Corporate Finance

Estimation of Cost of Capital 
 95

Under the ex-ante (expected) risk premium method, the average expected future return on a group of
stocks, say index stocks, is calculated and the concurrent risk-free rate is subtracted from it. The yield on
long term T-bond could be taken as Rf:

RPM = RM – Rf

The DCF model may be used to estimate expected return on stocks. A survey of analysts’ forecast of
growth rate in dividends may be used as surrogate for ‘g’ in the equation.

Ke = (D 1 / P 0 ) + g

The simple logic underlying risk premium approach is that if the premium is expected to remain constant
overtime, then the constant premium may be added to the prevailing interest rate to obtain cost of equity.
The risk premium should be estimated for fairly long periods of time. Academic studies make use of data
for few decades.

Estimating Cost of Debt

Debt is of two types: term loans from financial institutions and debentures sold to investors. The cost of
debentures is the investor’s required rate of return. Recollect that from the bond pricing equation:

P = ∑

=

+++

n

t

n

d

t

d kFkC

1

[ ]) 1( / [ / (1 ])

where
P is price,
C is coupon in rupees,
F is redemption price, and
kd is the investor’s expected rate of return.

The discount rate that equates the current market price and coupon and principal payments is the cost
of debt. Note that cost of debt is not the same as interest paid by the company. At the time of issue, the
company would set the interest rate equal to the investor’s expected rate, which is the yield on comparable
instruments. As time passes, the yield (YTM) may increase or decrease. In other words, if you have to find
the cost of debt, don’t take the interest rate payable by the company. Call up your Investment Banker and ask
him the prevailing yield on your company’s bond. You may point out that yields fluctuate. That’s precisely
the point. Why do yields change? Mainly for two reasons: changes in general interest levels and changes
in default risk of the issuer. When the interest rates in the economy increase, the investor’s expected rate
of return on this company’s bond increases. This increases the cost of both old and new bonds. Similarly,
the required yield may change due to changes in default risk of the instrument. Bondholders would have set
the interest rate at the time of issue after assessing the default risk. If the default risk increases later on, the
required rate of return (or yield or YTM or cost of debt) also increases. In sum, the cost of debt is in the
denominator and not in the numerator. This is the pre-tax cost of debt. Since, interest payments are tax
deductible, the post-tax cost of debt is kd(1 – T), where T is the marginal tax rate.