How to Calculate the Cost of Capital

Andrew  —  December 26, 2011 — Leave a comment

The cost of capital is a key variable in the financial feasibility study besides revenue and cost inputs.

In practice it’s probably more common for real estate development projects to use industry norms for the cost of capital. Or, it could be a figure advised by the finance department at the head office. However, it’s useful to understand the principle behind calculating the cost of capital.

Weighted Average Cost of Capital (WACC)

The project cost of capital is a function of two weighted components – equity cost and debt cost. The industry term for this is the Weighted Average Cost of Capital (WACC).

Cost of Debt

The cost of debt is a function of the risk free rate plus the debt risk premium associated with the company. The debt premium is influenced by the company’s market capitalization, gearing, earnings and business risks.

For a standalone resort let’s simplify and summarize the cost of debt as the interest rate charged by lending institutions.

Cost of Equity

The cost of equity is a function of – the equity beta, the risk free rate and equity risk premium. These are inputs in the Capital Asset Pricing Model (CAPM) to determine the cost of equity :

Cost of Equity  =  Risk Free Rate  +  Equity Beta  x  Equity Risk Premium

Risk Free Rate

Government debt is commonly used as a reference for the risk free rate. The debt duration to use should be more or less be in line with the investment horizon. The investment horizon for resort projects should correspond reasonably well with the 10-year / 20-year government debt rates.

Equity Beta

This is a function of how the equity value of your asset moves in relation to the overall equity markets. The beta for your asset class can be observed in the price movements of public listed companies in similar industries. In the case of resort projects a good proxy could be Banyan Tree Hotels and Resorts which is listed on the Singapore Exchange or PT Bukit Uluwatu Villa Tbk , which owns several resort properties managed by Alila Hotels and Resorts and is listed on the Jakarta Stock Exchange.

Equity Risk Premium (ERP)

I’ve seen suggested ERP between 5% to 7%. These figures are based on very long term data from US equity markets.  Other approaches calculate the ERP using the inverse of the Market Price Earning Ratio less the risk free rate.

Liquidity Risk

On top of the WACC it makes sense to add a liquidity risk factor. Real estate assets are not like liquid financial products traded on exchanges. It takes time to off load a physical property therefore some consideration has to be given for liquidity risk.  Its is not an easy number to pin point but adding in something like 5% does not seem out of the question. For properties in mature locations this figures can be reduced while for properties in lesser know and remote locations the figure can be adjusted higher.

Development Risk

Development risk is another factor to take into consideration and add in an adjustment factor. The time between project inception and a final operating business is faced with many hurdles. Projects and locations  encountering higher development risk should have higher adjustment factor compared to one with less development risks. Let’s use 5% to begin with.

Expected Inflation

Another adjustment to the WACC is the expected inflation rate. Surely you don’t want your returns to be eroded by inflation? You can obtained expected inflation figures from country statistics.

WACC example

Let’s work out a pre-tax Adjusted WACC for a resort project given some sample figures. Your financial advisor will be in a better position to advise on the appropriate figures for your project.

Risk Free Rate = 3%

Equity Beta = 1.5 (for a start we don’t have an actual figure but common sense says that resorts should be more volatile than the market beta of 1)

Equity Risk Premium = 7%

Cost of Debt = 6%

Expected Inflation = 4%

Liquidity Risk = 5%

Development Risk = 5%

Gearing = 70%

Calculated Cost of Equity = 13.5%

WACC = 8.25%

Adjusted WACC = 22.25% (after adjustment for liquidity, inflation and development risk)

The adjusted WACC is a figure that you’d want to surpass for the IRR.  Alternatively, it’s the discount rate you use when calculating NPV.

Downloads:

You can download the above calculations here.  And further reading by Hishamuddin Mohd Ali: Modern Portfolio Theory> Is There Any Opportunity for Real Estate Portfolio?

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