Session 13: Estimating Hurdle Rates- Financing Weights & Cost of Capital

In this session 13 of a 36-session corporate finance class, I'd like to look at the second way in which you can raise money, which is to borrow it. I'd like to start off by defining what I mean by debt and attach a cost to that debt as a precursor to estimating a cost of capital. Now that we have a cost of equity and a cost of debt that we've talked about in these last few sessions, let's talk about weighting these two items to come up with the cost of capital. And this is in fact going to be the last session in our discussion of hurdle rates, and those hurdle rates are going to be central in deciding what investments to take and which ones to avoid. So here's the basic principle for weighting equity and debt in a cost of capital. They should always be market value numbers, as opposed to what? As opposed to book value numbers. The reason I emphasize that is half of all companies actually still use book value weights to come up with cost of capital, and there are lots of reasons CFOs and others give for still sticking with book value weights. One is that book value is more reliable than market value, and they base it on the fact that book value is actually not as volatile. That's true, book value doesn't change as much as market value, but it doesn't change as much because accountants actually re-estimate book value only once every three months if you're a U.S. company, and perhaps even less frequently if you're a non-U.S. company. The fact that something does not move does not make it more reliable. The second argument you'll hear is that they're just being more conservative, but using book value weights is actually less conservative for most companies because it'll give you a lower cost of capital, and here's why. Book value weights will weight debt more and equity less, and the cost of debt is usually much lower than the cost of equity. The third reason people give is that their return in equity and capital numbers, these are accounting return numbers, are based on book value, and that's absolutely true. And because they're based on book value numbers, they argue that the cost of capital should also be based on book value numbers. That's nonsense. The cost of capital is a very different concept. It's the cost of raising funding from the market today. Your book values are completely irrelevant when it comes to your cost of capital. So in computing cost of capital, you need market value equity and market value debt. Now with a publicly traded company, the market value of equity should be relatively simple to get, right? You've got a share price, you've got a number of shares. So in most cases, getting a market value of equity is easy. Market value of debt is usually trickier because most companies, even those with bonds outstanding, have a significant amount of debt that's bank debt and that's not traded. So what most bankers and most analysts often tend to do is use book value of debt as a proxy for market value of debt while using market value of equity in their cost of capital weights. I think it's not only inconsistent, it's unnecessary. You can estimate the market value of debt relatively simply and let me use Disney to illustrate this point. Think about debt on a balance sheet. In the case of Disney, the company is 14.288 billion dollars in book value of debt. That's what you see on the balance sheet. If you go to the income statement, you'll see an interest expense of 349 million dollars. In addition, if you go look at the footnotes for Disney, they break out when the debt comes due and on average, the debt matures in about 7.9 years. You're saying, how does this help me? Think about how you compute the market price for a conventional bond. You take the coupons and the face value and you discount them back to today using the market interest rate today, right? Think of Disney's debt as if it were a gigantic coupon bond with a face value of 14.288 million, a coupon payment of 349 million and a maturity of 7.92 years. Remember, we computed the pre-tax cost of Disney already at 3.75 percent based on its rating. Try to estimate the market value of this gigantic coupon bond. What you see in my present value calculation there is a coupon of 349 million treated as a coupon. That's a first term there. It's a present value of an annuity plus the present value of the 14.288 million discounted back to today and that's a face value of the bond. And what you get is a present value of 13.028 billion is my market value for your interest bearing debt. You can take any company and convert the book debt that it has into market debt using this very simple approximation. So that takes care of the interest bearing debt. I have a market value for the debt. But there's one more loose end to tie up. Remember I said debt should include lease commitments as well. Now for U.S. companies, one of the advantages you have is they have to break out their lease commitments by year. Disney and its balance sheet as part of its footnotes specifies what its lease commitments are next year, two years out, three years out, four years out, five years out, and then gives me a lump sum beyond year five. I go to that table. I pull up the lease commitments. I take the fifth year's commitment, which is the lump sum of 1.784 billion, and rather than treat that commitment as all coming in after year five, I break it out into an additional seven years of annual commitments. You don't have to do this if you don't want to, but I think it's a much better approximation than treating that entire lump sum as coming in in year six. I then discount these lease commitments all back to today using the pre-tax cost of debt. Why the pre-tax cost of debt? Because these are pre-tax lease commitments, and the present value that I get for these lease commitments is $2,933 million. That's the debt value for my leases. I'm going to add that number on to the $13.03 billion that you saw on the previous page, and the total debt that I get for Disney as a company is $15.96 billion. From this slide on, that's what I'm going to treat as Disney's debt. Now you might wonder why I go through the trouble of converting leases to debt. In the case of Disney, the difference might be relatively small, but if you take a retailer or a restaurant company and you do this, you might find that the bulk of your debt takes the form of lease commitments. It changes the way you think about how much your company has borrowed. It changes your cost of capital. It'll change the value that you attach to the operating assets of the company. So I think it always makes sense to convert leases to debt, and especially when they're your primary form of borrowing. So when you do get a chance, here's a good way for you to make sure that you get this concept. Take any company. Get the market value of equity. That should be the easy number. Try to estimate the market value of debt. First start with the interest paying debt. Take the book debt, convert to market debt. You need a pre-tax cost of debt to do that, so you've got to do that step first. Then take the lease commitments and convert them to debt. Compute your market value debt ratio. Then just as an exercise, try the book value debt ratio. Because remember what I said earlier about it being less conservative? Check it out for yourself. Once you get those numbers, you're almost at the point where you can compute the cost of capital. In fact, with Disney, I can now compute my cost of capital. And this is where we've been leading with these last few sessions. So let me start with the cost of equity. To get the cost of equity, I start with the risk-free rate of 2.75 percent. That is my U.S. dollar risk-free rate in November of 2013. I use the bottom-up beta I estimated for Disney based on the five businesses it's in, 1.00. I use the equity risk premium I estimated for Disney based on where it operates. I come up with the U.S. dollar cost of equity for Disney in November of 2013 of 8.52 percent. To get the cost of debt, I start with the same risk-free rate, 2.75 percent. I add a default spread of 1 percent based on their actual rating, which is single A. And I net out the tax benefit based on a marginal tax rate of 36.1 percent to give me a cost of debt after taxes of 2.4 percent. To get the weights, I use the market value of equity, which I get by multiplying the share price by the number of shares. I estimated the market value of debt in the last few slides at 15.96 billion. That gives me weights for debt and equity of 82.4 percent equity and 11.6 percent debt. I plug in those weights. And with the cost of equity and cost of debt I've computed, the cost of capital I have for Disney as a company is 7.81 percent. Now remember that we did break Disney down into its businesses. So just as I compute a cost of equity for each of Disney's businesses based on the bottom of my betas, I can now compute a cost of capital for each of Disney's businesses. These are the minimum acceptable hurdle rates for each of the businesses that Disney is in. Now I can do the same thing for Valet. I break Valet down into its four businesses. I get the bottom of my beta, a cost of equity in U.S. dollar terms and a cost of capital in U.S. dollar terms. So I can estimate a cost of capital for any multi-business company. And I can also estimate a cost of capital for any of its businesses. In the case of Valet, if I want a U.S. dollar cost of capital converted to nominal REI cost of capital, I can use that differential inflation rate approach to come up with a nominal dollar cost of capital. If that's what, I'm sorry, a nominal REI cost of capital, if that's what I want to estimate. So now that we have cost of capital for our multi-business companies, Disney and Valet, let's extend that concept to the remaining companies in the domain. Let's start with Tata Motors. I want a cost of capital in rupee terms. I already have a cost of equity based on the automobile companies of 14.49% and after-tax cost of debt of 6.5%. And based on the market values of debt and equity, Tata Motors is about 70% equity, 30% debt. And that cost of capital of 12.15% reflects those weights. For Baidu, company's predominantly equity, 95% equity, 5% debt. The cost of equity we estimated was 12.91%. The cost of debt we estimated was 3.45% after-taxes. And here's why it didn't matter so much that we might have overestimated the rating for Baidu. Remember, it's only 5% debt. So let's say while we gave it a rating of AAA, let's say its true rating was BBB. The effect on the cost of capital would have been relatively small. So for companies where the bulk of the financing comes from equity, I wouldn't waste too much time trying to refine the cost of debt because it's not going to make that much of a difference anyway. For BookScape, I tried a refinement. I computed two different costs of capital. The first was as if it were a public company. So I gave it a market beta, a market cost of equity. The weights that I used reflected the fact that it's going to be pretty close to the industry average, which is 17.63% debt and about 82.37% equity. The cost of capital I arrived at as if it were a publicly traded company was 6.57%. But remember, we said the owner was not diversified. And because the owner is not diversified, the beta we should be using is a total beta. The cost of equity we end up with is much higher. With a higher cost of equity, the cost of capital I arrive at for the company is about 10.3%. Higher cost of capital because the owner is not diversified. And that's part of the issue you face as private businesses. It does make it more difficult to compete with public companies because owners tend to be less diversified than the owners of public companies. So here's the final part of the process. Once you have the cost of equity and cost of capital, the question is what next? And at this stage, you might be a little puzzled because we've described both these numbers as hurdle rates. How can they both be hurdle rates, you might ask? I mean, take Disney. The cost of capital is 7.81%. The cost of equity is much higher. Do you pick the higher of the two, the lower of the two, some average of the two? Well, the answer actually is surprisingly simple. You tell me how you compute returns. And I'll tell you what the right hurdle rate is. And here's how it's going to work. If you measure returns to equity investors, return on equity, cash flows to equity, cash flows leftover after debt payments, then the appropriate hurdle rate is the cost of equity. If you measure returns to the entire business, returns on capital, using pre-debt earnings, then the appropriate hurdle rate is the cost of capital. You cannot mix and match. You tell me how you measure cash flows or returns, and I'll tell you what the right hurdle rate to use. So we're at this, at least at this stage in the process, we have a measure of a hurdle rate for an investment. And let me restate that principle. It should be higher for riskier investments. And at this stage, we have defined what that risk is and how we capture it in a hurdle rate and should reflect the mix of debt and equity used to fund the business. We're now ready to look at the second piece of the investment principle. That's for the next session. Thank you very much for listening.