Cost of Capital Factors

The type of capital a company seeks affects its capital cost. Debt capital has a lower cost than equity capital due to its lower risk. Before considering the tax deductibility of interest, the cost of debt comprises the sum of a credit spread and the benchmark risk-free rate.

$$ r_d=r_f+ \text{Credit spread} $$

The credit spread reflects factors specific to a company, such as the riskiness of the business model, tax rates, growth prospects, and future profitability.

The cost of equity of a company comprises the sum of the equity risk premium and the benchmark risk-free rate.

$$ r_e=r_f+(ERP+IRP) $$

Where:

\(ERP\) = Equity risk premium (Market risk premium for bearing the systematic risk of investing in equities).

\(IRP\) = Idiosyncratic risk premium (Company-specific risk premium).

Factors affecting a company’s capital cost can either be top-down or bottom-up.

Top-down External Factors

These include macroeconomic factors.

1. Capital availability: Availability of more capital will lead to lower cost of capital and more favorable terms for corporate issuers. Developed countries have more liquid and established capital markets with greater capital availability, stronger laws, and stable currencies. There is a lower perceived risk of investing in companies with more mature capital markets than those with less mature capital markets.
2. Market conditions: These include such factors as the macroeconomic environment, inflation rates, and interest rates. In addition to risk factors specific to issuers, the ERPs and credit spread demanded by equity and debt investors reflect overall equity and debt conditions. Debt and equity costs are also low when credit spreads are tight, and interest rates are low. It is equally worth noting that high inflation rates increase companies’ capital costs. More transparent and predictable monetary policies in developed economies cause interest rates and inflation rates to become less volatile, leading to a lower cost of capital.
3. Legal and regulatory considerations, Country risks: Based on empirical evidence, a strong correlation exists between capital market conditions in different countries and the legal traditions the countries follow. Countries with stronger investor protection laws support more developed capital markets. Investors in such markets demand lower ERPs and credit spreads, leading to lower capital costs.
4. Tax jurisdiction: Interest expense is tax deductible in many countries, reducing a company’s after-tax cost of debt because of tax savings. A company with a higher income tax rate will likely experience greater tax benefits by using debt in its capital structure.

Bottom-up Company-specific Factors

The WACC of a company reflects the riskiness of its expected cash flow streams.

1. Revenue, Earnings, and Cash Flow Volatility: Investors positively view companies with recurring revenue streams since this indicates that their cash flows are more stable and less sensitive to macroeconomic volatility. For a given debt level, companies with lower revenue, earnings, cash flow volatility, and higher predictability have lower default risk and narrower credit spreads. This results in a lower cost of capital. Companies with higher ESD risks are likely to have a higher cost of capital since investors demand higher returns for the precedented risk of litigation cost, mitigation cost, or boycotts on company products.
2. Asset Nature and Liquidity: Companies with many tangible assets can access debt capital at a lower cost because the assets can be used as collateral. Companies with non-fungible, illiquid assets are likely to have access to higher-cost capital than those with more fungible, liquid assets, e.g., cash. If tangible assets are collateralized, they lower the issuer’s cost of debt but potentially increase its cost of equity.
3. Financial Strength, Profitability, and Financial Leverage: A company with declining cash flows, tight liquidity, and weakening profitability will have a higher cost of capital because its idiosyncratic ERPs increase and credit spreads widen. Business risk held constant, a company with a greater proportion of debt in its capital structure will have higher default risk and credit spread, leading to a higher cost of capital.
4. Security Features: Features embedded in the equity and debt securities a company issues can also affect its cost of capital.
   • Callability: Callable bonds incur higher costs or yields on debt capital at issuance because the investor will demand a higher yield on a callable bond than on an option-free bond. This is because the call feature in a callable bond puts investors at a disadvantage when interest rates fall, and issuers have the option to call back higher-cost debt.
   • Putability: Putable bonds incur lower costs or yields on debt capital at issuance because the investor benefits from the option to put the bond back to the issuer before maturity. Put features also allow investors to avoid any company-related event that increases the bond’s risk and reduces its price. The lower cost could increase in the future because the issuer is forced to refinance buying back puts at higher rates when interest rates increase.
   • Convertibility: Convertible bonds offer investors the option to convert the bond into common shares of the issuer at a specified ratio. In return, investors accept a lower rate of return than they would earn on option-free bonds, and the issuer’s convertible bonds will have a lower cost of debt capital. The lower cost could, however, increase if the investors decide to convert the bonds into stock in the form of equity dilution.
   • Cumulative versus non-cumulative: Cumulative preferred stock investors are paid any missed dividends before they are paid to common shareholders. Non-cumulative preferred stock only requires that dividends to common shareholders cannot be reinstated unless the preferred stock is being paid. Investors accept a lower rate of return on cumulative preferred shares because, upon liquidation, the preferred shareholders will have a claim on unpaid dividends before common shareholders.
   • Share class: Shares with poor voting or cash flow rights have a higher cost of equity capital.

Question

Lupin has gathered information about 2 companies, Gasolina Ltd and Underwood Ltd.

$$ \begin{array}{c|c|c} & \textbf{Gasolina} & \textbf{Underwood} \\ \hline \text{Net debt-to-EBITDA} & 3.0 & 3.5 \\ \hline \text{IC ratio} & 11.7 & 8.0 \\ \hline \text{Features in existing debt securities} & \text{Put} & \text{Call} \end{array} $$

Which company most likely has a higher cost of capital?

1. Gasolina.
2. Underwood.
3. Both.

Solution

The correct answer is B. 

Underwood operates with higher leverage, as indicated by a higher net debt-to-EBITDA, than Gasolina (3.5 versus 3.0) and a lower IC ratio. This will lead to a higher cost of capital.

A and C are incorrect. Gasolina’s lower leverage (3.0 versus 3.5) and a higher IC ratio will lead to a lower cost of capital. Debt securities with putable options incur lower yields or costs on debt capital.

Reading 20: Cost of Capital: Advanced Topics

LOS 20 (a) Explain top-down and bottom-up factors that impact the cost of capital.