Cost of capital is the average cost of a company to borrow funds from lenders or raise capital from non-bank shareholders – typically used as a measure for a business’s financial solvency. Bottom-up financial modeling is a technique used to develop an accurate assessment of the potential value of a business. By combining these two sources of information, companies can estimate the cost of capital using a bottom-up financial modeling approach.
Definition of Cost of Capital
Cost of capital refers to the rate of return required by the company to pay off the liabilities it has incurred. It includes interest, debt repayments, dividends, and other costs associated with raising funds. The cost of capital also represents the rate of return that shareholders should expect from investments made in the company. This is the rate used to establish the organization's threshold for acceptable investments.
Description of Bottom Up Financial Modeling
Bottom-up financial modeling is a powerful tool for estimating the cost of capital. It combines the company's financial information, such as revenues and expenses, with external market data to build a financial model for an organization. The model used for estimating the cost of capital is based on the company’s current and past financial information, as well as its future prospects. The model combines these sources of data to provide a basis for predicting the future cost of capital.
- Revenues and expenses
- External market data
- Company’s future prospects
- Current and past financial information
- Cost of capital is the average cost of a company to borrow funds from lenders or raise capital from non-bank shareholders
- Bottom-up financial modeling is a technique used to develop an accurate assessment of the potential value of a business
- Revenues and expenses, external market data, the company’s future prospects, and current and past financial information are required for bottom-up financial modeling
- Cost of capital also represents the rate of return that shareholders should expect from investments made in the company
Advantages of Bottom Up Financial Modeling
When estimating the cost of capital, a bottom up financial modeling approach offers several advantages. Not only does it provide a more clear view of all the sources of funds, but it also helps remove risk and highlights opportunities.
Detailed Model Removes Risk
A bottom up financial model provides a great deal of detail which can help to eliminate some of the unknowns associated with forecasting. This details not only provides more information, but more certainty as well. Because of the volume of detail included, the risk involved with making incorrect assumptions and judgements is much reduced.
Clear View of Sources of Funds
The benefits to estimating the cost of capital with a bottom up financial model continue with having a clear view of all the sources of funds. With such a detailed approach, it is much easier to recognize how much each source contributes to the overall cost. This eliminates the need to make assumptions regarding funding sources that may not be accurate.
Estimating the cost of capital with a bottom up financial model also provides the advantage of highlighting potential opportunities. When the model is detailed enough, it is much easier to see where certain efficiencies can be achieved, as well as any potential flaws in the current strategy. This advanced level of analysis is much more difficult to attain with more traditional methods.
Drawbacks of Bottom Up Financial Modeling
Creating financial models from scratch requires advanced business, financial and accounting knowledge, as well as proper financial modeling skills. Though Bottom Up Financial Modeling is a crucial part of the financial analyst's toolbox, it often involves several drawbacks.
Bottom Up Financial Modeling requires significant learning time and repetition in order to build proficiency in producing accurate financial models. Calculating the cost of capital using this method requires basic knowledge about financial modeling, along with an expert eye to ensure accuracy. Even with experience, building an accurate model from start to finish can take a significant amount of time. As the model grows complex, so does the amount of time required to develop and construct it.
Time Requires for Refinements
Accuracy is of utmost importance when discussing financial models. Usually, it takes considerable time and effort to refine the model such that it produces the right result. There are different scenarios that need to be tested and assumptions that need to be validated in order to make sure the ultimate result – cost of capital – obtained is accurate. This process can take a significant amount of time and effort.
Complexity Increases with Model Scope
The complexity of financial models increases with the scope covered by the model. The more complex the model, the more difficult it becomes to control the accuracy and predict any potential variance. It also increases the time to build and maintain the model, further impacting the cost of building the model.
Estimating the Cost of Capital with Bottom Up Financial Modeling
4. Steps in Estimating Cost of Capital using Bottom Up Modeling
a. Collect Data
The process of estimating cost of capital using the bottom up financial modeling starts with collecting relevant data for making informed decisions. Apart from data about the company, like revenue, profits, losses, cash flows, etc., you need to consider market data to help in forecasting the future market values of these filings.
b. Create Model Scenarios
Using the gathered data, you then need to create model scenarios, incorporating potential changes in the financial impact due to future events such as GDP growth, interest rate changes, demographic outlook, etc. As the number of variables considered increases, the analyst should strive to reduce the assumptions made, to minimize their influence on results.
c. Estimate Cost of Equity
After creating the model scenarios, the next step is to calculate the cost of equity. This is mainly done by employing the Capital Asset Pricing Model (CAPM) which assumes a set risk-return profile for a stock of an individual company. It takes into account the expected risk-free rate, market risk premium, the beta of the stock relative to the market and the equity risk premium.
d. Estimate Cost of Debt
The next step is to estimate the cost of debt. Generally, this is done by referencing the latest debt issuances of the company in question. Additionally, the weighted average cost of debt for the entire sector, can be used as a proxy for the company debt costs, if there aren’t any recent debt issuances of the company.
e. Accounting for Risk
Risks associated with the company, such as macroeconomic risk, geopolitical risk and industry risk are also accounted for. This may include changing tax rates, costs of labor, inflation estimates, private equity, foreign currency risk, environmental risks and market share risk, etc. All these factors should be considered while assessing cost of capital.
f. Calculating WACC
Finally, the Weighted Average Cost of Capital, or WACC, is estimated by calculating the average of the cost of equity and cost of debt, and weighting them based on the company’s capital structure. Once each component of the capital has been assigned a cost, the resulting WACC figure gives an indication of the rate of return the company is expected to generate in the future.
In order to understand how bottom-up financial modeling can be used to estimate the cost of capital, it is helpful to consider an example. We will review a case study regarding a company that is in need of financing.
The company given in this case study seeks financing to cover a large purchase. This purchase involves machinery and other elements that are necessary for the ongoing operations of the company. The estimated cost of the purchase is $2 million. This purchase is expected to be depreciated over a five-year life and generate savings in operating costs of $300,000 per year.
- The company is expecting to raise the full $2 million from outside sources.
- The company does not wish to issue any debt or equity in order to finance the purchase.
- The company expects to have annual savings of $300,000.
- The purchase is to be depreciated over 5 years.
- Financing costs are estimated at 5%.
In order to analyze the risks associated with this purchase, a bottom-up financial model was developed. This model included the following components:
- The estimated purchase cost, depreciation and resulting operating costs for the five-year period
- The expected financing cost and return on investment
- The impact of other factors such as inflation and exchange rate changes
The results of the financial model indicate that the cost of capital for this purchase would be roughly 4.5%, given the potential savings of $300,000 per year. This cost of capital is lower than the expected financing cost of 5%, indicating that the purchase is likely to be a good investment for the company.
After appraising the cost of capital with bottom-up financial modeling, there are a few steps to take in order to properly arrive at a valid result. The following sections discuss refining assumptions, verifying results, and finally, communication of results.
As with any forecasting or modeling technique, the assumptions should be closely scrutinized for reasonableness and plausibility. A few common assumptions that need to be considered are the company’s tax rate, expected growth in the company’s cash flows, and the forecasted rate of return for long-term debt and equity. It is critical to closely examine all assumptions and thoroughly evaluate any revisions before arriving at an estimate.
To ensure the validity of the results, the next step is to calculate the weighted cost of capital using a top-down approach. Then, the ability to compare and verify the results using both a top-down and bottom-up method brings a degree of confidence to the estimate.
Communication of Results
When discussing the output of the businesses' cost of capital, it is important to speak in terms of rates. For example, if the cost of capital is estimated to be 12.2%, that implies that the company has the responsibility of generating return in excess of 12.2% for any investment of equity or debt capital in order to achieve a positive return.
When communicating the results, be sure to compare them to past results, industry benchmarks, and peer group averages to analyze performance. This comparison is important for understanding how the results should be interpreted. Also, it’s beneficial to use this method to consider how much capital a company may need to support the business strategy going forward.
Estimating the cost of capital with bottom up financial modeling involves thoroughly evaluating the stakeholder’s own situation and analyzing the impact of their financial decisions. A cost of capital serves as a foundation for the valuation of financial assets and helps to determine if projects and investments will be financially feasible. It also helps investors consider how much capital to allocate towards particular investments.
Summary of Methodology
This bottom up financial modeling approach offers a way to estimate an organization or individual's cost of capital. The main strategy consists of the following steps:
- Calculating the weighted average cost of capital (WACC)
- Calculating the cost of equity
- Estimating the total debt cost
- Adjusting for taxes
These steps help stakeholders understand the cost of capital that would be associated with investments and projects.
Application to Relevant Financial Decisions
The cost of capital has a major influence in decisions related to investments and projects. Organizations and individuals should use this bottom up financial modeling approach to estimate their cost of capital accurately in order to make sound financial decisions.
For example, organizations can use their cost of capital to determine if they should pursue a new project or if they should allocate more money towards an existing project. They can also use the cost of capital to compare different projects and investments and decide which one would yield them the highest returns. Citizens, too, can benefit from this approach by using their cost of capital to make decisions about their investments and retirement plans.
In conclusion, the bottom up financial modeling approach helps stakeholders estimate their cost of capital and use that information to make informed financial decisions.