Corporate Finance Essentials will enable you to understand key financial issues related to companies, investors, and the interaction between them in the capital markets. By the end of this course you should be able to understand most of what you read in the financial press and use the essential financial vocabulary of companies and finance professionals.
3. Estimating the cost of capital: Starbucks; A Few Rounding Comments
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Estimating the Cost of Capital - An Application
In this session we will put to work all the concepts discussed in the previous session by estimating the cost of capital of a company. As usual, when putting theory into practice, a few complications arise and we will discuss how to deal with them.
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Javier EstradaProfessor of Financial Management
Department of Financial Management
[MUSIC]
Now, there's another way in which we could have calculated that proportion of
debt and proportion of equity.
And that is, remember that if a company is using only debt and equity, then the sum
of these two weights, or the sum of these two proportions must be equal to one.
So that means that we could have calculated the proportion of
equity as 1 minus the proportion of debt.
And that basically means 1 minus 1.16% and
we would have arrived to exactly the same, 98.84.
So the important thing there is that we,
we could actually go, go one way or, or the other.
But what's really important is that Starbucks is a company that is
almost fully financed by equity.
It is using 99% of debt.
And only 1% of, of equity.
And having gotten to this point, all we have left is basically
throwing everything in, literally, into the expression for the cost of capital.
And if we do that, remember, Xd, 1 minus tc, Rd plus xe multiplied times RE,
so we have 1.16% the proportion of debt, 35% the corporate tax rate,
2.3% the cost of debt, 98.84% the proportion of equity.
And 7.3% the cost of debt, if you actually run that calculation,
you will get the number that you're seeing on the screen, which is 7.23% and
we're simply going to round it out for the concluding thoughts that we have to 7.2%.
So having done everything that we've done, from this point on we
will think that Starbucks' cost of capital back in September 2013,
was 7.2%, just a little bit over 7%.
So, as we said before,
we're rather be approximately right rather than precisely wrong.
We're not going to take many decimals, we could even round that number up to 7%,
but we're simply going to talk from now on about 7.2% as
being Starbucks' cost of capital.
Before we think a little bit about this number with a couple of
concluding comments, just a couple of things looking back.
Remember everything we've done, we looked at the cost of debt
in terms of the yield to maturity of the bond that Starbucks had in the market.
We look at the cost of equity in terms of the CAPM and
in order to get to that cost of equity.
We made specific choices for the risk free rate, the market risk premium, and beta.
And then we simply look at the proportions of debt and
equity that Starbucks was using, and
this is a company that is using a lot of equity and very, very little debt.
Put all that together with the corporate tax rate which is
simply a statutory number, and we get a cost of capital of 7.2%.
Two or three thoughts to, to conclude.
Why is 7.2% so important for Starbucks?
Well, remember what this cost of capital is.
Basically, we're saying that at that particular point in time, if Starbucks
needed to raise capital, they needed to deliver an average return of 7.2%.
Most of that was to the equity providers and
a little bit of that was to the debt providers.
They need to deliver about 7.something % to the equity providers,
they need to believe only 2.3% to the debt providers, but
they're using a lot of equity and very little debt, so
when you put all that together, the cost of capital becomes 7.2%.
That means that Starbucks should not invest in anything from which they
do not expect more than 7.2%.
Otherwise they would be burning money,
because they need to deliver to capital providers an average return of 7.2%.
So you don't want to invest in anything from which you
don't expect at least that 7.2%.
From that point of view is that what we call before the cost of capital,
the hurdle rate.
Or the minimum required return.
So rounding point number one,
it is very important that you keep in mind why this number is important.
It's important because it gives Starbucks an idea of the investments they
should go for.
And the investments that they actually should forego or set aside.
We still have a full session in which we'll discuss project
evaluation about we're going to be a little bit paraphrasing what we just said.
We don't want to invest in anything from which I
expect a return that is lower than the cost of capital.
That's the critical importance of that number.
If you don't know what is your minimum required return how are you going to
make investment decisions?
It's impossible because you don't know what type of return you're aiming for.
So once you know your cost of capital you have a beacon.
We should not invest in anything that,
from which I expect a return lower than this particular number.
If you're not clear about what that number is you're basically shooting in the dark.
You don't know in what to invest simply because you don't know what is
the minimum required return on the investments that you should go for.
So that's comment number one.
Comment number two.
We're going to go back twice to this number.
In session five and
session six we're going to use this cost of capital first in project evaluation.
And in the two tools that we're going to discuss NPV or net present value and
IRR or internal rate of return we need the cost of capital.
In one case it'll be the discount rate.
In the other case it'll be a benchmark rate, but
in both of them we will go back to that cost of capital.
Also in our last session in which will be corporate value creation you can
imagine that you cannot create value if you invest at a return
that is lower than the cost of raising capital and the measure of value creation.
That we're going to discuss, EVA, or
economic value added, it basically says that.
You're going to create value if the return on the capital that you
invest is higher than the cost of raising that capital in the first place.
So, we're going to go back to the idea of the cost of capital, both when we
discuss project evaluation and when we discuss corporate value creation.
Rounding comment number two.
And I'm going to maybe quote unquote here how constant is this 7.2%?
What I mean by this is the following.
Suppose that you have a company and
Starbucks is a case in point that actually operates in many different countries.
Should Starbucks use 7.2% for all the countries or they
should use different discount rates for all the countries in which they invest?
There maybe companies, Starbucks is not quite the case there, but
there may be companies that have many different divisions.
The typical case is think General Electric.
General Electric is in all sorts of different segments of the market.
Should General Electric use this same discount rate for
all the very different divisions.
Boeing is another case in point.
Boeing actually has two very different divisions.
One is a commercial airline division, and the other is
a defense division which basically does contracts with the government.
Should these two divisions have the same discount rate.
Or should they have a different discount rate?
That's basically what I mean by constant.
Should it be constant across divisions?
Should it be constant across countries?
And there's a third dimension.
Should that cost of capital we estimated be constant over time?
Should we use that number for this year and the next and the next and the next.
Or should we actually change, use a number that changes over time.
Because, and we're going to talk a little bit about this later,
in another session, but if we agree.
And that's a big if, we don't have to.
But if we agree that 7.2 should be constant across countries,
across divisions, and over time, then we're done.
We've estimated 7.2%.
That's the number that Starbucks should use for all the countries, for
all the divisions and basically over time.
But if we don't agree, if we think that Starbucks should actually
require higher returns in some countries than in others or higher returns for
some products that for others, or
that the rate is going to change over time then we have more work to do.
And we have more work to do because now the question becomes well what rate we're
going to use in each country, or what rate we're going to use for
each division, or what rate we're going to use for each of the years?
So that, there's an important question which again,
we are not going to address right now.
But it's an important question.
Having estimated a number, a figure for the cost of capital,
is this number constant in the sense that we're calling it constant, or
do we need to do some more work?
Do we need to estimate rates for different countries, different divisions, and
different periods of time?
Third and final comment and with this, we're, we're done for today.
And that is, a question that we're not really going to address in this
session and in fact, we're not really going to address in this course.
It's a little bit more complicated an issue which is basically how you get
to minimize a company's cost of, cost of capital.
This is one of the main jobs of the CFO.
A CFO needs to determine how would the companies going to be financed, and that
means are they going to use only equity or are they going to use equity and debt?
Or equity debt and convertible debt.
Or equity debt, convertible debt and preferred equity and on and on and on.
What are the instruments that we need to use?
And in what proportions with the goal of trying to pay as little as possible.
That is, where we get the lowest possible cost of capital.
Now.
When you're exploring that it seems a little bit
strange that being the difference between the cost of equity and
the cost debt so large that Starbucks used so little debt.
Well th, that's something that we could actually explore but
that is the heart of what we call capital structure.
Capital structure is all about finding the ideal instruments to find on the company
and the ideal proportions in which those instruments need to be used and
again, that is not an issue that we're going to deal with now but
it's intimately related to the cost of capital because the ultimate goal of
the capital structure issue is to minimize that cost of capital.
It's to pay as little as possible to raise the capital that
the company needs in order to to invest.
So not all the companies are going to make the same choices.
Some will be very unlevered.
Some will be very levered, and that means not using debt, or using a lot of debt.
Some will need one source of financing, and some will need many.
And some will need them in very different proportions.
What matters is that market conditions are also going to play a role.
For example, if you look now in terms of relatively low interest rates,
interest rates in general are very low for historical standards.
Companies that had never actually issued debt before and
companies that may not even need debt are raising debt.
And the reason they're doing that is because debt is cheap and
because that actually helps them reduce the cost of capital.
So, the type of company that you are and the market conditions may
help determine what is going to be that minimum cost of capital.
Again, that is a topic of capital structure.
And although we're not going to address it directly the key
of capital structure is minimizing that particular cost of capital.
So as a rounding comment to this if it surprised you
that the cost of equity's over 7%.
And the cost of debt is just a little bit over 2%.
And Starbucks is using so much equity and so little debt.
Well, we need to assume that this is a very sophisticated company.
The CFO must know what he's doing.
And so if he thinks that the optimal proportions are so much equity and
so little debt, maybe it's because he knows that using more debt would not
be beneficial for the company.
In other words, we need to assume that a company like Starbucks has a CFO
that knows how to do his job and therefore that sounds like, the ideal, or the,
the sort of the ideal capital structure for, for Starbucks.
So, as you see.
Estimating a cost of capital is not that difficult.
Estimating cost of debt is relatively simple,
because that number is observable and that number is objective.
Estimating the cost of equity may look simple, but
there's a lot of choices that we need to do along the way.
Once we have made those choices, then of course it becomes just adding and
subtracting, and it becomes very easy to come up with a final number.
And then we need to put everything together taking into
account how much we're using of each of,
of the financial instruments that we use to finance the operations of the company.
And we bring all that together into a cost of capital.
And the most important thing,
having gone through the calculations, do not forget the importance of that number.
That's a beacon.
That's a number that tells a company you should not invest in anything from which
you do not expect a return at least as high at this particular number.
So this is it for session four but we're not done yet with the cost of capital.
We'll talk about the cost of capital in session five when we evaluate projects and
in session three, six.
When we actually do corporate value creation.
So see you soon for that.
[MUSIC]
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