COST OF FUNDS FOR BUSINESS

Estimating the Cost of an investment (Hurdle rate)

Objective Function: Maximizing the Value of a firm

Source: [Link]
Risk vs Return

Assume that you had to choose between two investments.

A B
Expected Return from investment = 15% Expected Return from investment = 15%
Standard deviation = 25%; with a very small Standard deviation = 25%; with the highest
possibility of quadrupling your money possible payoff of 60% return.
Would you:
a. be indifferent between the two investments, since they have the same expected return
and standard deviation?
b. prefer investment A, because of the possibility of a high payoff?
b. prefer investment B, because it is safer?
 Would your answer change if you were not told there is a small possibility that you could
lose 100% of your money on investment A but that your worst-case scenario with investment
B is -50%?
Defining Hurdle rate

• Any project requires financial resources. Resources have COST

• Projects are expected to generate RETURNS > COST
• COST depends on the RISK of investment. COST = Risk = HURDLE RATE
• Hurdle rate should be higher for riskier projects than for safer projects.

Types of Risk:

Micro vs Macro Risk Discrete vs Continuous Risk

Micro: Uncertainty about the potential market, Discrete: Risk that lie dormant for periods but
firm’s products, its competition, management show up at points in time.
team quality

Macro: Change in inflation, exchange rate, Continuous: Changes in interest rates or

politics, demographics, govt policies economic growth
Diversification reduces firm-specific risk

 Idiosyncratic volatility measures firm-specific risk (micro risk)

 Firm-specific risk can be reduced, if not eliminated, by increasing the number of

investments in your portfolio (i.e., by being diversified) for two reasons-

a. Each investment is a much smaller percentage of the portfolio, muting the effect
(positive or negative) on the overall portfolio.

b. Firm-specific actions can be either positive or negative. In a large portfolio, it is

argued, these effects will average out to zero. (For every firm, where something bad
happens, there will be some other firm, where something good happens.)
Marginal Investor

 The marginal investor in a firm is the investor who is most likely to be the buyer or seller
on the next trade and to influence the stock price - owns a lot of stock and also trade
that stock on a regular basis.

 If you observe the top holdings of a company, many a times all the top investors in a
company are institutional investors having diversified portfolio. But the largest investor
may not be the marginal investor, especially if he or she is a founder/manager of the firm

 Remember:
In Finance, most risk and return models assume that the marginal investor is well
diversified.
 Britannia Industries Ltd in 2023: Who is the marginal investor?

Holder Name Percentage

Associated Biscuits International Ltd. 44.76
LIC 4.15
SBI Fund Management 2.14
BlackRock Inc 2.00
Vanguard Group 1.97
JPMorgan Chase & Co 1.92
NACUPA Enterprises PTE Ltd 1.73
Valletort Enterprises Pte Ltd 1.73
Spargo Enterprises Pte Lts 1.73
ICICI Prudential AMC 1.47
Source: Bloomberg HDS page
Exercise

A key insight in risk and return models in finance is that some risks are diversifiable and others
are not. This is followed by the assumption that the marginal investor in the company is
diversified. Assume that you know the proportion of stock held by different groups and how
much trading they account for. Determine which group is most likely to contain the marginal
investor?

Investor Group % of stock held % of overall trading

Founders 50% 5%
Government 05% 5%
DIIs 15% 35%
FIIs 20% 45%
Retail 10% 10%
 Returns on Britannia Industries – last 5 years

Average monthly returns = 0.96%

Average annualized returns = 0.96% x 12 = 11.52%
Geometric average returns = ((1+0.0096)^12)-1 = 12.15%

The volatility of returns is measured using the standard deviation of returns. It measures the total risk of investment in the security
Average std deviation = 6.56%
Source: [Link]
Average std deviation = 6.56% x sqrt(12) =22.72%
Calculate Returns from Investment in Britannia Industries

Date of investment: Nov 17, 2020

No. of equity, Price and Amount: 100 shares @Rs. 3,540.00, Rs. 3,54,000.00
Ignore transaction costs and taxes

Dividends received:
 April 13, 2023 Rs.72.00 per share
 June 20, 2022 Rs. 52.50 per share
 May 21, 2021 Rs.12.50 per share
 April 8, 2021 Rs 62.00 per share
Date of Sale: Nov 16, 2023
No. of equity, Price and Amount: 100 shares @ Rs. 4,706.00, Rs. 4,70,600

Calculate Absolute returns

Source: [Link]
The Capital Asset Pricing Model (CAPM)

 Most risk and return models in finance assume that the marginal investor is well
diversified, and that the only risk that he or she perceives in an investment is risk that
cannot be diversified away (i.e, market risk or macro risk). Therefore, primarily economic,
macro, continuous risk is incorporated into the hurdle rate

Hurdle rate = Riskless rate + Risk premium

 Capital Asset pricing Model (CAPM) helps to calculate the Hurdle rate in an investment
 When CAPM is used to calculate the Hurdle rate on an equity investment,
Expected return or Cost of equity = Risk free rate + (Beta x Risk premium)
Ri = Rf +β x (Rm - Rf)
Component 1 of the CAPM: The Risk-free Rate

 On a risk-free asset, the actual return is equal to the expected return. There is no
variance around the expected return.
 For an investment to be risk free, then, it has to have
 No default risk
 No reinvestment risk

1. Currency matching: The risk-free rate should be in the same currency that your
cashflows are estimated.
2. Time horizon matters: The risk-free rate in valuation will depend upon when the
cash flow is expected to occur and will vary across time.
3. Not all government securities are risk free: Some governments face default risk
and the rates on bonds issued by them will not be risk free.
Risk-free Rate

 The Risk-free rate should be in the currency of the cash flows.

 A 10Y Treasury bond rate (sovereign bond rate) is ideal as a risk-free rate
 Treasury bills may be default free but there is reinvestment risk when they are used as
riskless rates for longer-term cash flows. A 6-month Treasury Bill is not riskless when
looking at a 5-year cash flow.
 Would a 5-year Treasury bond be risk-free? Not really. The coupons would still expose
you to reinvestment risk. Only a 5-year zero-coupon T-Bond would be risk-free for a 5-
year cash flow.

 CDS spread measures sovereign risk, CDS spread of Indian Govt bond = 0.8408%
 Risk-free rate in Indian INR = 10 Y t-bond yield – CDS Spread = 6.81%-0.8408% = 5.97%
Component 2 of the CAPM: Beta

 Beta is the measure of relative risk of the asset to the average of the asset class
considered
 The standard procedure for estimating betas is to regress stock returns (Rj ) against
market returns (Rm):
Rj = a + b Rm
where a is the intercept (alpha) and b is the slope of the regression which is the
regression beta or levered beta. It measures the riskiness of the stock.

 The R squared (R2) of the regression provides an estimate of the proportion of the risk of
a firm that can be attributed to market risk (macro risk of the firm). The balance (1 - R2)
can be attributed to firm-specific risk (micro risk of the firm).
Estimating Beta

 Estimation period and return interval:

 Use 5 years monthly return or 2-3 years weekly returns
 Longer periods provide more data points for running regression but firms change
with time
 Shorter periods can be affected by firm-specific event occurrence
 Shorter intervals suffer from the noise of stock not trading and investor’s biases

 Estimation of returns of the stock and index:

 Use adjusted close prices that include stock performance adjusted for corporate
actions like dividends, splits
 Use a wider-based index as the independent variable (Rm) that represents the asset
class
Determinants of beta

1. How discretionary is the product or service?

Cyclical companies and the companies selling discretionary products have high
beta

2. How much is the Operating leverage?

EBIT Variability Measure = % Change in EBIT / % Change in Revenues

3. How much is the Financial leverage?

Debt/ Equity, Debt / Capital
 Levered beta and Unlevered beta

 Regression beta is also called levered beta or beta of equity

 Levered beta is a function of the unlevered beta and the debt-equity ratio

βL = βu (1+ ((1-t)D/E))
where βL = Levered or Equity Beta, D/E = Market value Debt to equity ratio,
βu = Unlevered or Asset Beta, t = Marginal tax rate

 Unlevered beta captures business risk

Component 3 of the CAPM: Risk Premium

 Risk premium is the extra return that an investor demands for taking additional risk by
investing in a riskier asset class relative to the risk-free asset

 Ideally, the risk premium should be:

 Greater than zero
 Should increase with the risk aversion of the investor
 Should be higher for investing in riskier asset class

 The equity index represents the equity asset class.

 Therefore, Equity Risk Premium = Returns from investing in the equity index- risk-free rate
Rp = Rm - Rf

 The Rm of the Indian equity market from 2005 to 2024 is 15.02%.

If the Rf is 5.97%, the Indian equity risk premium is 15.02% - 5.97% = 6.82%
Cost of Debt

The cost of debt is the rate at which the company can borrow today for the long term.
It should reflect the default risk of the company and the interest rate in the market.

• Method 1: Look at the yield to maturity of the straight bond issue by the company that is
liquid and widely traded

• Method 2: Look at the rating for the company and estimate the default spread based on
that rating. Can a risky company issue safe debt? Different bonds from the same
company may have different ratings. Use the median rating for the firm

Cost of Debt kd = Risk free rate + Default spread based of credit rating of the company

Interest paid (1 − tax rate)

• Method 3: Cost of Debt kd = x 100
Total Debt of previous year
Cost of Preference Shares

• If the Preference stock is not traded and not redeemable, cost of preference stock is
dividend rate declared by the company while issuing it.

• If the Preference stock is traded, cost of preference stock is:

Dividend per share
Cost of Preferrence stock kp = x 100
Market price per share
Exercise
JG Enterprises has 50 million shares, trading at $4 a share; the cost of equity is 12%. It
has debt with a market value of $100 million and a pre-tax cost of debt of 6%. Finally,
the company has $100 million in market value of preferred stock; the preferred shares
are trading at $80 a share, with an annual preferred dividend of $6/share, what is the
cost of capital for the firm? (The marginal tax rate is 40)
Cost of Capital

Weighted Average Cost of Capital Model (WACC),

Market value of equity
𝐂𝐨𝐬𝐭 𝐨𝐟 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 = Cost of equity x
Market value of total capital

+Cost of debt x 1 − tax rate x

+ Cost of preference stock x

Cost of Capital

Cost of capital for Britannia Industries Limited in 2024:

 Cost of equity ke = 5.97% + 0.61 x (15.02% - 5.97%) = 11.5%

 Pre-tax cost of debt kd = 5.86%, After –tax cost of debt = 5.86% x (1- 0.25) = 4.40%

, , ,
 Cost of Capital ko = 11.5% x + 4.40% x = 11.39%
, , , ,
Cost of Convertible Bonds

Exercise
Lester Inc. is a publicly traded company. It currently has 5 million shares trading at
$20/share. The company has one convertible bond, with face value of $100 million, a
10-year maturity and a coupon rate of 2%; the bond has a market value of $120
million. If the current cost of equity for the firm is 10% and the pre-tax cost of debt is
5%, what is the cost of capital for the firm? (The marginal tax rate is 40)

_
.
Solution: Value of a straight bond= $2m x ( )+ = $76.83m
. ( . )

Value of the equity component in the convertible bond = $120m – $76.83m = $43.17m
Total equity value = $100 + $43.17 = $143.17m,
Total debt value = $76.83m, Total capital = $220m
. .
Cost of Capital = 10% x + 5% x (1 − 0.4) x = 8.77%
Risk Return relationship of various securities

Return

Equity shares

Preference shares

Corporate bonds

Government bonds

Risk-free security

Risk