Set out the top-down and bottom-up influences on a firm's cost of capital
The idea
Cost of capital depends on the environment and on the company. Top-down factors are country and market conditions: capital availability and market depth, interest rates, inflation and the business cycle, the legal and regulatory framework including contract enforcement and investor protection, currency risk and capital controls, and political or country risk. Bottom-up factors are company-specific: volatility of revenue, earnings and cash flow; business model and size. The nature of assets matters too, since tangible assets that can be pledged support cheaper secured borrowing. So do financial leverage and the features of each security, such as seniority, collateral and covenants. The trap is swapping the categories, for example calling a company's cyclical revenue a top-down factor.
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- Contrast the approaches for estimating what debt costs a firm
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- Contrast the approaches for estimating equity investors' required return
- Work out the cost of debt or equity investors' required return for both a listed and a privately held company
- Benchmark a company's cost of capital and capital structure against those of its peers