2. Cost of capital
• The Cost of Capital is the weighted sum of the cost of equity and the after-tax cost of
debt. It is expected returns demanded by both equity and debt investors.
• Weighted average cost of capital (WACC)= 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 ∗
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓𝑓𝑖𝑟𝑚
+
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑑𝑒𝑏𝑡
𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚
∗ 𝑃𝑜𝑠𝑡 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓𝑑𝑒𝑏𝑡
• 𝑃𝑜𝑠𝑡 − 𝑡𝑎𝑥 𝑐𝑜𝑠𝑡 𝑜𝑓𝑑𝑒𝑏𝑡=Cost of debt *(1-Marginal tax rate)
3. Estimating the cost of debt
• Never consider book interest rate(interest amount/total debt) to arrive cost of debt.
• The cost of debt is the rate at which you can borrow money long-term at currently, it will
reflect not only your default risk, but also the level of interest rate in the market, including
country-level risk.
Cost of debt (pretax)=Risk-free rate + firm’s default spread + country’s default spread.
• Approaches
• YTM of traded bonds.
• Looking up rating for the firm and estimating a default spread based on the ratings.
You have a lot of bonds, then take median rating.
• Can a riskier firm issue safer bond?
• How would you measure Bank’s cost of debt?
4. Synthetic credit ratings
• We can define synthetic credit ratings based on interest coverage ratio because of
the following reasons.
• It is first among the many ratios that are used by rating agencies, such as S&P,
and Moody’s to determine rating.
• The research has found a significant correlation between interest coverage
ratio and bond rating.
6. Tata motor-: Synthetic credit ratings (2020)
• Total debt=Rs 1247876 millions
• Interest payment=Rs 72433 millions
• EBIT=Rs 180997
• Interest coverage ratio=180997/ 72433=2.49
• Systematic Rating=B1B+
• Risk-free rate= 3.52%
• Country risk premium= 4.82%
• Default spread=3.51%
• Pre-tax Cost of debt=3.52% +3.51% +4.82%=11.85%
• Implied interest rate= 72433/ 1247876=5.8% (even less than govt long-term
bond)
7. Tax-Shield on interest amount
• When you borrow money, you can deduct interest expenses from your income to
arrive at taxable income. This reduces your taxes. When you use equity, you are
not allowed to deduct payments to equity (such as dividends) to arrive at taxable
income
8. • Tax benefits: The tax code is
tilted in favor of debt, with
interest payments being tax
deductible in most parts of
the world, while cashflows to
equity are not
Total investment 10,000 10,000
ROI 10% 10%
Debt @8% 0 5000
Equity 10000 5000
EBIT 1000 1000
Less Interest 0 400
EBT 1000 600
Less Tax @30% 300 180
PAT 700 420
10. Weights for the cost of capital computation
• In computing the cost of capital for a publicly traded firm, the general rule for
computing weights for debt and equity is that you use market value weights or
book value weight (?)
11. Tata motor: cost of capital(2020)
• Equity beta=2.08
• Cost of equity =Risk-free rate + ERP from matured market *equity beta +country risk
premium
• Cost of equity=3.52% +4.82% *2.08+4.82%=18.37%
• Pre-tax cost of debt= 11.85%
• Marginal tax-rate=25.17%
Cost of capital=18.37% ∗
380750
380750+901,941.01
+ 11.85% ∗ (1 − 0.2517)
901,941.01
380750+901,941.01
=13.99%
