Interview Question - Cost of Equity ALWAYS > Cost of Debt
I recently had a phone interview which was pretty standard with the fit stuff and then jumped into the basic valuation type stuff and then I started getting some questions that were digging a little bit beneath the surface to see if I actually knew more than the M&I guide, which, after a decent summer position, I'm pretty confident I do.
At a certain point, the interviewer asked me to answer the following-
"Cost of Equity is greater than Cost of Debt. Is this true
A. Always
B. Sometimes
C. Never"
Instinctively, I like to shy away from the ALWAYS/NEVER answer, because it seems like there are always some obscure situations that may differ your normal scenario. So I said, in a typical situation, I would say A. always... and mentioned things like Debt paid out first, tax shield, Re is usually higher than the borrowing rates, etc. BUT then mentioned, I think there could exist some obscure case in which this isn't true and therefore answer is technically B. Sometimes.
He basically said, no, it is ALWAYS. Can someone come up with the case where cost of Debt is greater than cost of equity?
Thanks!
i would say
cost of equity should always be riskier than cost of debt b/c equity lower on the capital structure and thus riskier (debt is guaranteed).
oops didnt read your question. Cost of debt can be greater than cost of equity if your beta for some reason is low (since there are multiple ways to derive beta) but it should always be lower.
In terms of the investor's perspective, I completely agree.
But what about in the company's perspective, as in, when computing WACC? It seems if a company has a very low beta, and the Rm is standard, but lending is very tight and the company's rate for debt is like 10 or 12%, to them it would be greater. Maybe I'm looking too far into it.
you shouldve asked the smuck to give you some examples.
Cost of equity is almost always higher than cost of debt. However, if a company already has a shitload of debt, no banks will be willing to lend to it unless the interest rates are through the roof. In such a case, cost of equity is less than cost of debt.
The cost of debt of non investment grade debt is not the nominal yield so the quoted interest rate does not equal cost of debt. Cost of debt is the expected return from the debt (i.e. there's an understanding you might default).
When calculating WACC and using CAPM to price the cost of equity, leverage is one of the components of the equity Beta (function of levered Beta). Therefore, shareholders will always demand a return that is higher than the cost of debt.
@ the poster above: The cost of equity is theoretical. In the scenario you described, if the company took on more debt at higher rates or not, using the CAPM theory, equity holders would demand an even higher return given the riskier capital structure (higher leverage would be reflected in the levered beta, increasing the cost of equity).
Yes, under modern portfolio theory, it should cost the company's existing shareholders the same whether they want to raise money by issuing more equity or debt. But I think the question here is what are the shareholders expected to make vs. what the bondholders are expected to make for their investment. Both investments carry a different beta and therefore a different market risk premium.
Find a company where the beta on the ASSETS is negative, and all of a sudden, the bondholders are looking to get in and earn around the treasury rate and the equity investors are getting in looking to earn less than that or even LOSE money for the privilege of owning an asset that goes up when everything else goes down.
This company is largely theoretical, but you can probably draw an example using some of the levered ETFs.
And what type of debt financing would have a negative beta and would behave in a contra cyclical manner? This is about funding, not a portfolio of assets.
Debt financing doesn't have a negative beta since you'd never want to lend money at lower than the treasury rate. But if I head to the COMEX and buy a bunch of gold futures, I'm effectively buying with the expectation that I will earn less than the risk-free-rate. Meanwhile LIBOR is priced into the futures contract. So my expected outcome is a loss, while my lender's outcome is a gain, but if the market crashes, up go gold prices. I'm essentially paying for the positive skew. My "risky" equity cost of capital is actually lower than the risk free rate under this circumstance since under MPT, a well diversified portfolio of negative beta assets is expected to offset the returns on positive beta assets.
Any company can have any assets. So the real question here is whether there exists any asset which has positive skew that you can take out an effective option on by setting up a corporation and borrowing to buy it. And the answer is yes.
And this is why most options traders think MPT is a joke.
The original question has to do with primary equity and debt capital markets, not secondary trading and portfolio/investment management.
Not necessarily. The real answer should have been "Define company" and "Define the economic environment."
If the economic environment is borrowing in a safe, boring currency like USD and we're talking about a corporation with operating profits, the answer is "Generally never."
If a corporation can own only a non-operating assets and borrow against it (which is perfectly legal- in fact, many traders do this to limit liability), though, there's plenty of ways to do that. Also, small loans relative to assets made in risky currencies viewed through the lens of a less risky currency or inflation-adjusted returns also complicate things.
Debt is really just a covered short barrier call position on the assets of a firm, with the covenants defining the extent of the barrier.
Not saying you're wrong but all of this is completely irrelevant in a banking interview (which is what the OP had). This was a basic corporate finance/valuation/CAPM/WACC question. You and the OP are both over thinking this. If you started to ramble on about risky assets, safe borrowing environments, currency/inflation adjusted returns, negative betas, and hedging, you would probably be cut off mid-rant and asked to leave.
i will agree that since this is a phone interview the idea is to keep it short and you should just say "never"
however a less obscure example is start up/high growth companies with negative cash flow
it is pretty much impossible for them to borrow money so the cost is infinite, however they can raise equity so cost equity
Fair enough. Most of us folks in the quant and trading world would have a lot of fun in a banking interview trying to find out where the interviewer cracks in terms of financial and economic analysis after they told us what (they believed) the actual answer was. And that's probably why we'd never get an offer from you guys.
If OP wants to get the offer, this probably isn't the way to do it.
If the interviewer had the kind of arrogance/intellect ratio you sometimes find in banking and the OP just wants to make the interviewer aware of his ratio, this "Never/Always" question was waaay too easy.
Illini, are you coming to happy hour on Monday?
Yup. You too?
Yes sir. I'll see you then.
Awesome.
In an Unlevered firm, shareholder should only be compensated for bearing a business risk on Fcf.
Soon as firm is levered up, it taks an additional risk: financial risk from leverage making Fcf more volatile and putting shareholder in the back seat of Fcf line.
So, for a right management, they will compensate shareholder with a higher return for letting management to take leverage risk.
However, it reduces WACC since interest is deductible, producing a higher value for a firm.
Do I sound too text book?
Cost of equity will ALWAYS be higher than cost of debt. Period.
Think about it, under what cases would a debt holder be given a higher return AND higher seniority to an equity claim? None.
What about the case for preferred shares? Cost of equity is greater than that of debt is due to higher riskiness. But for preferred shares which has some fixed income characters, this could be a different case I think. Any thoughts?
How so? It's still the low man on the totem pole against all other forms of debt in the event of a bankruptcy. Therefore, naturally it should require a higher cost/return.
Guess you are right. I was started with convertible debt and lost myself.
In any case can cost of equity be equal to costy of debt?
No. Cost of debt is always lower than cost of equity. Even as you increase leverage and the cost of debt increases, the cost of equity will also increase and always remain above the cost of debt. Always.
If you have an equity that pays off more in bad economic situations, that's more valuable in risk-adjusted terms compared to risk neutral than a bond that pays off the same in all situations.
There can be various scenarios where companies have a binary event payout structure under which cost of equity could be less than cost of debt.
the actual current cost of debt that the company is actually paying can possibly be higher than the cost of equity (due to poor timing, fx rates, etc.), but the theoretical forward looking cost of debt that is used to compute WACC can never be higher than the cost of equity
Reading through this threas I am fairly surprised the "negative beta" debate started so late. Nice thread.
It's not just negative beta, though. The problem with CAPM is that it assumes we have a continuous set of states in the economy that only run along one dimension- the price of the S&P 500.
It is possible to have negative outcomes for the economy where the S&P 500 winds up being very high- if oil prices go to $1000/barrel, that's a negative situation for most consumers, but the S&P 500 will probably go to 5000- and 90% of that will be the market cap of oil companies.
If that situation were certain, most consumers would pay $1.25 for an inflation-adjusted $1 in that future state where they will have to consume less. They'd suffer a negative return for a positive beta stock, and in the right distribution of state outcomes, would be willing to accept negative returns on the equity while demanding positive returns on the bond.
Historically, the best situation I can think of to debunk this claim is gold miners where traditional CAPM agrees with C-CAPM, but there can be situations where people may take negative returns on "positive beta" stocks.
These sorts of insights- as well as pricing the state optionality of takeover targets- are why it makes some sense for a PE firm to have at least one or two quants on the team and make occasional use of quantitative methods in valuations.
Hi there,
I'm not a quant and I like when things can be explained easily. So i won't argue with your quant-oriented answer because it sounds legit and i won't pretend i have the weapons to fight it. However, if you allow me, your gold mines example inspired me to find what seems an easy to understand exemple. I'd be glad if anyone finding it wrong could give me his argumentation: So if we think about a gold mine that we know will allow us to extract a lot of gold for the next 5 years and after this period will enable to extract an amount M with a very high variance (ie experts cannot say for sure if there still be tons of gold or no gold left after 5 years). In that case, i'm pretty sure you can have a cost of equity inferior to cost of debt : If you think about a 10 year matury financial debt, in 5 years debt holders have a high risk of not beeing repaid while shareholders expect so much money in the 5 first years of the gold extraction that even if the mine ends up beeing empty after five years they will have more than their required return. How does that sound? I'm pretty sure that if there is a flow in this argumentation it should stem from something i miss in the way the required return of such investor would be constructed.
Best.
Cost of debt versus Cost of Equity (Originally Posted: 01/02/2014)
In the WSO guide, someone was asked: "Graph WACC vs. cost of debt. Now cost of debt vs. cost of equity."
Any ideas on how to do this?
Situation specific. What krhender913 said above makes the most sense to me.
It will look like a downward sloping parabola empirically. The important thing to know is that, as debt increases initially in the capital structure, WACC will decrease because the cost of debt (and the additional tax shield) is less than the cost of equity. WACC will decrease until a point, at which the amount of leverage in the company makes it a risky investment because there is a potential that the company won't be able to make interest payments, and therefore both the cost of debt and cost of equity will rise dramatically. At this point, WACC rises again until the company reaches a capital structure with just debt (which is going to be very expensive). Feel free to follow up if this is unclear.
Not much to add to thezone here except maybe the graph that illustrates the whole thing: http://analystnotes.com/graph/l2/08/SS0829003.gif (unfortunately don't know how to embed pictures) I'd argue that both cost of debt and equity will be more "exponential" in their nature but this should suffice.
Interview Questions - How to come up with cost of equity (Originally Posted: 01/19/2010)
Hello all,
I am interviewing with a bank soon and have contacted one of the alums of my school who work there for advice. He gave me a few helpful tips tips, a couple of items I have questions about:
1) how to come up with the cost of equity using CAPM and how that changes when valuing a private company in terms of finding a beta, and how to determine an appropriate cost of debt in today's credit markets.
2) how to derive multiples from comps and how to adjust those multiples to make them applicable to your subject company. Also know the difference between the outcome of the two approaches (company comp & transaction comp) on a control versus minority basis and why the control premium exists.
For part 1) of course I know the CAPM formula, but can someone elaborate on the later parts? I am not sure about the beta (don't you just find it on yahoo finance and plug it into CAPM?) part and also the cost of debt part.
For part 2) i know that you find company comps via similar industries, regions, sizes, etc. However I do not know much about transaction comps and don't knwo the detailed difference between the two. I also do not know what's control vs minority basis and control premium?
If anyone can explain that would be great, thanks!
You compute beta by doing a linear regression on the stocks return.
control vs minority basis and control premium: consolidation methods perphaps?
Wikipedia is a pretty good place to start for stuff like this.
First, read the latest Vault Guide on Finance interviews and you'll have your answers there.
During an interview, I wouldn't say that you find beta equity by looking at yahoo finance. I've never been asked anything on deriving beta, so I wouldnt worry. More importantly, I'd know why CAPM is important...i.e. in your WACC formula, it's your cost of equity. With wrong CAPM, you get the wrong WACC, which leads to wrong discount rate, which means wrong NPV. Anyways, the risk-free rate is generally your T-bill rate. I'm not completely sure on this but for your market rate of return, let's say you are projecting cash flows for 5 years into the future, then you'd use historical market data for the last 5 years.
Cost of debt is usually found by risk-free rate + default premium (i.e T-Bill + Credit Risk Rate).
Hope this helps.
When calculating Cost of Equity for the WACC calculation....playing with excel models (Originally Posted: 06/24/2013)
When calculating Cost of Equity what would be an alternative to Beta as It is a rearview mirror... Maybe Implied volatility as it is "forward" forecasting ? Also how do you approach cost of debt as total YTM on all outstanding debt is quite hard to find/calculate. (I know of credit rating to yield tables available but represents huge assumptions/averages
For cost of debt: look in 10-k, they will list/you can figure out WA interest rate and maturity in aggregate.
Would I use (interest expense/total debt) / WA amortization period for maturity in aggregate. ?
debt ratio and the cost of equity (Originally Posted: 06/11/2015)
Suppose that total asset of a company is constant while debt rate gets higher. Can anyone tell me what happens to the cost of equity?
I think the cost of equity will increase due to the bankruptcy risk.... Am I correct?
The cost of equity isn't entirely effected by debt but can be depending on the situation
If you're referring to an increase in the firms overall debt at a huge rate or an increase in the interest rate, then yes, their cost of equity will increase due to an increase in the default risk premium as investors would like to have a higher risk premium to compensate for the additional interest payments which in turn would make the firms returns more volatile thus raising the cost of equity.
In your scenario... Cost of Equity goes up, Cost of Capital goes down
Why is this so? Shouldn't WACC go up when cost of debt and cost of equity both increases?
cost of equity (Originally Posted: 07/03/2015)
hi guys, Im struggling to calculate the cost of equity for real estate investment, please help - this should be different than normal cost of equity which is found either by CAPM or Dividend growth model also how to choose appropriate discount rate for DCF
many thanks to you all
Cost of equity should be the equity returns required by the investor. That depends on the asset you're investing in, the class, the holding period, and the strategy (core, value-add, distress). To get this, you would look at comps and what market equity investors have been getting for the investment, which will fluctuate with overall risk free rate, so sort of like the CAPM. PwC publishes national equity yield rates on average, which would capture your cost of equity; discretion needs to be made between levered and unlevered cost of equity too.
WACC, Cost of Equity, Cost of Debt Help. (Originally Posted: 06/24/2013)
When calculating Cost of Equity what would be an alternative to Beta as It is a rearview mirror... Maybe Implied volatility as it is "forward" forecasting ? Also how do you approach cost of debt as total YTM on all outstanding debt is quite hard to find/calculate. (I know of credit rating to yield tables available but represents huge assumptions/averages
There should be some existing threads on this forum about this actually. I'm not entirely sure myself, but I hope you find an answer.
You would have to estimate the cost of debt yourself.
you can do this by estimating a default spread over the risk free rate... Damodaran has tables with regards to this. Basically you find what the interest coverage ratio is to determine the spread. This is most most effective when company bonds are not traded.
The beta you insert to your cost of equity is forward looking... us bottom up betas (i.e. sector betas). You find the unlevered sector beta and relever it the D/E ratio.
Btw when doing this you should be using market weights for debt and equity.
For equity market value you look at yahoo and for debt you estimate it by trying using a present value of annuity formula. example... use normalized interest expense for C and total face value for P
C*( (1-1/1.075^6) / 0.075) + P/1.075^6
0.075 is the discount rate and 6 is the face value weight maturity of all outstanding debt.
The reason we use yield tables is because they can be interpreted as forward looking. There are alternatives such Z score analysis that is used by S&P and other credit analyst but the default measures tend to be highly correlated and therefore redundant.
Who is "we"? Do you mean on your junior-year finance exam? I can assure you nobody in real life actually does anything you just discussed.
Woah, calm down buddy!
Damodaran Investment Valuation ... all taken from his book
But who the hell is a Finance Professor at Stern anyway? http://pages.stern.nyu.edu/~adamodar/
Again, nobody uses yield tables in real life. Nobody in banking, nobody at a hedge fund, nobody at a PE firm...NOBODY. You would get your ass laughed out of any interview (or meeting) if you suggested doing that.
And you do what instead. Altman Z-score? Backward looking financial statements? i would use corporate bonds first but obviously not everyone has traded bonds.
And what was wrong with everything else I said? Do you suggest using book value of debt as weight instead?
And as far as betas are concerned for cost of equity, what would you do if you were valuing a private company that you cannot run a regression beta on or a public one that has illiquid market for shares? you would need to rely on sector betas. alternatively you can use an adjusted beta, but the weights tend to be trivial (apart from applying the well known fact that betas tend to 1 over time).
Can you provide your alternatives?
Also I highly doubt that someone who has been credited by Business Week as one top 12 U.S. business school professors and has been published in The Journal of Financial and Quantitative Analysis, The Journal of Finance, The Journal of Financial Economics, and the Review of Financial Studies would be 'laughed' out by anyone.
A PE firm should be the first to recognise that they cannot rely on regression betas to find the cost of equity.
also as far as hedge fund 'wisdom'...
refer to economist article "Hedge funds: Going nowhere fast" with a nice graph showing I would have been better off investing in ishares...
I can tell you what I don't do is blindly apply highly theoretical formulas.
You are very, very lost.
lol what formulas are "theoretical"?
a present value of an annuity is a present value of an annuity, there is nothing theoretical about it.
I love all the great array of alternatives you have provided btw...
How would I get cost of debt? I'd spend two weeks learning the company inside and out, and understanding the market for its publicly traded comps. From there I'd estimate where it would likely issue new debt and also apply a further premium, once again based on current market conditions, for the fact it's a new and possibly unknown issuer.
This shit is an art, not a fucking brainless science where you just say "I'm supposed to plug into this formula here, or that formula there."
So my question back to you is what is your experience or are you just flipping through your finance textbook? Because you also seem to not be able to link any ideas coherently.
No I am relying on an accredited finance professor who has respect among professors and practitioners. And are how are the ideas incoherent? It is all internally consistent.
How would you decide that premium? Would it be as arbitrary as the illiquidity premium placed on many private companies? Read Damodaran's article in CFA magazine where he asks practitioners to stop applying arbitrary premiums.
Also the fact that you look at publicly traded comps shows that you are using industry averages.
Its not about being a 'brainless science', the yield tables can give you a starting point (there are yield tables for different industries and market cap categories) and you can adjust it for qualitative factors but at the end of the day it instills discipline into the process.
Also what everything else I said? - Bottom up betas - Market Weights for determining WACC - Implied Risk premium
Also I wouldn't go as far as calling it an art lol. I never said that the yield table is an end of itself but it does provide a starting point.
Again, do you have any real world experience or are you just an NYU student/grad who takes everything Damodaran writes as gospel?
Damodaran is great when he distills abstract valuation concepts into intuitive ideas. But a lot of stuff he produces is also highly impractical.
You should learn to distinguish between the two.
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