Cost of capital/ capital structure

Weighted average cost of capital (WACC)

The average post-tax cost of a company’s various sources of finance, weighted according to their relative market values. It represents the minimum return a firm must earn on its existing assets to satisfy its creditors and investors.

Three ways of estimating cost of equity

1) Capital Asset Pricing Model (CAPM)

2) Dividend Discount model

3) Bond yield plus risk premium

Assumptions of the CAPM (5)

-Investors are rational and risk-averse

-Investors have homogenous expectations

-Investors can all lend and borrow at the risk-free rate

-All assets are publically held and traded

-No transaction costs

Problems with the WACC

1) Project risk could be different to the whole firm risk

2) Markets may be volatile (ie beta instability, market risk premium could vary etc)

3) Hard to estmate beta

Defining Beta

Beta is a multiplier. If the market moves by 1%, Beta tells you what your stock is likely to do:

• Beta = 1.0: The stock moves exactly with the market.

• Beta = 2.0: The stock is twice as volatile (Market up 1% - > Stock up 2%).

• Beta = 0.5: The stock is a "defensive" play (Market up 1% - > Stock up 0.5%).

Beta instability

Company systematic risk is not constant over time, leading to instability.

For eg, COVID affected companies’ sensitivities to the market. Market returns were going down, but companies like zoom’s returns were going up. This would lead to a negative sensitivity, which we do not use.