To take on a valuation through Discounted Cash Flow (DCF), you need to comprehend the concept behind the cost of capital. Lets start with a question: would you feel the same in receiving 100 USD today or 10 years from now?
You are most likely to have answered “today”. In fact, that would likely be the most common answer if you asked a group of people. That is because individuals (as any other economic agent) prefer the safety of knowing that the money is already in their possession to the uncertainty of receiving it in the future. That uncertainty is the basis behind the concept of risk: you cannot be fully assured that you will effectively receive that exact amount that you expect when it comes due. Therefore, even though the nominal value may be the same, the intrinsic value changes with time. Risk is the probability estimated for a series of negative outcomes.
The concept of cost of capital is a fundamental one in finance and it is part of feasibility analysis, corporate valuation, among others. If the intrinsic value is different from period to period, then periods cannot be compared directly and therefore the cost of capital aims at allowing for a comparability between periods. It may be defined as the return that an investor on a specific financial asset would require for the corresponding risk exposure. Through this definition you can understand that the cost of capital depends on both the investor’s profile and the investment profile. For investors have varying degrees of risk aversion, one project or company will have a different cost of capital for each investor profile. Likewise, one investor will estimate distinct costs of capital for different projects, because of his understanding of each.
As the cost of capital is the return demanded by investors or lenders, it is also the discounting factor of the future cash flows generated by projects or companies.
The cost of capital within a company
While the notion of cost of capital is broad, remember that the capital used to finance a company can be composed of equity and debt. For that reason, there are different concepts within cost of capital of a company:
- Cost of equity (re).
- Cost of debt(rd).
- Weighted average cost of Capital (WACC).
There are differences between financing a company with equity or through debt, namely in what regards to ownership (equity provides ownership whereas debt does not) and on the enforceability of capital. The enforceability refers to the hierarchy of existing claims over the company, in particular, if the company goes into an insolvency process. The hierarchy of claims is defined by law and contracts, but on general it follows this hierarchy:
Guaranteed credits are settled through the goods subject to collateral (such as mortgages). When it is found that guaranteed lenders will not be fully paid through the sale collateral, the remaining credit will be integrated in the credits.
Privileged credits through the sale on collateralized assets, whenever these are sufficient. If they are not, creditor that enjoy privilege of special on the real estate assets of the debtor will have priority over secured creditors. Usually employees are among the creditors that enjoy real estate special privilege on the debtor’s assets.
Common creditors include all liabilities of the company that are not backed by any type of collateral. The common creditors are paid in proportion of their claims, if debtor assets is insufficient for full payment.
The payment of the subordinated credits only takes place after fully paid common credits. Issued capital is a subordinated credit and for that reason, it has a reduced claim over assets.
This hierarchy puts debt on a higher rank of claim than equity, as equity is a subordinated credit. In an insolvency situation, debt is more likely to be receivable (or partially receivable) than equity. For that reason, financing a company with equity is riskier then financing the company with debt. On a general basis, equity investors will likely require a higher return than a bank when it lends money to a company, meaning that the cost of equity is higher than the cost of debt.
You should also take into consideration that not all debt has the same redemption level: it depends on the collaterals and guarantees. Likewise, equity is composed by different elements and it is usual that issued capital is less likely recoverable than other equity instruments.
Having in mind that debt and equity have different levels of risk, should bring you to the conclusion that the cost of capital of each must be different.