Comments on: Toward a New Theory of the Cost of Equity Capital http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/ Helping Institutions and Ordinary People Invest Better by Focusing on Risk Control Fri, 19 Mar 2010 11:55:38 -0400 http://wordpress.org/?v=2.8.4 hourly 1 By: David Merkel http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23544 David Merkel Wed, 21 Oct 2009 04:19:13 +0000 http://alephblog.com/?p=2086#comment-23544 Anon -- few if any analysts model it. Analysts are not portfolio managers, and they are certainly not corporate managers. Anon — few if any analysts model it. Analysts are not portfolio managers, and they are certainly not corporate managers.

]]> By: Anonymous http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23539 Anonymous Mon, 19 Oct 2009 20:36:24 +0000 http://alephblog.com/?p=2086#comment-23539 David: You're absolutely right about the silliness of M-M and "optimum" capital structures. That the cost of equity capital goes up after some debt/equity threshold is surpassed is obvious but non-trivial. What that threshold might be is entirely context relative to the economic climate, competitive advantage of the firm, and secular trends of the industry at the time. Importantly, the relationship of higher debt levels that lead to higher cost of equity is likely non-linear. Another less appreciated aspect is that managements generally prefer to finance with debt because it's cheaper and they don't have to worry about shareholder votes particularly for M&A. As Martin Whitman noted, it's rare for any company in the US to go for five years without some sort of transaction. Hence, most five year DCFs have to account for changing capital structures and what effect that would have on the cost of equity capital. But how many analysts actually model that? David: You’re absolutely right about the silliness of M-M and “optimum” capital structures. That the cost of equity capital goes up after some debt/equity threshold is surpassed is obvious but non-trivial. What that threshold might be is entirely context relative to the economic climate, competitive advantage of the firm, and secular trends of the industry at the time. Importantly, the relationship of higher debt levels that lead to higher cost of equity is likely non-linear.
Another less appreciated aspect is that managements generally prefer to finance with debt because it’s cheaper and they don’t have to worry about shareholder votes particularly for M&A.
As Martin Whitman noted, it’s rare for any company in the US to go for five years without some sort of transaction. Hence, most five year DCFs have to account for changing capital structures and what effect that would have on the cost of equity capital.
But how many analysts actually model that?

]]> By: David Merkel http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23538 David Merkel Mon, 19 Oct 2009 19:27:03 +0000 http://alephblog.com/?p=2086#comment-23538 ed -- I may not have tipped all of my hand, but it is far from silly. Take Falkenstein's recent book -- high yield tends to underperform. Or consider that less levered companies tend to return better over the long haul (will need to dig up the reference, but it came from a standard textbook used by the Society of Actuaries for their syllabus). M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms. ed — I may not have tipped all of my hand, but it is far from silly. Take Falkenstein’s recent book — high yield tends to underperform. Or consider that less levered companies tend to return better over the long haul (will need to dig up the reference, but it came from a standard textbook used by the Society of Actuaries for their syllabus).

M-M, like the CAPM, does not survive the data. Low leverage is a positive factor for returns in both debt and equity, and a decent part of that is the high costs of financial stress for highly levered firms.

]]> By: ed http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23537 ed Mon, 19 Oct 2009 18:29:55 +0000 http://alephblog.com/?p=2086#comment-23537 It's silly to say you're "not a fan" of Modigliani-Miller theorems. Before we can figure out what makes capital structure important, it is crucial to remove our fuzzy incorrect ideas about it. MM shows that capital structure matters precisely because of things like taxes, costs of financial distress, etc., and not simply because of fuzzy ideas about "risk." It’s silly to say you’re “not a fan” of Modigliani-Miller theorems. Before we can figure out what makes capital structure important, it is crucial to remove our fuzzy incorrect ideas about it. MM shows that capital structure matters precisely because of things like taxes, costs of financial distress, etc., and not simply because of fuzzy ideas about “risk.”

]]> By: Doug http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23536 Doug Mon, 19 Oct 2009 13:25:01 +0000 http://alephblog.com/?p=2086#comment-23536 "As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments." How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising "coupons" and get back value much greater than "par" at the end of his/her investment. I realize that models such as gordon growth take this into account, but you don't address it in your "debt plus a premium" calculation. “As for common stocks, they should trade at an earnings or FCF yield greater than that of the highest after-tax yield on debts and other instruments.”

How do you account for the potential for earnings growth in this calculation? The debt investor trades seniority and (in some cases, collateral) for a fixed claim on cash flows. Common stock investors often (but not always) will earn rising “coupons” and get back value much greater than “par” at the end of his/her investment.

I realize that models such as gordon growth take this into account, but you don’t address it in your “debt plus a premium” calculation.

]]> By: matt http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23532 matt Sun, 18 Oct 2009 19:47:16 +0000 http://alephblog.com/?p=2086#comment-23532 How does one calculate the cost of equity, ex post facto? It would be interesting to see a regression of the CAPM cost of equity on the real discount. How does one calculate the cost of equity, ex post facto? It would be interesting to see a regression of the CAPM cost of equity on the real discount.

]]> By: tom http://alephblog.com/2009/10/17/toward-a-new-theory-of-the-cost-of-equity-capital/comment-page-1/#comment-23531 tom Sun, 18 Oct 2009 14:21:34 +0000 http://alephblog.com/?p=2086#comment-23531 Or, you can calculate the IRR instead. While cost of equity is a good concept, we don't know if it can be measured - do we know for sure that it can be calculated? Perhaps it can't be done. Or, you can calculate the IRR instead. While cost of equity is a good concept, we don’t know if it can be measured – do we know for sure that it can be calculated? Perhaps it can’t be done.

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