Publication number: ELQ-79755-1
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How To Estimate The Cost of Capital For a Firm, Division or Project
This video demonstrates how to estimate the cost of capital using Sri Lankan hotel company Aitkin Spence as an example.
Professor Aswath Damodaran describes the Cost of Capital as the "Swiss Army Knife of Finance" because it is used in so many different places. This video will show you how to estimate the Cost of Capital for your firm, division or project. Aswath suggests that the Cost of Capital can be used in 3 key areas in business. These are:
- For investors as an 'opportunity cost'
- Within the company as a cost of financing: the cost of raising debt and
- Project analysis: as a hurdle rate used to decide whether to take
Aswath breaks the process of calculating the cost of capital down into 10 easy to follow steps:
1: Decide on currency: Aswath explains how to choose the currency that you will use when calculating the Cost of Capital, placing great emphasis on consistency with the currency in which cash flows are estimated. He suggests that it is often easiest to work within the local currency, however there can be exceptions.
2: Estimate a risk free rate in that currency: Here, Aswath demonstrates how you can estimate your risk free rate based on three different scenarios: a Government Bond Rate, a Government Bond Rate Minus and a Differential Inflation.
3: Estimate an unlevered beta for your company: In this section, Aswath runs through the standard approaches to estimating the beta, before showing a perhaps better approach to this process. This will allow you to accurately estimate an unlevered or asset beta through weighted averages of the businesses that your company operates in.
4: Estimate the equity risk premium for your company: This will show you how to break down the company's operations geographically before breaking it down further upon revenues, earnings or production. Then you will be able to calculate a weighted average of the equity risk premiums of the different countries/regions.
5: Estimate a cost of debt: This will help you calculate the rate at which you can borrow money for the long term. Aswath demonstrates simply how you can calculate this figure.
6: Take stock on the interest bearing debt that the company has: Aswath demonstrates how to look for interest bearing date from the balance sheet and use this debt to convert to market debt using interest expense and the average maturity of your debt.
7: Check for leases that are not capitalized: In this step, Aswath demonstrates how to convert your lease commitments into debt.
8: Check for hybrids: Hybrids are part debt, part equity. Aswath demonstrates how to use convertible debt or preferred stocks.
9: Estimate debt ratios: This will show you how to compute the market value of equity before computing debt to equity and debt to capital ratios.
10: Estimate the cost capital: This is a weighted average of debt and equity. Using the previous steps made, you will now be able to estimate a costed capital for your company.
For each step, Aswath demonstrates how it works in the context of Sri Lankan hotel firm Aitkin Spence. As such, each step is detailed, easy to follow and easy to put into practice. This step by step guide is an essential for anyone attempting to estimate your company's Cost of Capital.
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