Cost of Equity and Debt

[jake68]

How does the cost of equity of the target affect an LBO or investment decision? This is a private company and I know that publicly traded entities with the same risk characteristics have a cost of equity of 8.5%. I am wondering if it affects anything other than the initial standalone valuation used to determine the purchase price.

For the same company their interest expense / avg long term debt is 3.25%. Can I use this as their cost of debt going forward? Seems significantly smaller than the cost of equity.

Thanks

[wsthost]

Take a look at our free Share Repurchase video class at www.wstselfstudy.com (FREE TRIAL link).
That summarizes opportunity cost of capital changes.

In the context of an LBO, the cost of equity becomes the private equity sponsor's required return which we usually use about 25%.
As for cost of debt in LBO context, one would use the marginal cost of borrowing in an LBO context.

If in standalone context, and one is trying to figure out normalized industry WACC, and the 3.25% is too low (even though actual for the specific company in question), usually we would use an industry average or based on current spreads. This is covered in the WACC section of our Finance 101 video course.

[phiggins]

There are two ways to calculate your equity and debt base that go into your WACC calculation.

On one side you use book value (shareholders’ equity and total debt). This seems intuitive because it reflects the actual capital structure of the company.

On the other side you use market values (market cap for equity value and market value of debt for debt value). This seems to be what a lot of sell siders use, but there is one theoretical issue. If, for example, share price takes a huge hit, the proportion of equity to total capitalization decreases. Since equity is a more expensive form of capital, your WACC then decreases. Carry that through to your DCF and you actually get a (potentially large) bump to your calculated share price.

How do you reconcile the two or when do you use one versus the other?

[wsthost]

Recall that the WACC analysis is meant to capture the MARGINAL cost of capital for the company. As such, you definitely use MARKET VALUE of equity and debt.
In reality, for non-distressed companies, we proxy market value of debt by using book value of debt. Minor, immaterial differences, so no worries.

However, book value of equity is NEVER appropriate for WACC because you don't issue new equity valued based on shareholders' equity (book value), but instead, on the current market conditions. As such, were the stock to tank, and the company issues new equity at that time, (just think back to banks back in the credit crisis), then, yes, they'd be doing it at the worst time. The cost of equity would then rise since clearly the premium required for investors to invest has gone up (by simple virtue of the fact that prices dropped).

Also, we don't think that Shareholders' Equity is intuitively the "actual capital structure of the company" as you noted. Shareholders' Equity is an accounting term fraught with accrual concept of accounting issues. At day one of the company's IPO, it is the actual capital structure. But after that, it's not.

Now, our question to you is the flip opposite - if the stock rose dramatically instead of tanking, would you have the same question? Or you wouldn't have bothered asking this question because "stock prices generally rise not fall" (which is complete BS). The opposite scenario to your question is also true - and that is why companies like to issue more stock when prices are high because you can sell more stock and give up less ownership percentage.

If the price takes a huge hit, the proportion of equity to total cap would decrease, yes. But then the cost of equity capital in theory goes up. Two-way street!

Side Note: when calculating beta, specifically unlevering and then re-levering your competitors' betas for CAPM, the Hermada beta equation uses book value of equity and debt (not market values). This makes sense and isn't mixing apples and oranges because the variability to profits is based on ROE (book value of equity). Refer back to our Corporate Valuation slide materials in comparing Company A (unlevered) with Company B (levered).