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This exercise shows that the cost of capital is critical to value creation. Managers apply discount rates to penalize future cash flows, as we saw in chapter 2, because there is an opportunity cost to any investment. Those discount rates are often referred to as costs of capital because they refer to the penalties (costs) associated with deploying that capital. Where do those discount rates and costs of capital come from?
The key insight is that the costs of capital are a function of the returns that investors expect. In short, an investor’s expected return becomes the cost of capital for managers. The costs of debt and equity will be different; equity is a residual claim with a variable return, whereas debt has a fixed return that has priority for repayment.
The demand for additional returns to bear risk is a foundational idea in finance and relates to risk aversion.
Investors, like most of us, are risk averse. It’s human nature. As a consequence, if they are forced to bear risk, they will demand something in return.
But how do we actually operationalize the idea of cost of capital? How do we measure the appropriate amount to charge for risk?
The tax term requires a little more explanation. Interest payments are typically deductible expenses that can lower a firm’s tax payments. In effect, these interest payments shield a company from paying more taxes and are known as “tax shields.”
How much benefit the interest payments provide because of their deductibility depends on the tax rate. If tax rates are high, the ability to deduct interest payments is very valuable. If the tax rate is 40 percent, and a company has to pay $10 in interest payments, how much does it actually cost to pay $10? The company is out $10, but its pretax income is lower by $10, and that lowers their tax bill by $4, so the true cost is $6.
As discussed in chapter 2, diversification provides a powerful way to manage risks because as you diversify, you can maintain expected returns and reduce risk—the only free lunch in finance.
Because so much of a given stock’s variability goes away within the context of a portfolio, we need only think about the risk that doesn’t disappear—the systematic risk.
The measure of how a stock moves with the market is called a beta. More precisely, if a company has a beta of 1, it generally moves in sync with the market; if the market goes up by 10 percent, then the company’s stock is likely to go up by 10 percent.
A beta is surprisingly simple to calculate.
The intuition behind betas. The central intuition behind betas relates to insurance. High-beta companies expose shareholders to larger amounts of systematic risk that they can’t diversify away. Because of this, investors charge them a higher cost of equity. As a consequence, these firms have a higher weighted average cost of capital. And as a consequence of that, their values will be lower.
That last step is the trickiest—if you apply high discount rates, what happens to present values? They become lower, so a high beta leads to a high cost of equity that leads to a high WACC that leads to lower values.
Negative beta assets are special because when the world falls apart, they really deliver for you. As a consequence, you don’t demand much of a return from them, and that leads to high values.
Remember, the beta is the slope of the line. Notice how the slope of the line is negative, unlike the slope of the line for AIG and Yum! Part of the attraction of investing in gold is that when the world falls apart, the gold (hopefully) will be there for you, and that insurance is valuable and would lead you to ask for low or negative returns.
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While the CAPM is a really powerful theory, it’s also predicated on several assumptions that don’t always hold.
For example, it assumes no transaction costs and investors that are able to borrow and lend at relatively low rates, and many of these assumptions are inconsistent with reality.
Most important, the theory relies on the idea that investors are highly rational—an assumpti...
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Most concerning, it does not always appear that realized returns line up with betas a...
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While the capital asset pricing model is hotly debated, it remains the cornerstone of the cost of equity and is a dominant framework...
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The intuition for WACC is slippery, so it’s useful to think through three common misconceptions about costs of capital in order to build our intuition further.
Using the same cost of capital for all investments The first big mistake managers make is to use the same cost of capital for all the projects they invest in. The logic usually goes something like this: “Well, my capital providers have expected returns, so the cost of capital, no matter what I invest in, has to be the same for all my investment projects.” This logic is powerful, but it’s wrong.
Lowering your WACC by using more debt Another appealing, but incorrect, intuition is that a company can lower its WACC by using more debt, given that debt has a lower cost than equity. The thinking usually goes like this: “Debt is typically cheaper, and with a tax advantage, even more so. So if I just use more debt, I’ll reduce my WACC and, as a result, I’ll end up having a higher value.” That’s wrong.
Figure 4-11—the most difficult figure in this book—will help you see that WACCs can’t simply be lowered by taking on more debt. The figure shows what happens to betas on the vertical axis as the amount of debt used increases on the horizontal axis. One key difference from what we’ve seen previously is that there are three types of betas on the graph: equity betas, debt betas, and asset betas.
Corning likely believed, as Moel did, that the market was mispricing its future performance and that its future performance would be considerably better.
This question returns us to core strategic business concerns. If Corning believes that its work adds value to its product and that it can protect its operations in a competitive environment, it should be confident that pricing pressures will be temporary.
Moel agreed that there was price pressure. However, when he looked at Corning’s in-depth cost structure, he saw that the pricing pressure could be offset or even improved by its cost structure.
Therefore, Moel thought that the ROC of Corning was going to be better than the market thought and that in the future,
Forecasting the future is inherently difficult, and every decision the analyst makes carries the risk of being wrong. Faced with this difficulty, many analysts choose assumptions that extrapolate existing trends to determine future cash flows.
Valuation is difficult because you have to consider everything about a company—its intellectual property, its strategy, its competitive landscape, and so on—and
2015, due in part to low interest rates, Biogen took on $6 billion in debt in order to repurchase $5 billion of its own shares. This changed its capital structure; the net effect would be similar to not issuing those shares in the first place and taking on debt instead to purchase assets.
But what about the debt? According to Paul Clancy, Biogen’s CFO at the time, taking on that much debt was rare for the pharma company.
What does it mean to talk about a cost of capital? The first big idea is that costs of capital are associated with the expected returns of capital providers. And those expected returns are dictated by the risk investors bear.
Next is the idea of the capital asset pricing model. The costs of equity aren’t explicit. You need to rely on something to think rigorously about these costs.
The final idea is that you have to use the WACC with care.
In the next chapter, we will first combine the WACC and the idea of free cash flows to create the foundation of valuation
