order to apply it to the WACC it needs to be adjusted to take the effect of tax into account.

Equity means resources belonging to the company’s owners. However, "capital" in financial language is an ambiguous
term used to describe several things, including the sum of debt and equity. For this reason we use the term equity here
to refer to our Capital.

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THE COST OF EQUITY

We began this chapter by saying that one way of finding the cost of capital was to ask the
shareholders. It is not a bad method if there are just a few shareholders and they are readily
identifiable. For the managers of a company with just one owner it is easy to calculate the cost.
You just need to walk up to the boss’s office and ask him how much he wants to earn. In the case
of companies whose shareholders are on the board of directors, you have to wait until they meet
before you can ask them. But the problems begin when investors become a mass of impersonal
shareholders. This is what happens to publicly traded companies, with thousands of anonymous
and dispersed shareholders. In this case how can the CFO know how much this group of investors
expects to earn?

In large listed companies, the most important information the management team receives about the
shareholders’ opinion of their management is through the share price. If investors intuit that new
opportunities to make money will arise and they can exploit them, they will want to buy shares in
the company, albeit at a higher price than now; thus the price will rise. On the other hand, if they do
not believe the managers will invest in these new businesses but will lock up their resources in the
company’s safe, the shareholders will be willing to sell at lower prices than they do now, and hence
share price will fall.

If this is so, we could try to analyze how the market prices the company’s shares and what
investors’ motivations are when setting the share price. We are not inventing anything new. The
share valuation model we are going to describe was put forward by Williams in the thirties2.

Our model assumes that when someone invests in a share they expect to receive some form of
compensation in return. Shares compensate their owners in two ways: dividends and price
increases. Based on this premise we can set up the following mathematical relationship:

Dividend1 Share Pr ice1

Share Pr ice0  
(1  re ) (1  re )

What this says is that the share price today is related to the dividends paid at time 1, plus the share
price at time 1 and what the shareholder wants to earn (re) over the period between 0 and 1. To
give a concrete example, a Telefónica (Spanish telecommunications company) share today will be
worth the dividends paid during the year plus the share price at the end of the year, divided by one
plus what the shareholders want to earn, at an annual rate, by investing in Telefónica shares.

Dividend 2 Share Pr ice2

Share Pr ice1  
(1  re ) (1  re )

Dividend 3 Share Pr ice3

Share Pr ice2  
(1  re ) (1  re )

If you agree with the reasoning above, then you should also accept that the share price at time 1
can be represented by the dividend and the expected share price at time 2 and this, in turn, by the
dividend and share price at time 3.

Dividend1 Dividend 2 Dividend 3 Dividend n Share Pr icen

Share Pr ice0     ...  
(1  re ) (1  re ) 2
(1  re ) 3
(1  re ) n (1  re ) n

2
Although this model is commonly attributed to Gordon and Shapiro, its true author was Williams thirty years earlier.

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This means that it will always be possible to replace the share price by the dividend plus the next
share price, which means that the initial price of the share is justified as follows:

The first simplification we are going to make is to eliminate the share price term divided by (1+re)n
as being irrelevant. You might think that we are leaving out an important part of the value by not
including the final share price. But this is not so. The more years we take into account, the greater
the weight of the dividends in the current value, and the less that of the final share price. And, when
n tends to infinity, the value of the final share price divided by (1+re)n will tend to zero. The formula
would therefore look as follows:

Dividend1 Dividend 2 Dividend 3 Dividend n

Share Pr ice0     ... 
(1  re ) (1  re ) 2
(1  re ) 3
(1  re ) n

Our formula is not very useful at the moment. We would need to know the dividends for at least the
next hundred years in order to have an idea of the re that relates them to the share price.
Nevertheless, we can make this easier if we simplify the approach. It would suffice to establish that
even though we do not know what the dividends are going to be, on average, they are going to
grow at a given rate. In other words, the dividend on the second year will be equal to that in the first
year multiplied by one plus a growth rate, which we shall call g.

Div2 = Div1 (1+g)

Div3 = Div2 x (1+g) = Div1 x (1+g)2

Calculating the value of all the future dividends in this way, based on the first year’s dividend, we
would obtain:

Dividend1 Dividend1 (1  g ) Dividend1 (1  g ) 2 Dividend1 (1  g ) n 1

Share Pr ice0     ... 
(1  re ) (1  re ) 2 (1  re ) 3 (1  re ) n

The formula above looks complicated, but is just a geometric progression with a ratio of one plus g
divided by one plus r. If n tends to infinity and re is greater than g, this can be simplified as follows:

Share price = Dividend1/(re-g)

And rearranging this expression to obtain re:

Dividend1 Dividend1
re  g  re  g
Share Pr ice0 Share Pr ice0

We now have a simple formula with which to calculate the profits the shareholders expect, which
equates to the cost of equity. Our expression means that the shareholders’ expected return is the
same as the return on the current dividend plus the expected growth of the dividend. For example,
a company whose share price is €20 and which pays an initial dividend of €2, which we expect to
grow at a rate of 5%, would have an CE, or cost of equity, of:

CE =2/20 + 0.05 = 0.1+ 0.05 = 0.15 = 15%

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However, the fact that we can reduce the calculation of CE to a simple formula does not mean our
problems are over. The difficulty now is to predict a reasonable rate of growth in order to complete
the data we already have available, namely the dividend and share price.

An initial limitation on the growth is based on its dependency on the company’s return on equity
(ROE) and of the share of profits it distributes in the form of dividends (the payout ratio, which is
equal to the dividend/profits).

TABLE I

Years Assets Capital ROE Profits Pay-Out Divid. Reserves g

1 100.00 100.00 20% 20.00 50.0% 10.00 10.00

2 110.00 110.00 20% 22.00 50.0% 11.00 11.00 10.0%
3 121.00 121.00 20% 24.20 50.0% 12.10 12.10 10.0%
4 133.10 133.10 25% 33.28 50.0% 16.64 16.64 37.5%
5 149.74 149.74 25% 37.43 50.0% 18.72 18.72 12.5%
6 168.45 168.45 25% 42.11 50.0% 21.06 21.06 12.5%
7 189.51 189.51 25% 47.38 100.0% 47.38 0.00 125.00%
8 189.51 189.51 25% 47.38 100.0% 47.38 0.00 0.00%
9 189.51 189.51 25% 47.38 100.0% 47.38 0.00 0.00%
10 189.51 189.51 25% 47.38 100.0% 47.38 0.00 0.00%

Table 1 shows the time course of the data for a simple company with a hundred million in equity
and a rate of return of 20%. In the first two years the dividend grows at a constant rate of 10%,
given that the ROE and payout ratio remain constant. This means that the earnings retained in the
form of reserves and invested in profitable assets increase the profits and, as the pay-out ratio is
maintained, the dividend grows. In the fourth year, the increase in ROE to 25% makes the dividend
grow by 37.5%, although in years 5 and 6 the growth rate slackens given that the ROE remains
constant. In year 7 the increase in the pay-out ratio (all the profits are paid as dividends) swells the
dividend considerably. However, this extravagance prevents the assets from growing, which limits
profits in subsequent years, and hence future dividends, which have a zero growth rate.

In our example we could establish a mathematical relationship between the variables that limit
growth. This would be:

g = ROE x (1-payout)

The limitation on growth we mentioned is based on technical arguments, but a similar conclusion
can also be reached by taking a common sense approach. No human activity, not even increasing
the human population, which many people consider to be a gratifying task, can grow at a rate of
more than 5% for long periods. Moreover, if we analyze the growth of GDP in the countries of the
OECD –whose members are the most developed countries in the world– we see that growth over
the period 1960-1989 was 2.8% a year in real terms. This means that most companies need to
grow at that rate, because if most of them were growing faster, the OECD would be growing faster
too.

This easily understood argument does not stop you hearing statements like, “Our company goal is
to grow its sales and profits by 20% a year.”

There is no reason why a company cannot grow at 20% or more over a limited period of perhaps
five to ten years. What does not seem reasonable is to assume that this rate can be kept up
indefinitely. Our recommendation, which is based only on common sense and consequently of no
scientific value, is that over the long term g should not exceed inflation by more than two
percentage points.

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Although we have tried to make the cost of equity as specific as possible, we are left with a doubt
about how to evaluate the rate of growth of dividends appropriately. If you are interested in finance
you should immerse yourself in this kind of situation, as using deductive techniques it is possible to
tie down some of the uncertainties, but the main suspect remains at large. We therefore need to
look at a new path of investigation based on the most exciting relationship in finance: that between
risk and returns.

CALCULATING THE COST OF EQUITY USING THE BETA COEFFICIENT

Elsewhere in this book we have explained that financial risk is related to the variability of return on
investment. Investors always have a risk-free investment opportunity. They can always invest their
savings in government bonds and have the maximum guarantee that they will be repaid with the
corresponding interest. From this floor, investors will demand higher returns as the certainty of
recouping their investment, together with the interest due, diminishes. The next rung on the ladder
after risk-free securities is the case of bonds and debentures issued by large corporations such as
Telefónica, Endesa, etc. As these are not excessively risky compared with government bonds, they
only need to offer investors a slightly higher return in order to find buyers. In other words, when
people place their savings in assets other than government bonds, they want to obtain a higher
rate of return. This means that a first approximation to investors’ expected returns might be as
follows:

Investor’s expected rate of return = Risk-free rate of return + Risk premium

where the risk premium on government bonds is zero. For example, the return on short-term
government bonds and Telefónica bonds in January, 2009 was:

Letras del Tesoro (Treasury Bills) 1.15%

Pagarés de Telefónica (Telefónica debentures) 1.29%

Therefore, at that time the risk premium paid by Telefónica over the interest rate on treasury bills
was 0.24%.

If we look now at the differential on long-term debt we can see that in 2010 there was a risk
premium on Telefónica long-term debt vis-à-vis that of the Spanish government:

Spanish thirty-year government debt 4.71%

Telefónica thirty-year debt 5.875%

This is to say that there is a difference between what investors want to earn without risk by
investing in government debt and what they want to earn with risk, e.g., Telefónica debt. And they
give this difference a number in the form of a risk premium 1.16%

There is always a risk premium with reference to something. At the time of writing, the question of
Greek debt is on the boil. The markets suspect that Greece is likely to default and are demanding
higher interest rates than for other countries. The spread between the 3.0% interest on German
bonds and the 7.5% on Greek bonds is a risk premium "against" Greece of 4.5 points or 450 basis
points.

Let’s now move on to the next step, the difference between investing in fixed income securities and
variable income securities such as equities (i.e. shares). The risk inherent in this type of security is
clearly higher than that of fixed-income securities such as bonds. The returns that investors
demand on equities are therefore higher.

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Let’s pause for a moment and consider the idea of the risk of investing in the stock market. Chart 2
shows the return on the IBEX 35 —the index comprising the Spanish market’s 35 most liquid
stocks— over the past four years.

The chart tells us that €100 invested in early 2006 would have become 136.4 at the end of that
year. But €100 invested in early 2008, would have yielded a loss of 36.5%.

CHART 1

Return on the IBEX 35
   
2006  36.04%
2007  10.71%
2008  ‐36.50%
2009  38.27%

This variability justifies the demand for higher returns when investing in the stock market, even in
the case of a diversified portfolio such as the IBEX. We could, therefore, say that the rate of return
expected by investors who invest in a diversified share portfolio would be:

Expected rate of return = Risk-free rate of return + premium for investing in the IBEX

The results above do not mean that all shares went down by 36.5% in 2008. Some will have fallen
by less, and others will even have gone up. The same will have occurred with the increases in
2006 and 2007. This suggests that not all shares react in the same way to index movements.
Some are more sensitive, and go up or down more than the index, and others are less influenced
by the general situation, so fluctuate less. This has an immediate effect on the returns paid to
shareholders. The return from shares that go up and down more than the index varies more than
that of the index, while the return from those that vary less is less affected. A notion of risk
underlies this approach, but the question is: Can we measure this risk?

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GRAPH 1

Rentabilidad
Return on de
Shares
las acciones Share A A
Acción
20% IBEX 35

15%

10% Acción
ShareBB

5%

-20% -15% -10% -5%

5% 10% 15% 20%
Rentabilidad
-5% Return
del IBEX 35on
IBEX 35
-10%

-15%

-20%

We can do so by using the Capital Asset Pricing Model (CAPM). This model quantifies the
sensitivity of the return on shares with respect to changes in the profit or loss of the portfolio that
contains them. Let’s suppose that over a period of time we measure how much is earned or lost
(dividends, plus or minus share price increases or decreases) by investing in the IBEX 35 and how
much is earned or lost by investing in each of the shares that make it up. Let’s also suppose that
the return on one of the shares (share A) varies by 2% each time the return on the index varies by
1% and the profitability of share B changes by only 0.5%. Graph 1 shows the relationship between
the index and shares in companies A and B.

Obviously, the variation in the return on the IBEX 35 compared with itself is one. However, the
variation in the return on share A is twice that of the index and that on share B is half. What does
this mean? It seems simple: that an investment in share A carries twice the risk of a portfolio
matching the index and an investment in share B carries half the risk. And, if we establish a direct
relationship between returns and risk premiums, we can say that shareholders expect to get twice
the risk premium if they invest in A’s shares than they would get in the portfolio of all stocks in the
index, and half if they invest in B’s shares. The factor that multiplies the risk premium of a
diversified portfolio to obtain the premium on one of its component stocks is called the beta
coefficient. The application to our previous expression of the investors’ expected return when
buying shares would be:

Expected rate of return = Risk-free rate of return + Beta x premium for investing in the IBEX

Let’s put our IBEX example and our imaginary A and B shares to one side and expand our field of
observation to take in the general all-share index of the Madrid stock exchange (Indice General de
la Bolsa de Madrid). Historic data is available going back to 1941 so we can calculate the return
(RB) given by the stock exchange over the years. We can also determine the beta (ß) of each of
the shares by observing the variation in its profitability with respect to the index. Using this, and the
risk-free rate of return (RRF), which we also know, we have all the data we need to find out the
return that shareholders expect from each share.

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The expression is:

re = RRF + ß x (RB-RRF )

This means that the return a shareholder expects to obtain is equal to the return he can obtain
without risk, plus the risk premium for investing in the stock exchange (RB-RRF), multiplied by the
risk factor characterising this specific share.

How can we apply our new method to determine the cost of equity? Let’s select a company such
as Telefónica, for instance. We need some additional information in order to calculate how much
the shareholders want to earn.

1.- Risk-free rate of return. We shall take the rate of interest paid on the Treasury bills (letras del
Tesoro) mentioned earlier. In August 1994 this was 4.71%.

2.- Risk premium.- As we will see, we can estimate the risk premium (return from the stock
exchange less the risk-free rate of return (RB - RRF) of the Spanish market to be 6%.

3.- Finally we need a beta. Bloomberg offers a value for this parameter of 0.8374, which means
that Telefónica has a lower risk than the IBEX 35.

With these data we could say that,

CE of Telefónica = 4.71 + 0.8374x6 = 9.73%

Which tells us that Telefónica’s cost of equity in 2010 was 9.73%.

This completes our second version of the calculation of the cost of equity. As you will recall, the
first method was based on adding an expectation (the expected rate of growth) to a known item of
data (the dividend yield). In this second approach we also start out from a known piece of data (the
risk-free rate of return), to which we add a premium for exposure to a particular risk. Obviously,
neither approach clears up all of the uncertainties. In one of them we have to guess the long-term
growth rate of the dividend and in the other we have to deduce the future profitability of the stock
exchange. We will now try to set bounds as far as possible to the elements on which the calculation
of CE depends.

FACTORS DETERMINING THE COST OF EQUITY ACCORDING TO CAPM

THE RISK-FREE RATE OF RETURN

As we have already explained, we understand the risk-free rate of return to be that obtained from
securities issued by the State. This rate, which we referred to earlier as the floor for investments, is
based on the rate of inflation. In other words, it is a nominal rate that, except in exceptional
circumstances, contains the expected rate of inflation. This seems reasonable; no government
could hope to sell securities whose return is less than the decline in investors’ purchasing power.
The second issue to bear in mind is that government bonds have various maturities, each of which
has a different rate of interest associated with it.

Chart 2 shows the variation in August 19943 of the yields on US Treasury Bills as a function of their
maturities. The internal rate of return (IRR) is calculated based on the price of the securities and
the interest payments on them.

3
Source: Bloomberg, author’s calculations.

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The horizontal axis shows the maturity of the debt. Thus, in the upper curve, which shows yields in
2007, the annual interest rate for a maturity of 15 days was 5.02% and for 30 years it was 4.85%.
When short-term interest rates are higher than long-term rates, the yield curve is said to be
inverted. This occurs when rates are expected to come down.

The 2010 curve is a normal interest rates curve in which short-term rates are lower, 0.18% for 15
days, and 4.71% for 30 years. That interest rates rise as the maturity periods get longer is
reasonable, as although there is no danger of not recouping the capital invested, there is an
interest-rate risk.

CHART 2

If the interest rate on new debt issues rises —due to changes in economic policy or an upward
revision of expected inflation— the holders of old debt will be trapped in a less profitable
investment than the available alternatives, and the further off the maturity, the more trapped they
will be.4

The fact is that, whatever the circumstances of the market, there is no one single risk-free interest
rate. That being the case, which rate should we choose in order to determine the cost of equity:
One-year Treasury bills? Three-year bonds? Ten-year bonds?

The solution to this problem is to match the rate to the duration of the investment we are analyzing.
Don’t forget that what we are looking for is a discount rate with which to discount cash flows from a
potential business. The cost of equity is nothing more than an opportunity cost. Therefore, if what
we are going to analyze is a five-year project, we need to compare its return with the yield that we
can obtain from investments with the same time horizon. This is a fairly acceptable way of solving
the problem of the multiplicity of risk-free rates, as each particular investment will have an
appropriate rate depending on its lifetime. If the investment under analysis is short term, we will
choose the short-term rate, and if it is long term, we will choose the long-term rate. To give a
specific case, according to the interest rate curve in Chart 2 (which was valid at the time of writing),
the risk-free rate of return that we should take into account to determine the cost of equity for a
seven-year investment would be 3.55%.

4
Trapped does not mean that the owner of the shares cannot escape by selling them and buying a more profitable
investment, however. What happens is that when interest rates rise, the price of bonds goes down, and the investor
loses money if he sells, thus eliminating the yield difference between new bonds and old ones.

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But this would be for the U.S. market. We now need to find a yield curve for the Spanish market to
calculate our risk-free rate.

CHART 3

Interest rate curve for Spanish debt

In Chart 3 we have the yield curve for Spain provided by Bloomberg. If we wanted to find a
discount rate to discount for an investment project with a ten year horizon in Spain, the risk-free
rate would be 3.86%.

THE RETURN ON THE STOCK MARKET

Finding the risk-free rate of return was not too difficult. The institutional fixed-income securities
market gives us a precise way of finding the risk-free interest rate based on the interest rate curve.
In the case of the stock market the calculation is somewhat more complicated as there is no
method allowing us to determine its future returns. Nevertheless, we can always use the historic
data available and make predictions based on them. From a paper published by the Madrid stock
exchange (Bolsa de Madrid)5 on the historic returns on the Spanish stock market from 1941 to
1990 we have obtained the following information:

Annual rate of return measured as an arithmetic mean 14.872

Annual rate of return measured as a geometric mean 12.060

The rates are nominal, i.e., they include inflation and for statistical reasons that are beyond the
scope of this note, the arithmetic mean is the best for our purposes as our aim is to infer future
rates of return on the stock market by using historic averages. Although this figure may be an
acceptable indicator, we will meet an additional problem. According to our model, the return on the
stock market is made up of the risk-free rate of return plus a risk premium for investing in a
diversified portfolio of shares. This means that RB is influenced by changes in RRF, which means it
would be a good idea to calculate the historic value of the latter in order to isolate the risk premium
appropriately.

5
Sebastián, A.; Suárez, J. L. (1992). “Análisis de la rentabilidad histórica de la inversión en acciones, deuda pública y
renta fija privada en el mercado de capitales español”, Bolsa de Madrid. Bolsa de Madrid.

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Unfortunately, the available historic data for the yields on government bonds only go back to 1988.
We do not, therefore, have a sufficiently representative sample to compare with our long series of
stock market returns.

However, Pedro Díaz Montañés6 has tried to fill this gap by using the yield on state-owned
companies’ bonds to approximate the risk-free rate of return. Thus, by analyzing the period from
1960 to 1993 he has reached the following conclusions concerning yields, again calculated as
arithmetic means:

Return on the stock market 16.53

Return on fixed-income securities 10.76
Risk premium 5.77

Bearing in mind that the yield on the debt issued by the companies used for the sample is slightly
higher than that on government securities, we can, without risk of serious error, use a risk premium
of 6% for investing in the Spanish stock market.

This risk premium is similar in the rest of the world. IESE professor Pablo Fernandez has compiled
most of the risk premiums that academics publish in their books and they are all between 3 and
12%, giving us an average of 6%.

Professor Damodaran has come up with an original idea, namely to run a survey. On his website7,
of which we show a screenshot below, he asks, "What do you estimate the risk premium to be in a
mature equity market?"

FIGURE 1

We can see that 16,847 people voted and the majority, 76%, opted for rates between 4 and 8
percent. This also implies an average of six points.

6
Díaz Montañés, P. (1994). “Prima de riesgo de la renta variable.” Banco Santander de Negocios.
7
http://pages.stern.nyu.edu/~adamodar/ This site is a treasure trove of useful information on corporate finance.

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However, visitors to Damodaran’s website are financial experts, or at least aficionados. They
probably know that the risk premium tends to be around 6%. Maybe that's why they vote that way.
It is impossible to know, but take it from me that 6% is a reasonable risk premium over the risk-free
rate.

THE BETA COEFFICIENT

Table 2 shows the information Bloomberg provides its customers on the betas of Spanish
companies. We have selected the following, observed over the last two years:

TABLE 2

REPSOL YPF SA 0.9511

TELEFONICA 0.8374
IBERDROLA SA 1.0198
INDITEX 0.8037
ABERTIS 0.8827
ACCIONA SA 1.0107
BANCO
SANTANDER 1.3266
BBVA 1.3373
FERROVIAL SA 1.1119
RED ELECTRICA 0.7202

These are calculated by observing the return on the share and the profitability of the General Index
of the Madrid Stock Exchange weekly over a period of two years. Once the weekly data on stock
market returns together with that of a specific share have been obtained, they are matched by
linear regression, as shown in Graph 2. Clearly, the index is a straight line which forms an angle of
45 degrees with the axis of the yield of the IGBM or general all-share index of the Madrid stock
exchange (Indice general de la bolsa de Madrid) and it will have a beta of one, which is the
gradient of the 45 degree angle. However, if a stock has more risk (its price goes up and down
more than the index, which is what the points show on the graph), the regression line for these
points will form an angle of more than 45 degrees, as with share A and therefore have a slope of
more than one.

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GRAPH 2

Return on Shares

Return on the
IGBM

By contrast, more placid shares that vary less than the index must contain a line that will form an
angle of less than 45 degrees, like share B, and the value of their beta is less than one. For
example, Banco Santander and BBVA tend to rise more than the stock market when it goes up and
go down by more when it falls. Red Eléctrica is the opposite, rising and falling by less than the ups
and downs of the IGBM

In short, the beta of a share is nothing more than a statistically derived variable that, in more
sophisticated financial markets is normally available for those wishing to consult it. This means that
the beta coefficient is a bit like GDP growth. A financial director needs to know what it is based on,
but he doesn’t need to be able to calculate it. It is a piece of market data.

RECONCILING THE MODELS. GORDON–SHAPIRO VS. SHARPE

We have used two different models to calculate the cost of equity. These can be summed up
mathematically as follows:

Gordon–Saphiro Model Sharpe Model

CE = Div/Price+ g CE= RRF + ß x (RB-RRF )

Given that CE is the same in both expressions, we could use one of the formulae to calculate
variables other than re in the other. Let’s take the example we have been using so far, Telefónica.
Using the beta coefficient we have obtained a value for re of 12.5%. If we apply this figure to
Gordon’s model we could calculate the value of g corresponding to this CE as follows:

CE of Telefónica = 4.71 + 0.8374x6 = 9.73%

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Applying this 9.73% to the Gordon-Shapiro model, given that the price of Telefónica is, in the
spring 2010, €18 and analysts’ estimates of the dividend set it at €1.54:

0.0973 = 1.54 / 18+g

Rearranging for g:

g = 0.0973 - 0.08556 = 0.01174 = 1.17%

Thus, for a beta of 0.08374, a share price of €18 and a dividend of €1.54, the implied dividend
growth is 1.17%. Previously we said that it is unlikely that g will grow at a rate of more than four
percentage points above inflation, which would mean that a price of €18 is a bit low. Perhaps a
more reasonable price would be €20 or €21.

About, reasonable, and perhaps are words that produce mistrust among those aiming for
incontrovertible results. A pessimistic conclusion could be that we have been wasting our time
using models that, in the end, are unable to lead us to a precise determination of the cost of equity.
But we could look at it another way. We're not sure that CE is 9.73%, but we know that it is neither
20 nor 4 and, almost certainly, that it is not 15 or 8. This approach to valuing the cost of equity is
the result of reasoning and the wisdom of many intelligent people. I therefore propose to use it,
until we have something better, while being aware of the limitations of the models.

MORE ABOUT THE BETA COEFFICIENT. LEVERAGED AND UNLEVERAGED BETAS

In finance we distinguish between two types of risks: operational risk, which has to do with the
variability of the operating margin to changes in sales; and financial risk, which has to do with the
variability of profits as a result of changes in EBIT. This means that the shareholders of a debt-free
company will only run operating risk in relation to their investment, whereas if they have invested in
a company with debt, they will be facing the additional risk arising from the possibility of an
increase in fixed costs due to interest on the loans. Business risk has two components, the
business itself and the effect of debt. Moreover we should bear in mind that there can be no more
risk in the liabilities than that which is transmitted by the assets, so we could write:

This means that the risk of the assets should be shared between the owners of the liabilities, part
for the banks and part for the shareholders. However, that is not how it works, as they say, I do not
quite know why, that banks do not run any risks. If that were the case, the beta of debt (debt risk)
would be zero and the formula that relates the beta of the assets with the beta of equity would be:

What does this formula tell us? That when debt is zero risk, the risk on the equity increases with
the level of debt, so that if the company is 100% equity funded the risk of the liabilities is equal to
the risk of the assets, as we said earlier. However, if we start to get into debt, the equity risk begins
to outweigh the asset risk, because a part of the funding is risk-free. For example, if we take a risk
(beta) on assets of 0.8 and a debt of 30%, the equity’s beta would be:

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In the academic world there are many formulas (up to nine) for the equity risk associated with the
risk of the assets, but this one, used by the "professionals," is the simplest of all.

This is a two-way formula, used to calculate the equity’s beta, called leveraged beta, when we
know the beta of the assets, called unleveraged beta, and vice versa. The problem is that the beta
of the assets — you must take my word for it — can never be found by statistical methods. But that
does not put off an eager and tenacious academic. To better understand the relationship between
the betas I think it's best to give an example.

In 2000, Iberia was preparing to go public and needed a starting price. Analysts produced reports
to justify a range of values and they needed a cost of capital with which to discount the cash flow
forecasts. The steps are in Table 4 and were as follows:

First they used existing information from similar companies to Iberia present in the market and
were publicly traded. They took a sample of four: Delta, KLM, United Airlines and British Airways.
And, the equity betas were deleveraged using the relationship

So the beta for Delta's assets taking into account its D/E ratio was 0.83 and the beta of its equity,
0.91, was a result of:

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TABLE 3

Iberia's Weighted Average Cost of Capital

Delta United BA KLM Average

Beta of Equity (E ) 0,91 1,21 1,07 1,01 1,050
Debt/Equity (D/E) 0,83 0,81 1,82 1,62 1,270
Beta of assets () 0,497 0,669 0,379 0,385 0,463

Hypothesis RRF 5,38% PR 6,00% 35%

Iberia's Beta and Cost of Equity (CE ) at various levels of debt.

D/E  (1) CE

60% 0,740 9,82%

65% 0,763 9,96%
70%  D 0,786 10,10%
75%  E   A 1   0,809 10,24%
80%  E
0,833 10,38%
85% 0,856 10,51%
90% 0,879 10,65%
95% 0,902 10,79%
100% 0,925 10,93% C E  R RF   E P

WACC for various different levels of debt and Cost of Debt (CD ) and for E =E (1)

D/(D+E)
CD 8,0% 8,5% 9,0% 9,5%

 D   E 
37,50% CMPC  C D (1  t )    C E   8,09% 8,21% 8,33% 8,45%
DE  DE 
39,39% 8,08% 8,21% 8,34% 8,47%
41,18% 8,08% 8,22% 8,35% 8,48%
42,86% 8,08% 8,22% 8,36% 8,50%
44,44% 8,08% 8,22% 8,36% 8,51%
45,95% 8,07% 8,22% 8,37% 8,52%
47,37% 8,07% 8,22% 8,38% 8,53%
48,72% 8,07% 8,23% 8,38% 8,54%
50,00% 8,07% 8,23% 8,39% 8,55%

, , ,

If we calculate the four unleveraged or asset betas we get an average of 0.463, which represents
an approximation to the risk of the assets of international airlines.

Using these asset betas we can calculate Iberia’s equity betas for various different debt to equity
ratios. Thus, for a D/E of 60%, Iberia’s equity beta would be:

0.463 x (1 +0.6) = 0.740

And, as the level of debt increases, the equity beta rises to 0.925, when the debt equals equity.

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Once we have the beta of equity we can calculate the cost of equity if we have the Risk Free Rate
(RRF) which in 2000 was 5.38%, and the risk premium, which we assume is 6%. So for a D/E of
70% the cost of equity is:

CE = RRF + PR x E = 5.38% + 6% x 0.786 = 10.10%

We can now calculate the WACC for different types of debt interest and different equity betas. This
is at the foot of Table 3. The first column has the correlation between the percentages D/E and
D/(D+E), i.e. a D/E of 60% corresponds to a D/(D+E ) of 38% and a D/E of 100% corresponds to a
D/(D+E) of 50%.

If we put different debt interest rates in the rows, we arrive at a table of different WACC for different
costs of debt and equity. Thus, for example for a D/E of 75%, the equity beta is 0.809, the cost of
equity is 10.24% and, for a cost of debt of 9% and tax rate of 35% we will obtain:

WACC

This gives a figure of 8.36%. I can assure you that if you replicate all possible outcomes shown in
Table 3 in a spreadsheet, you will never have problems with the cost of capital.

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SUMMARY

Our aim has been to find a discount rate that represents, approximately, the cost of the resources
that will finance our future investments. This cost, which is called the weighted average cost of
capital (WACC), is obtained by weighting the cost of debt and that of equity as a function of their
relative importance in the company’s capital structure.

We have explained a simple way of calculating the cost of debt (CD) and converting it into a cost
after tax, given that interest represents a tax shield.

We have used two approaches to the cost of debt. The first, based on the Gordon-Shapiro share
pricing model, in which we can calculate CE if we know the dividend and the share price and can
estimate the long-term growth rate of the dividends; and the second, based on Sharpe’s asset
valuation model, which relates the expected return with the risk borne when investing in shares.
We have also distinguished between the risk of a company’s operations and the financial risk
produced by debt, and we have assigned a yield premium to each.

Throughout we have stressed the fact that our share valuation models always leave something to
guesswork and so appear imprecise. Nevertheless, they do have the advantage that they isolate
what is unknown from what is not, and allow “ceilings” and “floors” to be put above and below the
cost of capital, and also to set a figure within a reasonable range.

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ANNEX 1
SOME QUESTIONS THAT ALWAYS REMAIN AFTER STUDYING WACC

Can historic data be used to calculate WACC?

No. WACC is used to discount future cash flows from an investment project. The cost must
therefore be calculated based on:

1. The cost of the debt we can contract TODAY

2. How much the shareholders want to earn in the future if they invest TODAY.
3. The resulting debt/equity ratio after financing the investment.

We do not know what shareholders want to earn in the future, but we know that we do not know
and so can make assumptions about the risk premium and beta.

What value is used to weigh the cost of equity and debt? The book value or market value?

The market value should be used if it is available. Bear in mind that the cost of equity is calculated
based on the share price. When multiplied by the number of shares in circulation, this gives the
market capitalization.

Does WACC include inflation?

Yes, because if we use WACC inflation is included in the risk-free rate of interest, and if we use the
Gordon–Shapiro model it should be included in the rate of dividend growth.

Is the risk-free rate of interest before or after personal income tax?

Before tax. All the returns we have calculated in this chapter are before personal income tax but
after corporation tax (corporate income tax).

When you are going to finance a new investment with debt, is the WACC the rate after tax?

No. The best way to keep the criteria uniform in finance is to separate investment decisions from
financing decisions. In other words, an investment project that affects only the assets cannot be
better or worse depending only on how it is funded. Therefore, the discount rate should be the
weighted average cost, depending on the capital structure chosen for the company as a whole,
even if the project is funded only with debt or only with equity.

There is only one exception to this rule: projects that are linked to privileged finance. In this case,
the value of the project would be equal to the current value of its cash flows discounted at WACC,
plus the savings due to its being funded from privileged finance, which consist of the difference
between the nominal value of the finance and the current value of the cash flows discounted at the
market price of this type of finance. For example, the savings achieved for a project from a debt of
five million over five years, where the interest rate is 3% and the market rate is 12% will be:

3 3 3 3 103
100      0100  67.56  32.44
1.12 1.12 1.12 1.12 1.125
2 3 4

Therefore, the value of the project will be the net present value of the cash flows discounted at
WACC plus the 32.44 million contributed by the privileged debt.

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From the manager’s point of view, isn’t the dividend the cost of equity?

No. The dividend is a share of the profits that is distributed, but the shareholders do not forgo the
earnings the company retains in the form of reserves. They also consider them to be theirs and
entrust them to the managers because they expect them to invest them well. Thinking otherwise is
not good for one’s job security.

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BIBLIOGRAPHY

All the subjects dealt with in this chapter can be expanded upon, based on data from North
American capital markets:

 Brealey, R.; Myers, S. (1993). Fundamentos de financiación empresarial. McGraw–

Hill/Interamericana. Madrid.

A compilation of historic returns on worldwide capital markets can be found in:

 Ibbotson, R. G.; Brinson, G. P. (1987). Investment Markets. McGraw–Hill Inc.

The historic returns of the Spanish stock market can be found in:

 Sebastián González, A.; Suárez Barragato, J. L. (1992). Análisis de la rentabilidad histórica de

la inversión en acciones, deuda pública y renta fija privada en el mercado de capitales
español. Bolsa de Madrid.

The first work on the relationship between dividends and share prices appears in:

 Williams, J.B. (1938). The Theory of Investment Value. Harvard University Press. Cambridge,
Mass.

Years later the authors who gave their name to the formula relating the share price to the dividend,
the discount rate and the rate of growth of the dividend, published a paper. This appears in:

 Gordon, M. J.; Shapiro, E. (1956). “Capital Equipment Analysis: The required rate of Profit”.
Management Science 3 (October).

The basics of the Capital Asset Pricing Model (CAPM) were published for the first time in:

 Sharpe, W. F. (1964). “Capital Asset Prices: A Theory of Market Equilibrium under Conditions
of Risk”. Journal of Finance 19 (September)

An excellent work on leveraged and unleveraged betas is:

 Keith Butters, J.; Fruhan, W. E. Jr.; Mullins, D. W. Jr.; Piper, R. T. (1987): Case Problems in
Finance. IRWIN. ■ ■ ■

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