606 Making Key Strategic Decisions
lower cash f low. Then a discount rate or capitalization rate (multiple) is ap-
plied. The result is the value of the company’s equity. The direct equity and
debt-free methodologies are summarized below:
COST OF CAPITAL
Bob asks Victoria to explain the cost of capital. She says that when a business
owner or prospective buyer is raising capital, debt capital is less expensive than
equity capital. Debt capital represents those monies borrowed from a lender,
such as a bank, to fund the business. The lender expects a return on its invest-
ment in the form of interest. From a financial prospective, interest expense on
the debt is called the cost of debt.Therefore, the business pays interest, or the
cost of debt, which is often near the prime lending rate. ACME’s cost of debt
that it pays in interest is 9%. However, since ACME can take a tax deduction
for the interest expense, its actual cost of debt capital is 5.4% (9% interest cost
less 40% in reduced taxes). For every $100 ACME pays in interest expense to
the bank, its income tax obligation is lowered by $40 because interest is a busi-
ness expense that lowers taxable income. Thus, ACME’s after-tax interest ex-
pense is $60 ($100 minus $40 in reduced taxes).
In order for a business to raise equity capital (selling stock to investors), it
expects to provide the shareholders a rate of return. As previously discussed,
stocks of large public companies have had average returns of 10% to 12% per
year to the shareholders over an extended time period. Small public company
stocks have traditionally yielded 15% to 20% to shareholders. Since closely held
companies are frequently more risky than small public companies, most private
businesses must offer a rate of return to shareholders exceeding the returns of
small public stocks. Let’s say that a closely held business is raising capital by
selling stock. The return a company expects to give its investors (stockholders)
in order to attract their capital is called the company’scost of equity.
Therefore, a company has a cost of debt capital and a cost of equity capital.
Combined, they are referred to as a company’scost of capital.The cost of debt is
less than the cost of equity as illustrated above. Management of a business can
Direct Equity Methodology Debt-Free MethodologyNet income or net cash f low to equity
holders (defined later)
Net cash f low to holders of total in-
vested capital (defined later)Apply discount rate or capitalization
rate on a cost of equity basis (dis-
cussed later)
Apply discount rate or capitalization
rate on a weighted average cost of
capital basis (discussed later)Results in value of company’s equity Results in value of company’s invested
capital (debt and equity)
Subtract value of debt capital to arrive
at the value of the company’s equity