where, w = weights for the components
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- As a general rule, the weights used in the cost of capital computation should be based on market values
- In the debt component, for all interest-bearing liabilities, combine all debt - short and long term, bank debt and bonds - and attach the long-term cost of debt to it
- In other words, add the default spread to the long-term risk-free rate and use that rate as the pretax cost of debt
All Lease Commitments
- A firm that leases its assets and categorizes them as operating leases owes substantially more than is reported in the financial statements
- We should treat all lease payments as capital expenses and convert future lease commitments into debt by discounting them back to the present, using the current pre-tax cost of borrowing for the firm as the discount rate
- The resulting present value can be considered the debt value of operating leases and can be added on to the value of conventional debt to arrive at a total debt figure
Adjusted operating income = Stated operating income + Operating lease expense for the current year - Depreciation on leased asset
- Accounts payable, supplier credit, and other non-interest-bearing liabilities are best treated as part of noncash working capital and will affect cash flows. They would not count in debt.
Market Value of Equity
- If there is more than one class of shares outstanding, the market values of all of these securities should be aggregated and treated as equity
- If there are other claims in the firm - warrants and conversion options in other securities - these should also be valued and added to the value of the equity in the firm
Market Value of Debt
- When interest rates and default spreads are stable (like in mature companies in developed market), the book value of debt can be assumed market value of debt
- Else, convert book value debt into market value debt -
- Treat the entire debt on the books as a coupon bond, with a coupon set equal to the interest expenses on all of debt, and the maturity set equal to the face-value weighted average maturity of the debt, and to then value this coupon bond at the current cost of debt for the company
- As a final point, add the present value of operating lease commitments to this market value of debt to arrive at an aggregate value for debt in computing the cost of capital
Changing Weights
- Young firms often are all equity funded largely because they do not have the cash flows to sustain debt
- When analyzing firms early in the life cycle, we should allow for the fact that the debt ratio of the firm will probably increase over time towards the industry average
- Mature firms sometimes decide to change their financing strategies, pushing toward target debt ratios that are much higher or lower than current levels
- We should view the cost of capital as a year-specific number, and change the inputs each year
