0:11

So, now, hands on on calculating the cost of capital.

As you see, once you understand the concepts, it's not that difficult.

We're going to look at,

well, there's a couple of simplifications here, but more or less,

this is exactly what you have to do to calculate any company's cost of capital.

We're going to look at a popular one.

And we're going to look at a Starbucks,

a company which I actually do spend a lot of time.

Maybe you do, too.

and, and this company is popular, everybody knows it.

And we're going to look at this company at a particular point in time.

And that is in the third quarter, the end of the third quarter.

Of 2013, and at that particular point in time, question number

one is how was this company financing its investment activities?

And the company was mostly using debt and equity.

The debt of the company was given by a bond.

And that bond was actually four years away from maturity.

Again, remember as we discussed before that doesn't mean that it's a four year

bond, it might have been a ten year bond that, you know, six years have gone by.

And it's only four years away from maturity.

Either one or the other it's kind of irrelevant for us.

What matters is that that particular bond is four years away from maturity.

When we look at the book value what the company has in

it's books about this bond it's 449.7 million dollars.

Almost 550 million dollars.

But remember.

That each thing that the company, each debt, piece of debt or equity that

the company has in its books at a specific value, it may have a completely different

market value, completely or similar or they may, but it may have a different.

A market value.

More likely than not it will have a different market value and

that is the case with Starbucks.

Starbucks actually has a market value.

The bonds of Starbucks have a market value, 629.4 million.

So we have roughly 550 book value and 629 million of market value.

So as we said before there's a difference in this case between the market value and

the book value.

That difference comes together with a difference between the interest rate and

the yield to maturity.

In the case of the four year bonds that Starbucks had at that particular point in

time, the interest rate was 6.25%, but the yield to maturity was only 2.3%.

Now, just a quick reflection on that.

That basically means that when Starbucks issued that bond,

the market was actually requiring a much higher return than they're issuing now.

When you issue a bond, you typically put an interest rate or coupon that is more or

less what you think that the market will require at that point in time.

In other words when Starbucks issued this particular bond the Starbucks thought that

the market would require more or less 6.25%.

But maybe the company got less risky over time, or

the sector got less risky over time, or the economy got less risky over time.

It doesn't really matter for our purposes.

The only thing that matters is that.

If Starbucks were to issue a bond today, instead of issuing that with a coupon

of 6.25% they could get away with issuing a bond with a coupon of 2.3%.

Of course, we're talking about a bond that would be similar to the one that is

outstanding and that that's not increased very substantially the amount of debt.

If you obviously want to triple, or multiply by a large factor, the amount of

debt, well, the amount is going to charge you more because the more debt,

the riskier you become.

But if Starbucks were to issue a similar bond in a reasonable amount

then they would have to pay 2.3% today, which again that's another way of

thinking why the yield to maturity is the proper cost of debt.

Because it's showing me not what the market was requiring some time ago when we

issued the bond but what the market is requiring today.

So between that yield to maturity of 2.3% and the interest rate of 2.,

6.25 the relevant number for us is that yield to maturity of 2.3%.

4:19

Equity remember,

here we're going to calculate the cost of equity based on the CAPM.

And for the CAPM, we need three numbers.

We need the risk-free rate.

We need the market risk premium.

And we need the, the beta.

The risk-free rate at that particular point in time, we're going to use.

If you remember, of,

of all the, maturities that we looked at in session three, for the risk-free rate,

the the most popular, was the yield to maturity on ten year notes and

that's the one that we're going to use ten year notes of the U.S.

Treasury at that particular point in time in September 2013, we're yielding 2.9%.

So that'll be the starting point of our calculations.

Market risk premium.

Here we're going to go with a typical long term historical average.

If you remember,

the most popular of all the brackets that hold the numbers that we had.

In session three, that we explore through those service of practitioners was

an itera between 5 and 6%, and we're going to go right in between.

So we're going to assume that the market risk premium was 5.5%.

Remember, this is basically implying that historically, investors require

5.5 percentage points more to invest in relatively riskier equity,

as opposed to in relatively less risky, or in the limit, risk-free.

Government debt.

And finally, the beta, as we said before,

you don't really have to bother too much of estimating betas.

In session two we actually looked,

in session one we actually look at where those betas were, and you can find those

betas in Yahoo Finance, in Google Finance, you can find them in Bloomberg.

You can find them in actually many places.

I just double check two places to make sure that the betas are the same.

Remember the betas may change because the time period for

which we estimate the beta may defer.

Across different providers maybe Yahoo Finance and Google Finance.

They look back a different number of years.

So I looked in two places.

I looked in Morningstar, I looked in Yahoo Finance and

both of them actually were pretty much the same number which is 0.8.

And remember what 0.8 basically means.

Starbucks is a company that actually mitigates the market fluctuations.

This is typically three to five year beta and

that basically means that in this period, Starbucks,

when the market was going up and down 1%, Starbucks was going up a little bit less.

And down a little bit less,

80% of the upside of the market, and 80% of the downside of the market.

So a beta of .8 basically means that the,

Starbucks was mitigating all along the market's fluctuations.

And finally, we're going to use the how much equity we have.

And because we're going to, as we said before.

Concentrate on market values, we're not even going to look at the book value of,

of that equity.

So, in terms of market value,

Starbucks at that particular point in time had almost $54 billion.

That is $53.8 billion, and that is the number that we're going to be using.

The final number that we need is remember Starbucks has debt we need to

calculate the after tax cost of debt and

that depends on what, at what rate they pay corporate taxes.

And here again we're not really going to look into how much

Starbucks really pays and what kind of tax rates they get and so forth.

We're simply going to use the corporate tax rate,

which at this particular point in time it's 35%.

So, we could get a little bit more sophisticated here, but for

our purposes of understanding and calculating a cost of capital,

we're simply going to to go with a statutory rate.

7:57

So, in order to have all the numbers that we have discussed clear,

I'm going to keep that, the, those numbers in that little exhibit that you're

seeing there and, throughout our calculations.

You'll be seeing that little exhibit where we have the book value and the market

value of debt, the interest rate and the yield to maturity of debt, the risk free

rate, the market risk premium, and the beta to calculate the cost of equity, and

the market value of the equity, everything together with the corporate tax rate.

So let's start with the cost of debt.

After everything we said the cost of debt should not be much of

a problem because we need to remember only two things.

We need to know how much debt the corp, the company's using.

And eventually we need to put that in proportion.

To all the capital being used by the company but

we need to know how much debt in absolute terms first.

And that amount of debt, which we're going to call,

as we've been doing all along, D is 629.4 million.

Remember, that is the market value of debt, not the book value of debt.

And, as we said more than once before, that is the relevant number, because if

Starbucks wanted to retire all its debt, that is what it would have to pay.

It would have to pay $629.4 million, not $549.7 million,

which is the book value of the debt.

So, the actual amount of debt.

9:15

In Starbucks capital structure is that 629.4 million.

Second thing is the require return on debt.

Remember the RD that we need to calculate and that RD as we said more than once

before is the yield to maturity on the bond, not the interest rate on the bond.

In this case it's going to make a lot of difference because there's a large gap.

Between the interest rate and the yield to maturity.

Starbucks or the economy or

the sector has gotten a lot less risky over time, and the required return

today is a lot lower than the required return when the bond was actually issued.

And, for that reason we're going to be using the 2.3.

A yield to maturity as the pre-tax cost of debt, typically we just call

it the cost of debt, but it's before taking into account that when you're

paying interest from that debt you get the tax break that we talked about before.

And so, although we,

we're not going to use it specifically, because if you remember, we have that

corporate tax rate in the Expression that we have for the cost of capital.

we, you know, given the corporate tax rate of 35%,

we could actually calculate the after tax cost of debt.

And you remember how to do that.

It's 1 minus the corporate tax rate.

Multiplied by the cost of debt.

And that basically is 1 minus 0.35 multiplied by 2.3 and that gives us 1.5%.

So 2.3% is the before tax cost of debt or the pre-tax cost of debt.

And 1.5% is the after tax cost of debt taken into account that debt

payments give a me a tax shield and that reduces my cost of debt.

In any case, the numbers we're going to be throwing this numbers into the expression

of the cost of capital so we'll get back to these numbers a little bit later.

But 2.3 pre-tax cost of debt and 1.5% the after tax cost of debt.

11:10

Now we're going to go to the cost of equity and,

and here's where before we actually get into those numbers and

this is where the cost of debt, it's a little deceiving.

Because now it's going to look that we're throwing just three numbers and

we need to add up and just come up with a final number.

But remember, there's,

there's a lot of thinking that may need to go into what numbers we actually use.

We've already have made our choices, we chose, the 10 year yield for the risk

free rate and the 5.5% for the market risk premium, and we estimated the beta.

We actually took the beta out of Yahoo Finance and Morning Star.

But those are very specific choices.

Someone else calculating the cost of capital of Starbucks or the cost of equity

of Starbucks at this particular point in time may actually do different choices.

They may choose a bond with a higher or a lower maturity for the risk free rate,

they might use a different number for the market risk premium.

They might estimate the beta over a longer or a shorter period and they may actually

end up with three very different numbers from the ones that we're actually using.

So, keep that in mind.

It seems that it's going to be easy.

To calculate the cost of equity because we need to multiply two numbers and

then add up a third number.

But at the end of the day what's important is that a lot of thinking needs to

go into what are the actual numbers that we need to use.

So as we said before we have almost $54 billion.

53.8 billion.

The total amount of equity measured at market value.

We talked about a risks free rate based on the CAPM.

And remember this is already a choice that is when we say we're going to

estimate the cost of equity with the CAPM.

Well we could have actually chosen.

Many other different models.

Well, we have chosen the CAPM.

That's a choice, and some other people may disagree with that choice.

So, some other people may end up with a different number than we're

going to end up this particular case.

So, if we agree, that's a huge if, but

if we agree on the choices that we have made for RF, MRP, and

beta, we simply throw them into a CAPM equation, 2.9% for the risk free rate.

5.5% for the market risk premium, .8 for

the beta, and you add all that up and you get 7.3%.

So from the choices that we have made on a specific model, and

on specific parameters for that model or values of the parameters for that model.

We get a cost of equity for Starbucks of 7.3%.

And we have only one more thing to do.

And that is the proportions of debt and equity.

How much we're using or Starbucks is using of debt and how much are using of equity.

Well, we know one thing.

We need to use market values.

And basically now is putting together the two numbers we have discussed before.

Debt $629.4 million.

Equity, $53.8 billion, expressed in millions is 53,800.

Million dollars.

So as you see, we can stop here for the second and think, notice the huge

disparity that there is between the amount of debt and the amount of equity.

There's very little debt and a whole lot of equity.

So when we actually calculate the proportions,

the total amount of capital is over $54 billion.

But the vast majority of that is equity.

So once we calculate the proportions.

How do we do that?

Well, very simple, like any proportion.

We're using $629.4 million of debt.

Given a total capital base of $50.54 billion,

that gives me less than 1.2%, 1.16, to be a little bit precise, but less than 1.2%.

Almost 1% of debt.

Everything else is actually equity.

So equity we could the same calculation we're using 53.8 milli,

billion dollars of debt on 54.4 billion dollars of

capital that gives me 98.84% almost 99%.

So in round numbers we're using 99% of equity and just 1% of debt.

The Starbucks is therefore a company that is almost fully financed by equity.

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