Part 1
The company I have chosen is Starbucks. Using three bonds; I calculated the cost of debt by taking average of the coupon of the three bonds and then adding the tax effect. The cost of debt came out to 2.40%.
The company does not have any preferred stock in its capital structure. For calculating the cost of equity, I have used three methods, the risk premium method, the dividend discount model and the CAPM equation.
Risk Premium approach involves adding an equity risk premium to the bond yield (Boundless). The bond yield was calculated by taking the average of the YTM of the three bonds of the company. The bond yield came out to be 3.36%. The equity risk premium was calculated using the Fed model, using dividend yield and treasury yield. The treasury yield was subtracted from the dividend yield to get the equity risk premium. This equity risk premium was added to the bond yield to get cost of equity (Financial Times).
The second method using dividend discount model calculated the cost of equity using the dividend growth rate, current stock price and the dividend given by the company (Investopedia). The CAPM model involved calculating the cost of equity using risk free rate, for which 10 year treasury yield was used, the market return, for which NASDAQ three year average return was taken and beta, which was calculated by regressing last five year weekly stock price of Starbucks against NASDAQ close prices. The final cost of equity was calculated using average of the three costs of equity. It came out to 11.92%.
The cost of capital was calculated using both the market value of debt and equity as well the book value of the debt and equity. Book value of debt and equity was taken from the latest balance sheet while market capitalisation was taken as the market value of equity. As the market value of debt was not available, book value of debt was used as proxy. It is a reasonable assumption as the YTM of debt was very near to the coupon rate of the bonds.
The cost of capital using the market values came out to be 11.65% while the cost of capital using the book values came out to 9.18%. The large difference between the values is due to the very high market value of equity as compared to book value.
Part 2
The company should use market value of debt and equity while computing the cost of capital. The reason for this is that any new investment would be at the current value of capital and not the historic value.
The company has various product segments and thus each business segment should use its own cost of capital and not the firm wide cost of capital. The reasons being that the level of leverage, the target capital structure and also the risk premium for each business segment is likely to be different. So using the firm wide cost of capital may underestimate the cost for a new segment, while overestimating the cost for a stable and mature segment.
For example, Starbucks has segments of Coffee, handcrafted beverages, merchandise, fresh food and consumer products. Now Coffee and handcrafted beverages segments are related more to marketing and retailing the products while merchandise segment is related to manufacture of equipment and selling it. So the capital requirements and thus the capital structure of these segments will be vastly different. Merchandise business unit will have greater requirement of capital and may thus issue more debt. So while calculating the cost of capital for each of these segments, the particular business unit would have to take into account its own cost of capital.
If the company plans to invest in emerging markets, it would have to use different cost of capital for each of the markets as the country risk needs to be factored in. This country risk results in widely different risk free rates for each country along with different market premium.
As the company has mentioned previously that it wants to localise as much as it can in emerging markets, let us assume that the company is starting a new unit in India. Here, the cost of debt, the risk free rate as well as the market return would vary. So while calculating the cost of debt and equity, these would have to be taken into account.
As compared to 10 year US treasury yield of 1.75%, the 10 year Indian G-sec yield is 7.77%. Further the corporate tax rate is 25% as compared to 35% in US. Now when the company issues bonds in India for funding its capital needs, it would have to do it at a much higher coupon as compared to the average 3.7% of its three bonds in US.
Further, the cost of equity would get adjusted to a higher number due to higher market return and higher risk free rate. So while issuing fresh capital in India, the company would have to take this higher cost into account.
A small business can calculate the beta by delivering the betas of comparable publicly listed companies and then relevering the average beta. Also it may use book value of debt and equity as market values may not be available or the securities may be illiquid.
So for example, Aroma Espresso Bar, which currently has presence in US, Canada, Israel and a couple of markets in Europe, wants to find its cost of capital. As the securities are not publicly traded, it would have to use book value of debt and equity. Also, it would have to calculate its beta using average beta of Starbucks, Dunkin Brands Group, PepsiCo etc.
References
Boundless. The "Bond Yield Plus Risk Premium" Approach. Boundless. Retrieved from https://www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/approaches-to-calculating-the-cost-of-capital-89/the-bond-yield-plus-risk-premium-approach-383-8734/.
Investopedia. Dividend Discount Model – DDM. Investopedia. Retrieved from http://www.investopedia.com/terms/d/ddm.asp.
Financial Times. Company Information. Financial Times. Retrieved from http://markets.ft.com/research/Markets/Tearsheets/Summary?s=SBUX:NSQ.
