Cost of Capital

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Cost of Capital

  • Matt Anderson

    I’m starting this thread in order to gain a better understanding of the techniques used in determining the weighted average cost of capital for pre revenue, research and development, and exploration stage companies. Granted I’m a new student to corporate finance so I’ll be making a lot of assumptions.
    So these types of companies all seem to have a few things in common and that is they usually don’t have any tangible capital assets in place. Therefore I would assume, because they don’t have any collateral, they would be less likely to receive debt financing from lenders. If this is the case, their only method of raising capital would be to finance strictly through equity, until they develop or acquire a tangible asset. So I’m assuming the correct way to come up with a cost of capital for research and development firms is to look strictly at the cost of equity capital. So how do we go about doing this?
    One popular standard risk and return model analysts seem to favor to determine the equity cost of capital is the capital asset pricing model. However I think this model may fall short in determining the correct cost of capital for these types of firms. Maybe I could give some reasoning for why I think this is but I’d be interested to know if so far I’m on the right track with my assumptions.

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  • Jeff Oxman

    Matt,

    This is a good start for a firm that has earnings, no me gusta for pre-revenue firms. For them, they need high-risk equity financing. In such a case, you have to use the required return of the owner. For a firm like this, that’d be upwards of 20% minimum. Maybe closer to 50%.

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      Rick Rule

      Jeff is correct.

      Given that the probability of success is less than the probability of failure for every exploration and research and development entity, that the probabilistic net present value of the enterprise is zero, and therefore any equity raised at any price above zero has a subzero cost of capital.

      This ignores several complex valuation discussions including intangible assets and capital, optionality etc.

       

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        Matt Anderson

        Understood, Rick. A sub zero cost of capital makes sense if the firm is never able to develop an economic asset but what happens when, for example, an exploration company makes an economic discovery with a positive NPV? Do the initial providers of equity capital finally get their returns in excess of 20 to 50%? Should we then differentiate the second round of funding needed to develop the asset and discount those cash flows accordingly by traditional cost of capital methods?

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      Matt Anderson

      Jeff,
      Thanks so much for confirming my suspicions. I read that the cost of equity is implicit whereas the cost of debt is explicit. So as you say, with regards to pre revenue firms, the cost of equity is determined by the owners high-risk required return which can vary. When discussing firms with earnings, should we look at the CAPM as the best tool in the shed but not the be all and end all when determining the cost of equity?

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      Rick Rule

      Jeff

      For exploration or process R&D, our prospective return on equity requirement is 35%. I hasten to say we don’t always achieve that.

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        Jeff Oxman

        Of course – like VC, it’s a return weighted by the probability of getting nothing. Is that industry standard or how did you choose 35%?

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    Jeff Oxman

    Matt,

    So the CAPM is one model that falls under the classification of “factor risk models” or just factor models. It specifically says the only risk equity holders care about is the market risk, and there’s a lot of assumptions built into this result. There is also the Fama-French three factor model which includes size and value risk factors. But in the research there are something like 300 different identified risk factors, and so it’s hard to really believe any of them. Which is why people go back to CAPM. It’s not a good model, but it’s about the best one there is in terms of factor models.

    There’s a guy at Notre Dame, Peter Easton, who works on cost of equity, and he’s got a way of estimating it from accounting earnings. I haven’t looked at it in a while, but I recall it’s better than CAPM and such models.

     

     

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      Matt Anderson

      Thanks for that information, Jeff.
      Since there are so many different types of investors out there with different needs, it makes sense that there would be different models used for determining the cost of equity. When it comes to capital budgeting, doesn’t the decision to proceed in a project need a close to precise cost of capital though? It just seems that all of these various models could cause some confusion in a precise cost of equity.

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        Rick Rule

        Matt

        Precision is the stuff of dreams!

        As investors, and particularly as speculators, action is a function of the juxtaposition of probabilities, not about being right, but more right, or at least less wrong.

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        • Bruce Kent

          Rick please correct me if I am wrong, we have learned from you to Look for Value

          in this context also from the view point what we could loose. That is

          current liquidation value versus market capitalazation of a junior mining company.

          The easy part of the valuation are the redundant assets: add up cash substract debt and you get the liquid assets.

          The hard part is the valuation of the physical assets. Rules of thumb are common in the industry but dangerous.

          – For a producing asset you have a NPV calculation to make.

          Value it on a discounted cash flow basis: Take the cash flow going forward using todays prices and todays costs and discount the cash flow back at a 10 % discount like the SEC.

          Valuation of a junior exploration or development company is more nebulous:

          One way is to ask the technical people, geologists, engineers, the CEO of the subject company and those of one of their peers who ar familiar with the activity of the subject:

          What could you sell the company on the street for to Newmont e.g.. What would you get for it in cash.

          Another way to value it is if the company has an exploration project that is farmed out you could see what somebody else would be willing to pay for it to earn an interest in the project and assume what the real value of the company is, were it liquidated vesus what the market capitalization is. Market capitalization is what the public is willing to pay for the assets rapped in the story that is the company. Total market capitalization is all the shares outstanding times the per share prize adding debt if there is any.

          It is not an exact science it is just so much closer than most people get because most people never ask the question.

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        • Rick Rule

          Wonderful post especially your conclusion. We will never get it right, the search for perfection in this case is a form of procrastination, but we can understand the probabilities better than our competition, if only because they are lazy, and inept.

           

          Note also that discount rates are subject to internal debates, even within Sprott. Best to construct a simple economic model, and look at a matrix of results, utilizing a range of commodity price, discount and exchange rate inputs. Remember, all this, and you still won’t get it right.

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        • Bruce Kent

          Thank you for your excellent consideration. Quantifying the impact of risk on the cost of capital for any particular company or investment is arguably at once one of the most essential and one of the most difficult analyses in the field of corporate finance and investments, including valuation and capital budgeting.

           

           

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        • Rick Rule

          managers argue for discount rates based on inflation expectations, or market interest rates for benchmark securities, like LIBOR or the US 10 year treasury.

          For non investment grade issuers, with completed bankable feasibility studies, the senior project debt ( 65% loan to project expenditure) the total loan cost approaches 15%, and can include additional charges for political risk coverage.

           

          I would argue that the analyst should use a discount rate with a bias towards the projects cot of capital.

           

          Obviously, the issuers find this approach inconvenient.

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        • Matt Anderson

          Rick,
          If the expected returns for debt financing a bankable feasibility study are around 15%, what should the expected returns for equity holders be on a project? I’m assuming it would be higher than the debt holders as there is more risk involved for them. Do you find risk and return models, such as the CAPM, to be helpful in determining the cost of equity for the types of projects you mentioned?

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        • Rick Rule

          CAPM is a flawed model for developers, but all of the models in use are variations on it.

          Investors must use a very different set of decision making tools, paying attention to market imperfections and reactions.

           

          As to return requirements, if BFS documents were more consistent and reliable, A reasonably modest premium to debt ( project debt, unsupported on the issuers balance sheet is quasi equity) would be sufficient. My experience has shown that the imprecision in BFS documents and the volatility in commodity prices demand substantial premiums to debt in equity total returns,

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        • Matt Anderson

          It’s good to know that there are other measuring sticks used to determine return on equity and that not all is beholden upon the CAPM or similar models. It sounds like this is where we could get into some proprietary methods based on personal experience in the industry. I’d be interested to know more about your criteria for determining the cost of capital in the resource industry, within reason of course.

           

          It’s interesting to note that even BFSs can be imprecise. I’ve heard it said in the mining industry that no one knows how much economic ore can be extracted from a deposit until the last ounce of product is extracted and the mine is shut down. So¬†again, to yours and Jeff’s point, we can’t achieve perfection, especially in regards to what Mother Nature yields up from the ground, but we can get close or closer than others.

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        • Jeff Oxman

          Matt, you can check out Duff & Phelps, they do a reasonable job of estimating industry costs of capital: http://www.duffandphelps.com/insights/publications/cost-of-capital/index

          I think their risk-free rate is too high (4%) but it’s all pretty reasonable after that.

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    Jeff Oxman

    Precision is easy but deceptive. I can use one set of numbers and get one cost of capital and that’s (seemingly precise). Or I can use a bunch of tools and a bunch of numbers, and a bunch of scenarios, then I’ll have a range of costs of capital and thus a range of NPVs for a project. Then the managers use their best judgment to move ahead or not with a project. I use an example in class where I show a project (it was a gold mine in Nevada, come to think of it) was profitable at something like 10% discount rate, but unprofitable at 9%. So if you calculate a “precise” cost of capital at 9.5%, what do you do? It’s always a judgment call.

    Keep in mind, too, that a lot of businesses I’ve talked to about this use rules of thumb or arbitrary numbers, no models at all. So I’m kind of talking about what you should do, not what is generally done. I do think, though, that bigger firms have sophisticated treasurers who do know what they’re doing.

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    Matt Anderson

    Having a range of cost of capitals and a range of NPVs makes much more sense than trying to nail down a perfect scenario that more than likely won’t work out. Even when it comes to everyday investing, I think most investors have a myopic view on their portfolios in that they expect a certain outcome but there could be many different outcomes, some not so pleasant on their portfolios.

     

    I’m beginning to see that capital budgeting isn’t an exact science. There are so many variables, especially in regards to companies that produce a specific commodity that can fluctuate wildly depending on where it is in in the cycle. For example, having the price of oil go from $140 per barrel to $40. This must throw off NPV calculations in a huge way.

     

    Yes, I imagine most firms that use rules of thumb will more than likely have their asses handed to them in the end.

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    Jeff Oxman

    I want to echo what Rick & Yani were talking about, because it really can’t be said enough. I think Matt gets this, but hopefully there’s some folks trolling who can learn this too, and here it is: perfection is your enemy.

    In valuation, we want to use all our tools to help understand the company and come up with a valuation, yes, but even more than what we want to understand the firm and the value drivers so we can sort the wheat from the chaff. If you want to try to get more and more precision and more complexity, and I know many people do, that’s fine to a point, but eventually it’s just masturbating with a cheese grater: sort of interesting, but mostly painful.

    Finding that point where you’re crossing from good complexity to bad is hard. I think it’s a wisdom issue – wisdom coming from experience. And this assumes you have time to do the deep analytics. As a colleague once told me, sometimes you have to go before you know.

    I liken this to the internet trolls talking about nutrition or exercise. So many people are looking for the perfect diet or exercise program, which is completely non-productive. See above about cheese graters. The key is to start doing a little better each day. So with valuation: don’t worry about getting the precise tool or whatever. Just start working and improve a bit each day. There’s no substitute for actually doing the work.

     

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      Matt Anderson

      Jeff,
      Perfectly said. I see now that doing is learning and learning is doing. So with that, I need to practice my craft and utilize you and Rick’s and others expertise as guidance in analyzing companies. Granted I know next to nothing about creating spreadsheets with excel, although my wife has some experience using it, but will give it a shot.

       

      I’ve been utilizing Damodaran’s website. The guy has an unbelievable amount of information from undergraduate to MBA courses on there, so that’s helping quite a bit. However, the draw back to the whole online learning process is that you can’t ask questions to the professor. So It’s nice supplement his teachings with feedback from you guys.

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        Rick Rule

        The thing to do is practice and employ. Do it publicly where people can,watch, comment and compare.

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        • Matt Anderson

          Will do, Rick. Do you have any companies in mind for a simple and easy to understand valuation?

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        Jeff Oxman

        I can send you some basic material if you want (let me know), but there’s lots of books on using Excel to create financial models.

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        • Matt Anderson

          I would definitely be interested in the material. You can inbox me here and we could exchange emails if you’d like. I’m sure creating spreadsheets can’t be too difficult with a little practice. Any material you can send would be appreciated.

          Thanks for the link on the different industry costs of capital too.

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    Bruce Kent

    Gentlemen, again any corrections, suggestions and comments are welcomed.

    Mines are made not found, it takes people to find the ore, lift it and make it into money. If I am not mistaken, other critical questions Rick has generously taught us to consider to ask the CEO of a junior mining company in this context are:

    Tell me about your management Directors, especially their past succeses ( technical and financial) in mining and markets.

    Although there are hundreds of thousands of earth scientists in the world there are estematly between 10.000 and 12.000 economic producing mines. A prospector is consequently more willing to approach a team that has already been successful in the past, just as a stock broker would more readily be willing to provide this kind of team with capital and on better terms.

    It is important to get very specific with the resumees of the officers. It is not enough to hear that someone was successful in mining. In what capacity were they successful? Were they an explorationist? Did they as an engineer turn around a mine that had been failing? Did they come from the land acquisition side? Was their success due to politics? What specific talents do they have to bring to a project. Mining business is a very diverse business so one skill set is not necissarily suited to another task. The range of skill sets involved in prospect generation and exploration are very different from skill sets in mine production or mine construction.

    More over past success in the financial part of the mining industry rather than just the technical part is critical. As a minority shareholder you look for people who can raise money, people who can access financial markets. It is not enough that a team makes a mine, they have to make you money, making a mine.

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