Session 13: Estimating Hurdle Rates- Financing Weights & Cost of Capital
New Section
In this section, the speaker discusses the concept of raising money through borrowing and emphasizes the importance of defining debt costs as a precursor to estimating the cost of capital.
Understanding Debt and Cost of Capital
- The speaker explains the process of combining the cost of equity and debt to determine the cost of capital, crucial for making investment decisions based on hurdle rates.
- Market value numbers should be used when weighting equity and debt in the cost of capital calculations, contrasting with book value weights commonly used by companies. Book value weights can lead to a lower cost of capital due to debt being weighted more than equity.
- Despite arguments for using book value weights such as reliability and conservatism, market value is essential for determining the true cost of capital. The speaker debunks misconceptions around relying on book values for cost calculations.
Analyzing Market Value vs. Book Value
This section delves into why market value is crucial in computing the cost of capital, emphasizing its relevance over book value in determining funding costs accurately.
Importance of Market Value
- Estimating market value debt involves converting book debt using a simple approximation method. The speaker uses Disney's example to illustrate how to calculate market value debt from publicly available financial data.
- By considering interest expenses, maturity periods, and discounting methods akin to bond valuation, one can derive an accurate market value for interest-bearing debts like corporate bonds or loans.
- The process involves treating debts as giant coupon bonds with face values and coupon payments, enabling a straightforward calculation method for determining market values accurately.
Incorporating Lease Commitments into Debt Valuation
This part focuses on incorporating lease commitments into overall debt valuation to provide a comprehensive view of a company's financial obligations.
Handling Lease Commitments
- Converting lease commitments into debt equivalents allows for a more holistic assessment of a company's financial liabilities. By discounting lease commitments back to present value using pre-tax costs, one can obtain an accurate representation of total debt.
Cost of Capital Calculation
In this section, the speaker discusses the process of converting leases to debt and computing the cost of capital for a company.
Converting Leases to Debt
- Converting leases to debt changes the cost of capital and impacts the valuation of operating assets.
Estimating Market Value of Equity and Debt
- Calculate market value of equity by estimating market value of debt, starting with interest-paying debt and converting book debt to market debt.
Computing Cost of Capital for Disney
- Compute cost of equity using risk-free rate, beta, and risk premium.
- Determine cost of debt by adding credit spread based on actual rating and tax benefit.
- Calculate weights using market values of equity and debt to derive cost of capital for Disney.
Cost of Capital for Multi-Business Companies
This part focuses on extending the concept of calculating cost of capital to multi-business companies like Vale.
Cost Analysis for Vale
- Break down Vale into its businesses to compute individual costs.
- Use differential inflation rates to convert US dollar cost of capital to local currency if needed.
Cost Analysis for Specific Companies
The discussion shifts towards determining the cost of capital for specific companies like Tata Motors, Baidu, and Bookscape.
Cost Evaluation for Tata Motors & Baidu
- Analyze costs based on equity-debt structure and market values.
Impact on Cost due to Diversification
- Higher owner diversification leads to lower total beta, affecting overall cost analysis.
Hurdle Rates Determination
Exploring how hurdle rates are determined based on returns measurement.
Hurdle Rate Clarification
- Choose between cost of equity or cost of capital as hurdle rate based on returns measured (equity vs. entire business).