Cost of Capital based on credit rating and ERP
Hello
I talked to a HF manager (bottom-up) about how he is going about estimating cost of capital. In the email he said that he is using a "build-up method from the corp". He then gave me an example where BBB+ company normalized 10 year is ~4% plus normalized credit ~1.3% plus erp ~3.5%.
I am having a hard time understanding where those numbers are coming from. Could anyone please provide some details? Is is some kind of an average BBB+ yield? How do I get this number for BBB-? What does normalized credit means? And I assume erp is Equity Risk Premium, where do I get that too?
Thanks a lot, I appreciate your time and efforts very much.
1) Yes, there are average yield for bonds by maturity/credit rating. They're available on bloomberg.com. 2) "Normalized" sounds like his way of accounting the historically low rates we have today. Maybe the LT average for a BBB+ company is 5.3%? Don't know, don't care. 3) Yea, ERP = equity risk premium. Sounds like he want to use a ~9% discount rate and is working backwards.
If you want to see a good way to estimate the overall equity risk premium, check out Damodaran's website.
KarateBoy explained the definitions well. The equation (using the CAPM and WACC) is:
Cost of equity = risk free rate (ten year t-bond) + beta * implied equity risk premium
Cost of debt = number implied by credit rating = BBB+ = 4%
WACC = (cost of equity)(% equity) + (cost of debt)(% debt)*(1-t)
*using the market values of equity and debt for the percentages
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