•Cost of Debt = 12% + 1% = 13% •(This assumes the riskfree rate has no country risk premium embedded in it.)Approach 2: Use the differential inflation rate to estimate the cost of capital. For instance, if the inflation rate in BR is 8% and the inflation rate in the U.S. is 2%Cost of capital== 0.1644 or 16.44%
Aswath Damodaran58Dealing with Hybrids and Preferred StockWhen dealing with hybrids (convertible bonds, for instance), break the security down into debt and equity and allocate the amounts accordingly. Thus, if a firm has $ 125 million in convertible debt outstanding, break the $125 million into straight debt and conversion option components. The conversion option is equity.When dealing with preferred stock, it is better to keep it as a separate component. The cost of preferred stock is the preferred dividend yield. (As a rule of thumb, if the preferred stock is less than 5% of the outstanding market value of the firm, lumping it in with debt will make no significant impact on your valuation).
Aswath Damodaran59Decomposing a convertible bond…Assume that the firm that you are analyzing has $125 million in face value of convertible debt with a stated interest rate of 4%, a 10 year maturity and a market value of $140 million. If the firm has a bond rating of A and the interest rate on A-rated straight bond is 8%, you can break down the value of the convertible bond into straight debt and equity portions.•Straight debt = (4% of $125 million) (PV of annuity, 10 years, 8%) + 125 million/1.0810= $91.45 million •Equity portion = $140 million - $91.45 million = $48.55 million
Aswath Damodaran60Recapping the Cost of Capital
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