application of the weighted-average cost of capital in

ISSN 1822-7996TAIKOmOJI EKONOmIKA:SISTEmINIAI TYRImAI: 2011.5/2

Elvīra ZElgAlVEIrina bēRZKAlNE

introduction

Corporate financing is one of themostresearched topics.Capital structurehas alarge role in company valuation because theoptimalsizeoffinancialleverage(debt-equity ratio) canmaximise the value ofthefirmandminimise its costof capital.Therefore,thistopicisespeciallyimportantin the changeable conditions of economic development.Becausetheworldeconomicdownturnhas impactedLatvia to a greatextent, Latvian companies are trying to optimise operations by improving their

organizational structure and reducing ex-penses. A company has several sources of financing,andmostofthemhaveitscost,therefore, the cost of total capital is de-terminedbytheweighted-averagecostofcapital(WACC),whichisoneofthetoolsofcorporatefinancialmanagement.

Inrecentdecades,thefactorsinfluenc-ing the cost of capital have been analysed; there is empirical research and investiga-tionsonthesubjectofcalculatingWACCinpractice.However, therearestillmanyunansweredquestions andproblems.Forexample, there are discussions onwhat

application of the weighted-average cost of capital in latvia: analysis, problems

and possibilities for improvement

Thepaperanalyses thepossibilities toestimatetheWACCanditscomponents inpracticebyapplyingtheexistingformulasinsixsizeableLatviancompanies,aswellasinvestigatestherecentresearchinthefieldofcapitalstructureandWACC.Theauthorsofthepaperproviderecommendationstoenhancethemethodsofcalculating capital costs. Keywords: weighted-averagecostofcapital,costofdebt,costofequity,capitalassetpricingmodel.

StraipsnyjeanalizuojamosgalimybėspraktiškaiapskaičiuotikapitalokaštųsvertinįvidurkįirjosudedamąsiasdalisšešiosedidžiosioseLatvijosbendrovėse,taikantegzistuojančiasformules;tiriamipaskutiniaimoksliniaidarbaikapitalostruktūrosirkapitalokaštųsvertiniovidurkiosrityje.Straipsnioautoriaipateikiarekomenda-cijas,kaippagerintikapitalokaštųskaičiavimometodus.Raktiniai žodžiai:kapitalokaštųsvertinisvidurkis(WACC),skoloskaštai,reikalaujamakapitalogrąža,pa-grindiniokapitaloįkainojimomodelis.

JEL Classifications: G3/G32.

Elvīra ZELGALVE–Dr.oec.professor,HeadofFinanceDepartment,FacultyofEconomicsandManagement,UniversityofLatvia.Address:Aspazijasbulvaris5,Riga,Latvia.Phone:0037167034620.E-mail:[email protected]ēRZKALNE–Mg.oec.Phone:0037129992532.E-mail:[email protected].

Elvīra ZElgAlVE, Irina bēRZKAlNE144

kinds of cost of capital are to be included intheequationforestimatingWACC.Thebasic rule is: the cost of capital used for long-term investments must be taken into consideration,whileshort-termcommer-cial capitalfinancingmustnot.However,if a company is a permanent user of bank overdraft arrangements, one candiscussthe necessity of the inclusion of this kind offinancinginWACCcalculations.

InLatviatoo,thisproblemistopicalforseveral reasons. First, there is no thorough empirical research on capital structure. Sec-ond,thecalculationandusageoffinancialratiosandotherfinancialindicators,includ-ingtheweighted-averagecostofcapital,inanalysisisnotwidespread.

The object of the research is the weighted-average cost of capital and itscomponents.

Theaim of the article is to investigate the equations for estimating the cost ofthedifferentsourcesoffinancingandtheweighted-averagecostofcapitalproposedby foreign scientists, and, based on the ap-plicationoftheequationsinLatviancom-panies, toput forward recommendationsforimprovingtheequationsofthecostofcapital and their practical application in the changing economic environment of Latvia.

Inordertoachievetheaimofthepaper,there are tasks:toinvestigatetheequationsfor estimating the cost of different sources of capital and theWACC; to analyse themost recent scientificpublicationson theweighted-averagecostofcapitalanddiscussthemostfrequentproblemsofthepracticalapplicationof the equations; to estimatecapitalcostsandtheWACCforsixcompa-nies; tomakeproposalsonmodificationsofthetraditionalequationsputforwardbyforeign scientists, so that the application of theseequationsinLatviancompaniescouldbeeasierandmoreefficient.

Themethodology of the paper includes quantitative and qualitativemethods ofresearchineconomics–monographicandeconometric methods, time series analysis andcorrelation,aswellasgraphicaldepic-tion.

the wacc and its components

Acompanyhasseveralsourcesoffinancing,andmostofthemhaveitscost.Therefore,the cost of total capital is determined by the weighted-averagecostofcapital(WACC).

TheWACCiscalculatedbymultiplyingthecostsofeachcapitalcomponentwithitsproportion in the total capital, and adding together all the multiples.

WACC=Ke * (E/(E+D)) + Kd * (D/(E+D)) (1)

whereKe –costofequity;Kd –costofdebt;EandD–equityanddebtcapital(Jacobs,2005).

Hence, theweighted-average cost ofcapital(WACC)isimpactedbythecostofdebtand thecostofequity,whichare, intheir turn, made up of several components. Thefirststepindeterminingtheweighted-average cost of capital is to determine the cost of every separate component.

the cost of common stock capital

gP

gDrE +

+=

0

0 )1( (2)

where rE–thecostofcommonstockcapital;D0 – current dividendor the dividend abouttobepaid;g–theexpectedgrowthrateofthedividend; P0–currentpriceofcommonstock(Watson,Head,2007).

APPlIcATION Of ThE wEIghTED-AVERAgE cOST Of cAPITAl IN lATVIA: ANAlYSIS, PROblEmS AND POSSIbIlITIES fOR ImPROVEmENT 145

the cost of preferred stock capital

n

drp P

Dr = (3)

whererpr–thecostofpreferredstockcapital;Dd–dividend;Pn–netamountthatwillbere-ceived by the company for each share of preferred stock (the cost of issuing shares is subtracted) (Watson,Head,2007).

The cost of retained earnings. It is amistake to regard earnings as a source of fundswithoutanycostsandprice.Retainedearningshavenoservicingcosts.However,there are alternative options involved be-cause these funds can be diverted to the shareholders,whocanmakeotherinvest-mentswiththismoney.

Therearetwowaysofdeterminingthecost of the retained earnings capital:

a)CAPM (capital asset pricing model) method.

)(* fmfi rrrr −+= β (4)

whereri–requiredreturnofaparticularstock;rf–returnofarisk-freeasset;rm –averagere-turnofthestockmarket;β–riskcoefficientofaparticularstock(Tham,Velez-Pareja,2001).

b)DCF (discounted cash flow) method.

)(* fmfi rrrr −+= β (5)

whereri–expectedreturnofaparticularstock;P0 – currentpriceof commonstock; g– theexpectedgrowthrateofthedividend;D1–first-year expected dividend per share of common stock(Watson,Head,2007).

the cost of debt

)t1(rKd −= * (6)

whereKd –thecostofdebt;r–nominalinterestrate;t–rateofcorporateincometax(Watson,Head, 2007).

Whendetermining andanalysing thecost of each capital source, a logical rela-tionship emergesbetweenprice and riskthat is undertaken by the supplier of capi-tal.Equityreflectsthehighestlevelofriskbecause the investors have to encounter the uncertainty of dividend payments and capital gains, and because of the place of shareholders in the hierarchy of stakehold-ers in the case of corporate bankruptcy whentheyarelasttorecoverfunds.There-fore, this sourceoffinancing is themostexpensive,whileretainedearningscapitalonly slightly cheaper.

Thecost of preferred stock capital islowerthancommonstockcapitalbecause:

–Dividendsmustbepaidtopreferredshareholders before dividends to common shareholders;

–Inthehierarchyofstakeholders,pre-ferred shareholders are higher up (in a more preferable position) than common shareholders.

D.Watson andA.Head (2007)pointoutthatthecostofcorporateequityisin-fluencedbyseveralfactors(Figure1).Theminimal requirement of shareholders istherisk-freerateofreturn,whichroughlycorresponds to the return of government bonds.The shareholderswill ask for anadditional contribution due to the under-taken business risks, because company earnings constantly change depending on thechangesinthewholesectorofindustry.Bothpartsareformingthetotalcostofeq-uityifacorporationisfinancedsolelyfromequity.Whenacompanystartsusingdebt,itsdivisible earningswilldecreaseby theamount of interest paid. Volatility caused by the necessity to make interest payments is afinancial risk that increaseswith theaugmentation of the level of debt in the company capital structure. At a very high level of debt, a possibility emerges that the


companywillbecomeinsolvent;therefore,the bankruptcy risk exists.

For company creditors, the situation is completely different – the amount ofrepaymentisfixed,itdoesnotchangewithcompany earnings.The creditors donotencounterfinancial riskbut they assumethebankruptcyrisk.However,comparedtoshareholders, it is smaller because creditors are higher up the hierarchy in the case of a bankruptcy, and usually it is possible to covertheloanwithcompanyassets.

Thecostofcapitalcanbecalculatedalsoas average cost of capital (represents past financialdecisions) andmarginal costofcapital (the cost of an increase in capital). Thereisafollowingrelationship:whenthemarginalcost(MC)ofcapital is lessthantheaveragecost(AC),theaveragecostofcapital declines. As soon as the marginal cost overtakes the average cost of capital, the average cost increases.The curve ofthe marginal cost of capital is ascending because in the beginning company usually attractstheleastexpensivecapital–debt,

andthenmovesontoequityasasourceoffinancing(Watson,Head,2007).

Therefore, when calculating theweighted-averagecostofcapital(WACC),thereisaproblemindeciding,whichcostofcapitaltouse–averageormarginal?OtherproblemsofWACCestimationare:

• Some securities are not traded per-manently, therefore, their market price can-not be determined (for example, shares of a non-public stock company), and a similar problemcanarisealsowithbonds.Oneop-tiontosolvethisproblemistofindasimilarpublic stock company and take the market price of its shares (plus an additional pre-mium to reflect a greater risk in the case of a non-public company);

• Estimating the cost of capital pro-vided by convertible bonds is a complicated task due the very nature of the security. Inthebeginningitislikeastraightbond(debt) and has the cost of debt, but later, if it is converted into common stock, it becomes an element of equitywith thecostofequity;

Fig. 1. Factors influencing the cost of equity Source: Watson, Head, 2007.

Required return on equity, %

0 Level of debt

Financial risk

Bankruptcy risk

Risk-free return


• Problems can arise also in the case of debtwithaninterestswapagreement.Themainquestioniswhetherthecostofcapitalshould include the interest rate at the point of dispensation of capital, or the interest ratestatedintheagreement(Watson,Head,2007).

Therearealsodiscussionson the sub-ject ofwhat kindof capital costs shouldor shouldnotbe included in theWACCcalculation.Themain rule,which isusu-ally observed, is: cost of capital used for long-term investments should be included in thecalculation (equity,preferredstock,medium- and long-termdebt, aswell asleases),whileshort-termcommercialcapitalshouldnot.However,ifacompanymakesapermanentuseofbankoverdraftarrange-ments,onecandiscusswhether thiskindoffinancingshouldbeincludedinWACCcalculations.There is auniversalopinionthat, for the calculation of the capital cost, marketvaluesshouldbeused(buthow,forinstance, in some cases to determine the market value of debt?) but there is no com-monlysharedopiniononwhattodoifthedebt is denominated in foreign currency. InordertoincludethiscostofdebtintheWACCcalculation,itmustbeconvertedintolocalcurrency.However,furtherproblemsarise–atwhatexchangerateand,iftheratechanges,shouldtheWACCberecalculated.

Moreover, it must be mentioned that a complicated calculation of the capital cost can also be in the case of a line of credit (it can be provided for a year, and also for a longeror shorterperiodof time),whichusuallyhastwointerestrates–onefortheused part of the line, and another for the unused part of the credit line. Taking into consideration that the company can receive and repay the line of credit at any moment, there are problems to achieve a correct estimateoftheWACC.

recent publications and most common problems

In1958,M.MillerandF.Modiglianipub-lishedtheirpaper„Thecostofcapital,cor-porationfinanceandthetheoryofinvest-ment”, and 1958 is regarded as the yearwhenthemoderntheoryofcapitalstruc-turewasborn.In1963,bothauthorsmademodifications to theirmodel („Taxes andthecostofcapital:acorrection”).However,eventoday,financialmanagersandscien-tistsstill investigatethequestionwhetherthe used sources of capital have an impact oncompanyvalue,andifso –howtoestab-lish the fact and make precise calculations. Whenoneanalysesthecapitalstructureandcompany value, it is necessary to take into consideration the economic cycle because the state of the economy at the moment of analysisisasignificantfactortoachieveabetterunderstandingofcorporatefinancingdecisions.

Intheresearch„Determiningtheopti-mal capital structure: a practical contempo-raryapproach”(DeWet,2006),theEhrhardtandBrigham (2003) approachwasusedbutseveraldrawbacksofthemethodologywerepointedout,aswell.Theyincluded,forexample, the calculation of the cost of debt wheninterestratesarenotincludedinthefinancialreport.Whenestimatesarebasedon interest-bearing debt yield rates that are inadequatelyhighorlow,theanalysiswillnotbesuccessful.DeWetalsomentionsthatthe approach is based on a very simple valu-ationmodelfoundedonthefreecashflowwithoutanincrement.ThevaluationmodelusedmultipliesEBIT(earningsbeforeinter-estandtaxes)withtheexpression(1–taxrate)anddeflatestheresultbytheWACCto arrive at the total value of the company.

Several studies look at the application of theCAPM(capitalassetpricingmodel)in


optimising capital structure and maximis-ingcompanyvalue. In theresearch„CostofCapitalforNon-TradedFirms”(Velez-Pareja,2005),ithasbeenemphasisedthatthe model is not practically applicable for small- and medium-sized enterprises (SMEs)andnon-tradedfirms, sincesuchinformation as, for example, the market returnandbeta arenot available–usingtheCAPMmodelisimpossiblewithoutthisdata.So,non-tradedcompaniesorfirmsinemerging markets cannot use the orthodox approaches (CAPMetc.) due to the lackof data. Many practitioners in emerging markets use beta or market risk premiums from the S&P 500 data (United States) and addthemarketrisk.ThemarketriskisthedifferencebetweenthereturnonUSbondsand the return on the bonds issued by the respective country in US dollars. Usage of theCAPM is also investigated in thepaper„AConsistentMethodologyfortheCalculationoftheCostofCapitalinEmerg-ingMarkets” (Villarreal,Cordoba,2010).TheoriginalCAPMmodeldeterminestherelationshipbetween the required returnand the current return on assets, and their systematicornon-diversifiablerisk.Atthepointofequilibrium,theopportunitycostequals requiredandexpectedreturn.TheoriginalCAPMmodel also assumes thatthere are no transaction costs, there is no information asymmetry and that investors can reduce the unsystematic part of risk by diversifying.Ofcourse,theseassumptionsdonotwork inpractice, even less so inemerging markets. J. E. Villarreal and M. J. Cordobaapplythemodeltakingintocon-siderationthenon-existenceofanefficientmarket and the market risk.

K’D=Rf+intermediationspread+CR (7)

whereK’D–thecostofdebt(beforetaxes)inan

emerging economy; Rf–risk-freerateofreturn;

Intermediationspread–reflectsalltransactioncosts;CR–premium,which reflects countryrisk(Villarreal,Cordoba,2010).

KE={[KD(1-r)] + [βE(Rm-Rf)]}+CR (8)

whereKE –thecostofequity;KD–thecostofdebt;r–taxrate;βE–thebetaofequity,whichisameasureofequity’ssystematicrisk;Rm–ex-pected market rate of return; (Rm–Rf)–expectedmarketriskpremium(Villarreal,Cordoba,2010).

Asignificant factor that influences thecapital structure and the cost of capital is theeconomiccycleandchangesinit.Thisquestion isdiscussed further in thepaper„Optimal Leverage, itsBenefits, and theBusinessCycle”(Hess,Immenkotter,2011).Incontrast topreviousresearch,bothau-thorsmodelEBIT(earningsbeforeinterestandtaxes)withastochasticprocessthatisbasedontheeconomiccycle.Intheperiodofeconomicgrowth,EBITincreases,while,in recession, it decreases. According to the trade-off theory of capital structure, a com-pany chooses an optimal capital structure taking intoconsiderationtaxbenefitsandpotential costs of financial distress that, in their turn, depend on macroeconomic conditions. As a result, an optimal capital structureandbenefitsfromattractingdebtareidentifiableintheperiodsofeconomicgrowth and recession.Themodel showsthatfinancingdecisionsvarypro-cyclicallywith theeconomiccycle. In theperiodofeconomic growth, a company chooses ahigher level ofdebt forfinancing invest-ments,whileinrecessionequityisusedtoagreaterextent.Positivegrowthexpectationsreduce the risk of bankruptcy and increase debt but, in recession, the insolvency risk growsandconsequentlycompaniesreducedebttodiminishrisk.Ifacompanymanagerwants to set anoptimal capital structure,it isnecessary to startwithaprecise and


correct evaluation of the current state of the economyandtheexpectedincreaseinEBIT.Ifmistakesaremadeinthisstagealready,applicableresultswillnotbeacquired.Com-paniesthatworkwithahigherthanoptimallevel of debt encounter costs of being over-levered.Thesecostsarehigherinaperiodof economic growth than in a recessionbecausemarginalcostsofpotentialfinan-cialdistressintheperiodofanupswingarehigher due to pro-cyclical optimal leverage ratio.Viceversa,ifamanagerusesalowerlevelofdebt,anotablebenefit fromtaxesisnotutilized.These costs– frombeingunderlevered–aregreater ina recession.Whencomparingbothcosts–frombeingunderleveredoroverlevered–HessandIm-menkotter conclude that being overlevered ismoreexpensive.Therefore,aninferenceisdrawn:ifacompanyhasdifficultyinsettingprecisely the optimal capital structure, then the company should apply a conservative policy, evaluate the macroeconomic risk, andattractasmalleramountofdebt.Costsfromasmallertaxbenefitarelessthanthepotential bankruptcy costs.

Comparativelyinnovativeapproachinsetting an optimal capital structure is ex-amined in thepapers„TheCostofDebt”(Binsbergen, Graham, Yang, 2010) and„OptimalCapital Structure” (Binsbergen,Graham,Yang,2011).Theauthorsprima-rilystressthatthetheoryoffinancerulesthat the optimal level of debt is reached inthepointwhenmarginalcostsofusingdebt equalmarginal benefits. Itmust benoted that they focus on the total level of debt,whichoptimallymustbeemployed,without distinction of the nature of theusedcapital–short-orlong-term,fixedorvariable, and such like.

Theauthorsoftheaforementionedpa-pers construct themarginal benefit andmarginal cost curves of debt (Figure 2). Point A has an optimal level of debt because the marginal benefit and marginal cost curves intersect there.However,atpointsBandC,thecompanydoesnotemploytheoptimalcapitalstructure,andconsequentlycosts appear (tinted areas in Figure 2).

Additionally, a formula is being pro-posed to calculate the cost of debt, namely

Fig. 2. Marginal benefit and marginal cost curves of debt usage

Source: Binsbergen, Graham, Yang, 2011.

x – debt intensity B A C too little debt optimal debt too much debt

Marginal Cost of Debt Curve

Marginal Benefit of Debt Curve

y =

MB,

MC

Cost if enterprise were to use too little debt

Cost if enterprise were to use too much debt


MC(IOB)=α+β*IOB=0.117–0.039COL +0.015LTA–0.018BTM–0.024 INTANG+0.080CF+0.063DDIV+4.733*IOB (11)

whereDDIV–1ifacompanymakesdividendpayments; 0 if a company does not make divi-dendpayments;COL–collateral,thesumofallphysical assets and stocks divided by the total valueofbookassets;LTA–thelogoftotalbookassets;BTM–bookvalueofequity/marketvalueofequity;INTANG–intangibleassets/bookvalueoftotalassets;CF–netcashflow/bookvalueoftotalassets;IOB–interest/bookvalueoftotalassets(Binsbergen,Graham,Yang,2011).

All indicators that characterise a com-pany(exceptDDIV)arestandardised,i.e.,the average is subtracted and the result is dividedby the standarddeviation. In theconclusion of the paper, the authors also examine other factors that influence the costofdebt–ifanenterprisehasafinancialdivision; if an enterprise has a credit rat-ing (if so, information asymmetry is being reducedfromthepointofviewofinvestorsand,hence,thecostofdebtis lower);themacroeconomic conditions are being taken into consideration (for example, the credit spread).

Onecaninferthatthemajorityofrecentpublished research turns an increasing at-tention to theproblems thatoccurwhenthecostofcapitalandWACCarecalculatedin practice. Scholars analyse existing prob-lemsandsolutionsarebeingsought–bymodifying existing calculation methodolo-gies,aswellasbyofferingnewapproaches.Also, more emphasis is being put on the role of the economic cycle in setting and optimising the capital structure,which isappreciated by the authors of this paper because the condition of the economy and itsconsequences(theavailabilityofcredit,forecasts of the future, inflationary expecta-tions, interest rates, and such like), directly

affect the rest of factors that have an impact on capital structure and the cost of capital.

the application of existing wacc formulas in latvian companies

For this study, six companies were se-lected – five (all) joint-stock companies(JSC)publiclytradedontheBalticofficiallist in the Riga Stock Exchange, and one limitedliabilitycompany(LLC),whichon21 April,2011,wasthelargestLLCinLatviain terms of common stock at stated value (LVL146 079 000)(Lursoftstatistika,2011).Thestudyusesdatafromcorporateannualreports beginning from the year 2002 until theyear2009.Ithastobementionedthatduring the lastdecadeonly twoof thesecompanies have paid dividends – „SAFTehnika”(in2004,2005,2006,2009,2010)and„VentspilsNafta” (in2003and2009)(NASDAQOMXRiga,2011).

AsshownbyTable1,thecompaniesin-cluded in this study have a diverse range of operations–therearemanufacturingenter-prises,aswellascorporationsthatprovideservices.Theturnoveroftheirsharesrangesfrom LVL 0,54 million to LVL 5,47 mil-lion,whiletheircapitalisationisfromLVL8,47 million to LVL 141,05 million.

The financial crisis (2007-2010) also heavilyaffectedthecompanies intheOf-ficial listat theRigaStockExchange.Theshare price peaks of 2006 have not yet been reached but current company indicators are varied,forexample,thesharepriceofJSC„Grindeks”in2010isapprox.92%ofthepricein2006,whileforJSC„SAFTehnika”thisindicatoristhelowestofallfivecom-panies,namely,onlyapprox.11%(however,JSC„SAFTehnika”haspaiddividendsin2006ofLVL0.2per share,while in2009


and2010–LVL0.23pershare)(NASDAQOMXRiga,2011).

Figure3showsthestructureofassetsforall six companies (long-term investments andcurrentassets),aswellasthepropor-tion of debt at the beginning (2002) and the end (2009)of theperiod inquestion.Asmentioned before, the companies operate in different sectors of industry, therefore, there are large variations in the structure of both sidesofcompanybalance-sheets.Thereisa demonstrable difference in asset struc-ture betweenmanufacturing enterprises(JSCGrindeks,JSCOlainfarmunJSCSAFTehnika) and service enterprises,whichhave a larger proportion of long-term in-vestments in company assets, and a smaller

proportionofcurrentassets.Outofthesixcompanies, four have seen a reduction in the proportion of debt in the seven-year period,theexceptionsbeingJSCOlainfarmandJSCLatvijasKuģniecība.Theaverageproportionofdebthasdeclinedfrom35,6%in2002to26,5%in2009.

Thecalculationofthecostofcommonstock capital according to the formula 2 canbeappliedonly to companies,whicharemakingdividendpayments, i.e., JSCSAFTehnikaandJSCVenstpilsNafta.Fur-thermore, in this case too, the application of theequation isnotqualitativebecausedividend payments are irregular and the expectedgrowthrateof thedividendcanbe determined only as a rough estimate.

Table 1The indicators of company stock included in the study

Company First date of trading

β (Damodaran, 2011)

Data on the trading of securities (2011)

Turnover, million

LVL

Capitalisa-tion, million

LVL

Price of the last transaction

(25.04.2011), LVL

1 2 3 4 5 6JSCVentspilsNafta[diversifiedholdingcompany]

20.10.1998 (Officiallist)

0.06 2.12 141.05 1.350

JSCSAFTehnika[manufacturing of telecommunications equipment]


no data 0.54 8.47 2.850

JSCOlainfarm[pharmaceutical manufacturing]

09.06.1997 (Second list),


1.22 0.63 32.82 2.330

JSCLatvijasKuģniecība[shipping]


0.35 5.47 84.00 0.420

JSCGrindeks[pharmaceutical manufacturing]

01.06.1998 (Second list),


0.47 2.38 62.30 6.50

Source: NASDAQ OMX Riga, 2011.


The equation 3 of the cost of preferredstockcapitalhas the sameproblemswithregardtodividends –iftherearenodivi-dend payments, the cost of capital cannot be determined.

Onecanusetwomodels–theCAPMmodel4andtheDCFmodel5–tocalculatethe costof retainedearnings capital.Theauthors of this paper believe that use of the CAPMmodelcanyieldmorepreciseresultsthantheuseoftheDCFmodel,sinceitisimpossible to determine the g variable (ex-pectedgrowthrateofthedividend)ifthereare no dividends paid.

So,theCAPMmodel isbeingusedtodetermine the cost of retained earnings capital.Thenecessarydataforthecomputa-tionareasfollows:

• rf[returnofarisk-freeasset]–tra-ditionally, it is the return of bonds issued by the state; on February 4, 2011, the inter-estrateofgovernment10-yearbondswas6,625%(NASDAQOMXRiga,2011);

• rm [average return of the stock mar-ket] – in January, 2010 itwas 7,50% inLatvia (Damodaran, 2011);

• β [risk coefficient of a particular

stock] – according to the company (datafromJanuary,2010),exceptJSCSAFTeh-nika [no data] (Damodaran, 2011).

Thecalculationofthecostofdebtwasconducted as follows: the item „interestpaymentcosts”wasdeflatedbytheamountof debt in 2009. In the case of JSC SAFTehnika, the interest payments in the ref-erenceyearwereLVL4 170but the item„overdraftsinbanksandcreditcards”wasLVL1 896.However,onemustnotethatthetotallimitallowedisnotknown,namely,itis possible that, during the year, the used amountwas greater; therefore, the inter-est payments surpass the limit used at the endoftheyear.Inanycase,basedonthesedata, it is not possible to determine the cost of debt.

Consequently,takingintoconsiderationthatisimpossibletocalculatebothcosts –the cost of equity and the cost of debt,onecannotcalculateanddrawconclusionsabouttheWACC(Table2).Hence,itispos-sible to infer that the traditional formulas for the calculation of the cost of capital are notsuitabletotheexternalusersoffinancialreports of Latvian companies.

Fig. 3. Asset structure and debt ratio of the companies in the study, in 2002 and 2009


Enhancement of the cost of capital calculations and its approbation in latvian companies

Whileattemptingtocalculatethecostsofcapital for capital components, and the weighted-average cost of capital in sixLatvian companies, the authors of this researchmetwith several problems andobstacles:

• Therearenecessarydata lacking tocalculate the cost of some kinds of capital, or the data used are approximate [for in-stance, the return of a risk-free asset, the average return of the stock market, risk coefficientofaparticularstock];

• Theinformationondebt inthean-nualreportsoftenislimited[forinstance,inthecaseofJSCSAFTehnikatheamountofinterestpaidisknownbuttheoutstand-ing debt is given only for the end of year];

• The calculation formulas are pro-vided for companies that make regular dividend payments; if a company makes

dividend payments irregularly, it is not pos-sible to determine the g [expected dividend growthrate]preciselyandcorrectly.

Themajorityofcostofcapitalequationsin the sources of scientific research are meantforsituationswhenadditionalcapitalis about to be attracted to make invest-ments. Some formulas take into account the costs of raising capital (commissions, state duties, costs of issuance, notary services, and such like) but, for example, the formula of the cost of debt does not employ the costs ofraisingcapital.Theaimofformulasistodeterminethecostofcapitalwhichisabouttobedrawnin,notthetotalcostofcapitalat this moment. Problems are also caused by thevariableinterestrates(whicharefixedto interbank interest rates), the possibility of continuous repayment and dispensation of credit, loans in foreign currency, the use ofdifferentfinancinginstruments(forex-ample, convertible bonds, etc.

Firstofall,onemustdefineapurposefor the formulas of cost of capital calcu-lations. It is also necessary to take into

Table 2The costs of capital sources of the companies included in the study

Cost of capital / company

JSC Grindeks

JSC Olainfarm

JSC Latvijas Kuģniecība

JSC Ventspils

Nafta

JSC SAF Tehnika

LLC Lattelecom

1 2 3 4 5 6 7Cost of common stock capital

Cannotbedetermined, the dividends are not being paid



Cannotbedetermined, the g cannot be calculated

~8.1%

Cost of preferred stock capital Thiskindoffinancingisnotbeingemployed

Cost of retained earnings capital

7.04% 7.69% 6.93% 6.67% Nodata

Cost of debt 1.36% 4.68% 4.93% Noborrowingfrom credit institutions

Cannotbedetermined, the data are lacking

3.4%


consideration that factors influencing capi-tal structure and factors influencing the costofcapitalaretwodistinctthings.Forinstance, itwas not taken into accountwhenformula11wasdevisedbecausethecalculation does not include the nominal interest rate, or the tax rate. Also one must take into accountwhat is the object ofthecalculation –thecostofthehistoricalstructure, the current cost of capital, the cost of capitalwhen additional capital isbeingdrawnin,etc.Forinstance,thefor-mula 7 for the calculation of the cost of debt is adequate if the aim is to acquireinformation on the cost of capital, for ex-ample, in a sector of industry but not on the cost of debt in a particular company. Theequation for calculating the cost ofdebtmustunequivocally include the taxrate (taking into consideration that interest payments reduce theobject of corporateincome tax), aswell as the interest rate,because, in essence, the creditors put into theinterestratetherisk-freereturn,aswellas other potential risks.

For thepurposeof simplicity, let’s as-sume that a companyhas two sourcesofcapital, for which the company pays acost –equity[shares]anddebt[borrowingfromcredit institutions, financial leases,

borrowingfromothercompaniesorshare-holders,andsuchlike].Whenitraisesdebt,a company must count on the necessity to cover the costs associatedwith raisingcapital [drawingupdebtagreements,no-tary costs, state duties, chancellery duties, insurance costs, commissions, and such like] and interestpayments.Thecostsofdrawing in capital are bynature one-offpayments, that is, the payment is being madewhen the capital is received.Onemust note that such costs can also arise in the period of capital usage (the premium payments for insuring the collateral) and at the end of the period (duties for removing the collateral in the respective register) but whenwecomparethesecostswiththeonescommitted at the beginning of period, they turnouttobecomparativelyinsignificant.Whenattracting equity, a companymusttakeintoaccounttwokindsofcosts–thecosts of raising capital (by increasing the number of shares if the company is traded on the Stock Exchange) and dividends (al-though, one must note that dividends may not be a regular payment, if the company takes a decision not to commit its earnings fordividends).The relationshipbetweencapital structure and the cost of capital is depicted in Figure 4.

Fig. 4. The total cost of capital employed and its components

Equity

Debt

Total capital

Dividends

Interest payments

Costs of raising capital

Costs of raising capital

Regular payments

One-off payments

The total cost of capital employed


Ifonetakesintoconsiderationonlytheregular payments related to the cost of capi-tal, it can be considered that the cost [from the company’sperspective] equals inves-tor’sreturn.Inpractice,thisconsiderationis only approximate because the company has to make additional one-off payments mentioned above that do not increase the return for the investor but the company has to cover these costs (inotherwords, thetransaction costs).

Theauthorsofthisresearchfocusonthedynamics of the historic costs, and it is the price that is taken into consideration, i.e., the expression of the value of a commod-ityinmoneyterms,reward,andpayment.Theauthorscalculatethecostsofdifferentkindsofcapitalaccordingtothecashflowprinciple–incomingflows(thecapitalat-tracted)andoutgoingflows(paymentforthe use of the capital).

In theprocessofestimating the cost of common stock capital, one must take into considerationwhether a company ismakingdividendpayments(orwaspayingdividends in the previous reference period), ornot.Ifthecompanyhaspaiddividendsin the reference year, the cost of common stockcapitalcanbecalculatedasfollows:

KAD

rk

E0= (12)

where rE – the cost of common stock capital;D0–dividendpaidinthereferenceyear;AkK–share capital (paid).

If, in thereferenceperiod,acompanyhasdrawninadditionalequityandthecostsof attracting capital have been paid, these costs must be taken into consideration and must be included in the numerator of the formula (D0 + costs of raising capital).

Ifthedividendsarenotbeingpaidinthereference year, the calculation of the cost

of common stock capital is conducted ac-cording to the methodology of calculating the cost of retained earnings capital. Al-though, the nature of the payments (regular orone-off)associatedwiththecostcannotbe immediately identifiable, this capital isnotfreeofcharge.ThemethodologyoftheCAPMmodelisdifficulttoapply,sincethere arenodata on the risk coefficientof theparticular stock, and also the twoother variables are approximate indicators thatarebasedontheeconomyasawhole.In its turn, theDCFmodel canonly beappliedtojoint-stockcompanies.Further-more, it appears that the dividend paid by the company only once, are included in the calculationof the costof capital twotimesintworeferenceperiods(inperiodt1 whenthecompanydoesnotpayadividend,and in period t2whendividendpaymentismade). Retained earnings are character-ised by alternative options because these funds can be diverted to the shareholders, who,intheirturn,caninvesttheminotherprojects.Therefore,onecanreckonthatthecost of retained earnings capital must have twocomponents,whichare:

• Theminimal returnon alternativeoptions, namely, the return on risk-free asset,whichisvaluedbytheauthorsofthispaper roughly at the level of the return on government bonds;

• Theaveragereturnofthestockmar-ketandthecostofcompanydebt–approxi-mately reflects the return if the shareholders will invest funds in the stockmarket orlend them.

2Am

firr

rr+

+= , or (13)

][ fmEi rrrr +−= (14)

whereri–requiredreturnonaparticularstock;rf–returnonarisk-freeasset;rm–averagereturnof the stock market; rA–thecostofdebt.


Theformula13isbeingusedifthecostofdebtisknown;initsturn,formula(14.)is employedwhen the costofdebt isnotknownbut there aredata on the cost ofcommon share capital.

It isnecessary to emphasise that, outof all the methodologies of calculating the cost of capital, it is the calculation of the cost of retained earnings capital that can be characterisedasthemostabstract.Thisiswhyitcanonlybearoughestimate.Whencalculating the cost of this kind of capital, the cashflowprinciplementionedbeforeisnotbeingused–thefundsarenotbeingraised in reality and the repayment is also not being conducted.However, the ade-quacyofthereturntotheriskisbeingtakenintoconsideration,namely,thatwhencom-paringthiscostofcapitalwiththecostofcommon stock capital, the cost of retained earningscapitalisslightlylower,butwhencomparingwiththecostofdebt–higher.

The cost of debt if solely regular or interest payments are being made can be calculatedwiththeapplicationofformula6.However,ifthedebthasjustbeenraisedinthe reference period, and there are notable one-off costs, then these costs must also be includedinthecalculationofthecost.Ifthecosts of raising capital (commissions, state

duties, insurance premium payments, and suchlike)areknown,thenthisdatamustalsobeincludedintheequation.

)100*__()*(

kapitalsPiesaistizmaksasPiesaistest)(1rrA +−= (15)

wherePriesaistes_izmaksas–thecostsofraisingcapital; Priesaist_kapitals–theamountofcapitalraised.

Consequently, ifacompanyusessuchloan products as a line of credit or an over-draft (that have two costs – the cost ofused funds, and the cost of reserved funds), then the cost of reserving funds must be included in the calculation of the cost of debt because, on the one hand, the com-pany pays a price for these funds, and on the other hand, it also increases the return of the lender.

Theauthorsofthispaperconductedthecost of capital estimation in six Latvian com-panies using the formulas mentioned above:

• Lattelecom,LLC(Figure5)–takinginto consideration that the company practi-cally every year makes dividend payments, and also that in several annual reports the companyalreadydidincludetheweighted-averagecostofdebt,itwaspossibletocal-culate the cost of share capital, the cost

Fig. 5. The cost of capital of Lattelecom, LLC, from 2002 until 2009


of retained earnings, the cost of debt, as wellastheWACC.In2006and2007,thecompanydidnotusedebt,however,takinginto consideration the high proportion of equityinthecapitalstructure(~85%,whichis the highest in the period of the study), consequently, theWACCdidaugment inthesetwoyears.Beginningfrom2003,onecanobserve a following relationship: thecost of common stock capital > the cost of retained earnings capital > the cost of debt, whichcorrespondstothetheoryoffinanceand the risk level of the particular type of investment.

• JSCGrindeks,JSCLatvijasKuģniecībaunJSCOlainfarmdidnotmakedividendpayments in the reference period, there-fore, it is not possible to determine the cost of common stock capital.However,the annual reports provide a comparatively large amount of transparent information oncorporatedebt.Thismeansthatthecostof debt (Figure 6) and the cost of retained earnings capital (Figure 7) can be esti-mated.However,JSCSAFTehnikaandJSCVentspilsNaftamake irregular dividendpayments (2-3 times in the 8-year period). Moreover, the companies for the duration ofseveralyearsusesuchfinancialproductsasoverdraftandlineofcredit,therefore,itis impossible to estimate a correct cost of debt from the data of the annual report.

• Onemustnote that annual reportsoftenhaveinformationontheinterestratebut usually the rate is tied to theRIGI-BORorLIBORindex(3or6month),andwithout the knowledge of, which date’sindex the interest rate is tied to (and on whichdates the changehappens), an ef-fective estimate of the interest rate is not possible. Moreover, the annual report in essenceshowsthesituationinthecompanyatacertaindate(attheendofthefinancialyear)–informationthatisstaticbynature.

However,forthecalculationsinquestion,a more detailed information (dynamics) is necessary. For example, one takes the data on the interest payments from the income statementandthecashflowstatementbut,during the year, the loan, apparently, has been repaid before the due date (or, accor-ding to the repayment schedule, a seasonal pattern is set) because the interest rate is inadequately high. Even if one uses theaverageamountoftheborrowing[(loanatthe beginning of year + loan at the end of year) / 2], a credible result is not attained. Itattests that thecompanyseeminglyhasrepaidasignificantpartoftheloaninthesecond half of the reference period but, without the necessary information, it isimpossible to determine the cost of debt.

• Theaveragecostofdebt(Figure6)is4,4%(theaverageforfourcompaniesinthe8-yearperiod).In2002,thecostishigher,and in the following two years the costdroppedbelow4,4%but,intherestoftheperiod, measured variations are observable between4%and5%.

• Thevariationsofthecostofretainedearnings capital are not considerable be-tweencompanies,whichistobeexpected,takingintoconsiderationthat,intheequa-tion for calculation, the cost of share capital or the cost of debt is the only varaible from companydata.Othervariables(theaveargereturn of the stock market, the return on a risk-free asset) are the same for all compa-nies.Ifonecomparesthecostofdebtandthe cost of retained earnings capital, the re-lationship that the cost of retained earnings capital>thecostofdebtiscompliedwith,whichisinaccordancewiththetheory.

To sum up, one can infer that the re-sults obtained by calculating the costs of separate sources of capital confirm the assumptionsinthescientificliteraturethatthe cost of common stock capital is higher


thanthecostofretainedearnings,which,in its turn, is higher than the cost of debt to take into consideration the risk un-dertakenby the investors.However, onemustnotethat,anyway,theexternaluserofafinancialreportdoesnothavealargeamountof information,which isneededtobetakenintoaccountwhenthecostofcapital is estimated and analysed. Also, the information in the annual report must be looked at critically (see the example above on the partial repayment of the loan during thereferenceperiod).Theauthorsofthis

paper did not include the costs of raising capital in their calculations because this informationisnotreflectedadequatelyinthe annual report.

conclusions

When the cost of each source of capitalis calculated and analysed, a logical rela-tionshipemergesbetweenthecostandtherisk,which isundertakenby the supplierofcapital.Equityreflectsthehighestlevel

Fig. 7. The cost of retained earnings capital / share capital in Latvian companies, from 2002 until 2009

Fig. 6. The cost of debt in Latvian companies, from 2002 until 2009


of risk because investors have to encoun-ter the uncertainty of dividend payments andcapitalgains,aswellastheirplaceinthe hierarchy of stakeholders in the case ofabankruptcy–investorsarethelasttoredeemtheirfunds.Therefore,thissourceoffinancing is themost expensive,whilecapital formed by retained earnings is only slightly cheaper, and, in its turn, the cost ofdebt is the lowest among thedifferentsources of capital.

ThecalculationofthecostofcapitalandtheWACCin thescientific literatureandpractice identifies several problems. Forinstance,thereisaproblemwithwhichcostof capital to choose (marginal or average); some securities are not traded permanently, therefore, their market price cannot be determined; the calculation of the cost of convertible bonds is complicated, too.

Onecan infer that themajorityof re-cent published research turns even greater attentiontotheproblemsthatarisewhenthe calculation of the cost of capital and the WACCisconducted inpractice.Scholarsanalyse the existing problems and look for solutions–bymodifying the existingcalculationmethodologies,aswellasoffer-ingnewapproaches.Also,moreemphasisis being put on the role of economic cycle in setting and optimising capital structure, whichisappreciatedbytheauthorsofthispaper because the state of the economy and its consequencesdirectly affect theotherfactors that influence the capital structure andthecostofcapital,aswell.

Thecostsofbothmaincomponentsofcompany capital (the cost of equity andthe cost of debt) is impossible to estimate inacompany,andhence,theWACCcan-not be estimated and analysed, if a regular dividend is not being paid and the beta

of thesecurity isnotknown.So,onecanconclude that the traditional formulas of cost of capital calculations are not suitable totheexternalusersoffinancialreportsofLatvian companies.

Thecostofcapitalcanbesplitintotwoparts–regularpayments(dividends,inter-est payments) and one-off payments (costs ofraisingcapital).Thisdivisioncanbeap-pliedtoequityanddebtalike.

Theauthorsof thispapermodify thetraditional equations of computing thecosts of capital, in order for them to be applied inLatvian companies.However,not in all companies andnot always theequations can be applied due to lack ofdata in theannual reports.Theproblem,whichhasbeen encounteredmostoften,concerns theuseofoverdraftand lineofcredit arrangements because annual re-portspresentthefinancialpositionattheend of the reference period (i.e., the used funds) but during the reference year the limit can be used and repaid several times. Therefore,thecorrectcostofdebtcannotbe determined.

Theobtainedresultsinestimatingsepa-rate costs of capital according to the meth-odology proposed in this study, comply withtheassumptionsinscientificliteraturethat the cost of common stock capital is higher than the cost of retained earnings capital,which,initsturn,exceedsthecostof debt, taking into consideration the risk undertakenbyinvestors.However,theex-ternaluserofafinancialstatementanywaydoes not have access to a large volume of information thatwouldbe taken intoac-countwhenthecostofcapitalisestimatedandanalysed.Theinformationincludedinthe annual report must be looked at criti-cally, too.


References

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9. Miller,M.,Modiglian,iF.(1958).Thecostofcapi-tal,corporationfinanceandthetheoryofinvest-ment//AmericanEconomicReview.Vol.48,No.3.

10. Tham,J.,Velez-Pareja,I.ANoteontheWeightedAverageCostofCapitalWACC.Internetaccess:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=254587.[AccessedMarch28,2011].

11. Uzņēmumustatistika/Lursoftstatistika.Internetaccess:http://www.lursoft.lv.[AccessedApril21,2011].

12. Velez-Pareja, I.CostofCapital forNon-TradedFirms. Internet access: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=366981. [AccessedMarch 28, 2011].

13. Villarreal, J.E., Cordoba, M.J. A ConsistentMethodology for theCalculationof theCostofCapital inEmergingMarkets. Internet access:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1663845.[AccessedMarch28,2011].

14. Watson,D.,Head,A.(2007).CorporateFinance.Principles&Practice.4thed.-Boston:PrenticeHall.

Thepapersubmitted:May15,2011Prepared for publication: September 1, 2011

1. Binsbergen,J.H.,Graham,J.R.,Yang,J.OptimalCapital Structure. Internet access:http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1743203. [Accessed March 28, 2011].

2. Binsbergen,J.H.,Graham,J.R.,Yang,J.(2010).TheCostofDebt//JournalofFinance.Vol.65,No.6.

3. BiržaNASDAQOMXRiga:Dividendes. Inter-netaccess:http://www.nasdaqomxbaltic.com/lv/shares/dividendes-2/. [Accessed April 21, 2011].

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Elvīra zElgalVE, irina bĒrzkalnE

kaPitalo kaštų sVErtinio ViDurkio taikymas latVijojE: analizė, ProblEmos ir tobulinimo galimybėss a n t r a u k a

Kapitalostruktūrayrasvarbusveiksnysapskaičiuojantįmonėsvertę,nesoptimalusfinansiniosvertodydis(skolinto ir nuosavo kapitalo santykis) gali padidin-ti įmonėsvertę ir sumažinti kapitalokaštus.Todėlšis klausimas yra ypatingai svarbus kintančiomis ekonominiovystymosisąlygomis.KadangipasaulioekonomikosnuosmukisturėjoženkliąįtakąLatvijai,šiosšaliesbendrovėsbandooptimizuotiveiklątobu-lindamossavoorganizacinęstruktūrąirmažindamosišlaidas.Bendrovė turi keletąfinansavimo šaltiniųirdaugumaišjųturisavokainą,todėlvisokapitalokaštai nustatomikapitalo kaštų svertinio vidurkio(KKSV)pagalba, kuris yra vienas iš korporacijosfinansųvaldymoįrankių.

Pastaraisiais dešimtmečiais buvo analizuojamiveiksniai,turintysįtakoskapitalokaštams;yraatliktinagrinėjimaiirtyrinėjimaidėlkapitalokaštųsvertiniovidurkioskaičiavimopraktikoje.Tačiauyradardaugneatsakytųklausimųirproblemų.Pavyzdžiui,vykstadiskusijosdėlto,kokioskapitalokaštųrūšysturibūtiįtrauktosįlygtįapskaičiuojantkapitalokaštųsvertinįvidurkį. Pagrindinė taisyklė: turi būti atsižvelgta įkapitalokaštus,panaudotusilgalaikėmsinvesticijoms,oįtrumpalaikįkomerciniokapitalofinansavimą–ne.Visdėlto, jei įmonėyranuolatinėbankooverdraftosusitarimonaudotoja, gali būti aptariamabūtinybėįtrauktišiąfinansavimorūšįįkapitalokaštųsvertiniovidurkioskaičiavimą.


Latvijoješiproblemataippatyraaktualidėlkele-topriežasčių.Pirma,nėraatliktakruopščiųempiriniųkapitalo struktūros tyrimų.Antra, skaičiavimas irfinansiniųkoeficientųbei kitųfinansinių rodiklių,įskaitantkapitalokaštųsvertinįvidurkį,naudojimasanalizėsenėrapaplitęs.

Straipsnio tikslas yra ištirti lygtis skaičiuojantskirtingųfinansavimošaltiniųkaštusirkapitalokaštųsvertinįvidurkį,pasiūlytąužsieniomokslininkų,bei,remiantis lygčių taikymuLatvijos įmonėse,pateiktitolesnes rekomendacijasgerinantkapitalokaštus irjųpraktinįtaikymąbesikeičiančiojeLatvijosekono-minėjeaplinkoje.

Siekiant straipsnio tikslo, iškelti šie uždaviniai: ištirtikapitalokaštųišskirtingųšaltiniųskaičiavimolygtisirkapitalokaštųsvertiniusvidurkius(KKSV);

išanalizuotinaujausiasmokslinespublikacijas apiekapitalokaštųsvertinįvidurkįiraptartidažniausiaipasitaikančiaslygčiųtaikymopraktikojeproblemas;apskaičiuotikapitalokaštusirkapitalokaštųsvertinįvidurkįšešiomsbendrovėms;pateiktipasiūlymusdėltradiciniųužsieniomokslininkųpateiktųlygčiųmo-difikavimo,kadšiųlygčiųtaikymasLatvijosįmonėsebūtųlengvesnisirefektyvesnis.

Straipsnyje pateikiamos rekomendacijos dėlkapitalo kaštų skaičiavimo ir autoriaimodifikuojatradicines užsieniomokslininkųpasiūlytas lygtis,kadšioslygtysgalėtųbūtitaikomosLatvijosįmonėseefektyviau.Patobulintoslygtysyranaudojamosem-piriniuosetyrimuosepenkioseakcinėsebendrovėseirvienojeribotosatsakomybėsbendrovėje.

application of the weighted-average cost of capital in

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