Project Appraisal

Swagat Kishore Mishra

Department of Economics and Finance
WILP: Project Appraisal
Lecture 10
Email: swagat@goa.bits-pilani.ac.in
Tel. 0832-2580207 (O) 08879506995 (M)

Course No. ETZC414

Project Appraisal

September 16, 2014

Cost of Capital

The Cost of Capital

To value a company using enterprise DCF, we discount free cash flow by the weighted
average cost of capital (WACC). The WACC represents the opportunity cost that
investors face for investing their funds in one particular business instead of others with
similar risk.

In its simplest form, the weighted average cost of capital is the market-based weighted
average of the after-tax cost of debt and cost of equity:

D
E
WACC k d (1 Tm ) k e
V
V
To determine the weighted average cost of capital, we must calculate its three
components: (1) the cost of equity, (2) the after-tax cost of debt, and (3) the
companys target capital structure.

Successful Implementation Requires Consistency

The most important principle underlying successful implementation of the cost of
capital is consistency between the components of WACC and free cash flow. To
assure consistency,

It must include the opportunity costs from all sources of capital debt, equity,
and so onsince free cash flow is available to all investors.

It must weight each securitys required return by its market-based target weight,
not by its historical book value.

It must be computed after corporate taxes (since free cash flow is calculated in
after-tax terms). Any financing-related tax shields not included in free cash flow
must be incorporated into the cost of capital or valued separately.

It must be denominated in the same currency as free cash flow

It must be denominated in nominal terms when cash flows are stated in nominal
terms

The Cost of Capital: An Example

The weighted average cost of capital at Home Depot equals 9.3%. The majority of
enterprise value is held by equity holders (91.7%), whose CAPM-based required
return equals 9.9%. The remaining capital is provided by debt holders at 2.9% of
an after-tax basis.

The Cost of Capital: Home Depot

Source of
capital

Debt

Proportion
of total
Cost of
capital
capital

8.3%

4.7%

Equity

91.7%

9.9%

WACC

100.0%

Marginal
tax rate

38.2%

After-tax
opportunity
cost

Contribution to
weighted
average

2.9%

0.2%

9.9%

9.1%
9.3%

Lets examine the components of WACC oneby-one, starting with the cost of equity

The Cost of Equity

To estimate the cost of equity, we must determine the expected rate of return of the
companys stock. Since expected rates of return are unobservable, we rely on assetpricing models that translate risk into expected return.
The three most common asset-pricing models differ primarily in how they define risk.
The capital assets pricing model (CAPM) states that a stocks expected return
is driven by how sensitive its returns are to the market portfolio. This sensitivity is
measured using a term known as beta.
The Fama-French three-factor model defines risk as a stocks sensitivity to
three portfolios: the stock market, a portfolio based on firm size, and a portfolio
based on book-to-market ratios.

The Arbitrage Pricing Theory (APT) is a generalized multi-factor model, but

unfortunately provides no guidance on the appropriate factors that drive returns.
The CAPM is the most common method for estimating expected returns, so we begin
our analysis with that model.
5

The Capital Assets Pricing Model

The CAPM postulates that the
expected rate of return on a
companys stock equals the riskfree rate plus the securitys beta
times the market risk premium:

Expected return
Percent

E[Ri] = rf + Bi (E[Rm] rf)

To estimate a stocks expected
return, you need to measure
three inputs:
1. The risk-free rate

2. The market risk premium

Beta (systematic risk)

3. The stocks beta

Component 1 of the CAPM: The Risk Free Rate

To estimate the risk-free rate, we look to government default-free bonds. For
simplicity, most valuation analysts choose a single yield to maturity from one
government bond that best matches the entire cash flow stream being valued.
For U.S.-based corporate valuation, the most common proxy is the 10-year
government bond rate. This rate can be found in any daily financial publication.
Yield to Maturity on Government Bonds

Percent

Ideally, each cash

flow should be
discounted using a
government bond with
a similar maturity.

Source:Bloomberg

Years to maturity

Component 2 of the CAPM: The Market Risk Premium

Sizing the market risk premiumthe difference between the markets expected return
and the risk-free rateis arguably the most debated issue in finance.

Methods to estimate the market risk premium fall in three general categories:
1. Extrapolate historical excess returns. If the risk premium is constant, we can
use a historical average to estimate the future risk premium.
2. Regression analysis. Using regression, we can link current market variables,
such as the aggregate dividend-to-price ratio, to expected market returns.
3. Use DCF to reverse engineer the risk premium. Using DCF, along with
estimates of return on investment and growth, we can reverse engineer the
markets cost of capital and subsequently the market risk premium.

None of the methods precisely estimate the market risk premium. Still, based on
evidence from each of these models, we believe the market risk premium as of yearend 2003 was approximately 5 percent.

Method 1: Use Historical Excess Returns

Investors, being risk-averse,
demand a premium for holding
stocks rather than bonds.

Historical Annual Market Risk Premium, 1900-2002

If the level of risk aversion hasnt

changed over the last 100 years,
then historical excess returns are a
reasonable proxy for future
premiums. But many econometric
issues quickly arise. For instance,

Which risk free rate should be

used to compute the excess
return?

Which method of averaging is

better, arithmetic or geometric?

Percent over bonds

Japan
Germany
Australia
Italy
Sweden
South Africa
United States
The Netherlands
Median
France
Canada
United Kingdom
Ireland
Spain
Switzerland
Denmark

Arithmetic
mean
9.5
8.7
7.6
7.6
7.2
6.8
6.4
5.9
5.9
5.8
5.5
5.1
4.8
3.8
2.9
2.7

Geometric
mean
5.4
4.9
6.0
4.1
4.8
5.2
4.4
3.8
4.0
3.6
4.0
3.8
3.2
1.9
1.4
1.5

Standard
deviation
33.3
29.7
19.0
30.2
22.5
19.4
20.3
21.9
20.3
22.1
18.2
17.0
18.5
20.3
17.5
16.0

Source: Ibbotson Associates: Dimson-Marsh-Staunton (DMS), 2003

Is a prediction based on U.S.

data too high?
9

Using Historical Excess Returns: Best Practices

To best measure the risk premium using historical data, you should:
Calculate the premium over long-term government bonds
Use long-term government bonds, because they match the duration of a
companys cash flows better than do short-term rates.

Use the longest period possible

If the market risk premium is stable, a longer history will reduce estimation
error. Since, no statistically significant trend is observable, we recommend the
longest period possible.

Use an arithmetic average of longer-dated intervals (such as five years)

Although the arithmetic average of annual returns is the best predictor of future
one year returns, compounded averages will be upward biased (too high).
Therefore, use longer-dated intervals to build discount rates.

Adjust the result for econometric issues, such as survivorship bias.

Predictions based on U.S. data (a successful economy) are probably too high.
10

Method 2: Regression Analysis

Predicted Market Risk Premium

Using advanced regression

techniques unavailable to earlier
authors, Jonathan Lewellen of
Dartmouth found that observable
variables, such as dividend
yields, do predict future market
returns.

based on the dividend to price ratio

9
7
5

Plotting the models predictions

reveals one major drawback: the
risk premium prediction can be
negative!
Other authors question the idea
of using financial ratios, arguing
unconditional historical averages
predict better than more
sophisticated regression
techniques.

Percent

3
1
-1
-3
-5
1955 1960 1965 1970 1975 1980 1985 1990 1995 2000
Source: Lewellen (2004); Goyal and Welch (2003); McKinsey analysis

11

Method 3: Reverse Engineer Discounted Cash Flow

Using the principles of discounted cash flow, along with estimates of growth, various
authors have attempted to reverse engineer the market risk premium.
We use the key value driver formula to reverse engineer the market risk premium.
After stripping out inflation, the expected market return (not excess return) is
remarkably constant, averaging 7.0%.

Predicted Market Risk Premium

By reverse engineering market DCF
20

Subtracting the real

interest rate of 2.1%
from our estimate of
7.0% leads to a risk
premium just under 5%.

Percent

15

10

5
0
1962

1972

1982

1992

2002
12

Component 3 of the CAPM: Measuring Beta

The most common regression

used to estimate a companys raw
beta is the market model:

R i R m
Based on data from 1998-2003,
Home Depots beta is estimated
at 1.37

The Beta for Home Depot

Percent

Home Depot monthly

stock returns

According to the CAPM, a stocks

expected return is driven by beta,
which measures how much the
stock and market move together.
Since beta cannot be observed
directly, we must estimate its
value.

S&P 500 monthly returns

13

Estimating Beta: Best Practices

As can be seen on the previous slide, estimating beta is a noisy process. Based on
certain market characteristics and a variety of empirical tests, we reach several
conclusions about the regression process:

Raw regressions should use at least 60 data points (e.g., five years of monthly
returns). Rolling betas should be graphed to examine any systematic changes in a
stocks risk.

Raw regressions should be based on monthly returns. Using shorter return periods,
such as daily and weekly returns, leads to systematic biases.

Company stock returns should be regressed against a value-weighted, welldiversified portfolio, such as the S&P 500 or MSCI World Index.
Next, recalling that raw regressions provide only estimates of a companys true beta,
we improve estimates of a companys beta by deriving an unlevered industry beta
and then relevering the industry beta to the companys target capital structure.

14

An Alternative Model: Fama & French

In 1992, Eugene Fama and Kenneth French published a paper in the Journal of
Finance that received a great deal of attention because they concluded,

In short, our tests do not support the most basic prediction of the
SLB [Sharpe-Lintner-Black] Capital Asset Pricing Model that average
stock returns are positively related to market betas.
Based on prior research and their own comprehensive regressions, Fama and French
concluded that:
Equity returns are inversely related to the size of a company (as measured by
market capitalization).
Equity returns are positively related to the ratio of the book value to market value
of the companys equity.
With this model, a stocks excess returns are regressed on excess market returns, the
excess returns of small stocks over big stocks (SMB), and the excess returns of high
book-to-market stocks over low book-to-market stocks (HML).
15

The Cost of Debt

The weighted average cost of capital represents the blended rate of return for a
companys investors, both debtholders and equity holders:

D
E
WACC k d (1 Tm ) k e
V
V
To compute the WACC, we must estimate the cost of debt (kd). To do this we look to the
yield to maturity (YTM). Although YTM represents a promised yield, it is a good
approximation for expected return for investment grade companies.

To compute yield-to-maturity, you have two options:

1. Compute the yield-to-maturity on long-term bonds by reverse engineering the
discount rate needed to set DCF equal to the price.

2. Compute the yield-to-maturity indirectly by adding a default premium (based on the

companys rating) to the risk free rate.
Lets examine the indirect method
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Typical Market Weights Across Industries

To place the companys

current capital structure in
the proper context, compare
its capital structure with
those of similar companies.

Industries with heavy fixed

investment in tangible assets
tend to have higher debt
levels.
High-growth industries,
especially those with
intangible investments, tend
to use very little debt.

Median Debt-to-Value, 2003

In percent
Information technology
Healthcare
Aerospace and defence
Industrial machinery
Consumer discretionary
Consumer staples
Oil and gas
Chemicals, paper, metals
Telecommunications
Airlines

0
4
12
13
15
19
22
26
30
33
47

Utilities

Note: Market value of debt proxied by book value. Enterprise value proxied
by book value of debt plus market value of equity

17

The Purpose of the

Cost of Capital

The cost of capital is the average rate paid for the use of

the firms capital funds

Capital refers to money acquired for use over long periods

Generally used to start businesses and acquire long-lived assets

The cost of capital provides a benchmark against which to
evaluate investment returns
Projects should not be undertaken unless they return more than the cost
of the funds invested in them => the cost of capital.

Rule is equivalent to

Project IRR exceeds the cost of capital

Project NPV > 0 when calculated at the cost of capital

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Capital Components

A firms Capital Components are

Debt

Borrowed money, either loans or bonds

Common equity

Ownership interest

Preferred stock

A hybrid security, a cross between debt and equity

Capital structure is the mix of the three capital

components - generally expressed in percentages

19

Returns on Investments and the

Costs of Capital Components
Investors provide capital by purchasing securities

Returns paid to investors adjusted for taxes and administrative

expenses are the firms costs

The risk levels of Capital Component securities differ

Leads to different investor returns for each component
And different costs to the issuing firm for each component

Equity is the riskiest investment, earns the highest return, and has the
highest cost
Debt is the safest investment, earns the lowest return, and costs the
firm least
Preferred Stock offers investors intermediate risk and return levels and
has a cost between that of equity and debt

20

The Weighted Average CalculationThe WACC

A firms cost of capital is a weighted average of

the costs of the three capital components
where the weights reflect the $ amounts of
each component in use

Referred to in two ways

k, the cost of capital

WACC, for weighted average cost of capital

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The Weighted Average Calculation

Q: Calculate the WACC for the Zodiac Company given the following information about its
capital structure.
Capital Component

Example

Debt

Value

Cost

$60,000

9%

Preferred Stock

50,000

11

Common stock

90,000

14

$200,000

A: First calculate the capital structure weights based on the values given. For example the
weight of debt is $60,000 $200,000 = 30%. Next, each components cost is multiplied by
its weight and the results are summed as shown:
Capital Component
Debt

Value

Weight

Cost

$60,000

30%

9%

2.70%

Preferred Stock

50,000

25%

11

2.75%

Common stock

90,000

45%

14

6.30%

$200,000

100%

WACC =

11.75%

22

Capital Structure and CostBook Versus Market

Value

We can think of the WACC in terms of either book or

market values of capital components

For both structure and component costs

Which is the correct focus?

WACC used to evaluate next years capital projects

Must be supported by capital raised next year

Book values reflect capital raised and spent years ago
Current market values represent our best estimate of next years
capital market conditions

Market values are the appropriate basis for WACC

For capital structure
For component costs

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Capital Structure Customary Approach

Structure: Assume the firm will either

Maintain present capital structure based on the current market prices of its
securities
Or strive to achieve some target structure also based on current market prices.
Costs: Always use market-based component costs to develop the WACC.

24

Calculating the WACC

Step 1: Develop a market-based capital structure

Step 2: Adjust market returns on the underlying securities to reflect the costs of the
three capital component
Step 3: Combine in calculating the WACC

25

Developing Market-Value-Based
Capital Structures
Example 13.2

Q: The Wachusett Corporation has the following capital situation.

Example

Debt: Two thousand bonds were issued five years ago at a coupon rate
of 12%. They had 30-year terms and $1,000 face values. They are now
selling to yield 10%.
Preferred stock: Four thousand shares of preferred are outstanding,
each of which pays an annual dividend of $7.50. They originally sold to
yield 15% of their $50 face value. They're now selling to yield 13%.
Equity: Wachusett has 200,000 shares of common stock outstanding,
currently selling at $15 per share.
Develop Wachusett's market-value-based capital structure.

26

Developing Market-Value-Based
Capital Structures

Example

A: The market value of each capital component is the current price of each
security multiplied by the number outstanding.
The price of Wachusett's bonds in the market must be determined. We
know the bonds have 25 years remaining until maturity, pay interest of
$120 annually ($60 semi-annually) and are yielding 10% annually (5%
semi-annually). Thus, each bond is selling for $1,182.55 in the market,
calculated as shown below.
Pb = PMT[PVFAk,n] + FV[PVFk,n]
= $60[PVFA5,50] + $1,000[PVF5,50]
= $60(18.2559) + $1,000(0.0872)

= $1,182.55

Because there are 2,000 bonds outstanding, the market value of debt is
$1,182.55 x 2,000 = $2,365,100

27

Developing Market-Value-Based
Capital Structures

Example

The firm's preferred stock represents a perpetuity that pays $7.50 annually
and is yielding 13%. Thus, the value of each share of preferred stock is
$7.50 / .13 = $57.69
And the total market value of Wachusett's preferred stock is
$57.69 x 4,000 = $230,760
Each share of Wachusett's common stock is trading at $15, thus the total
market value of the firm's equity is
$15 x 200,000 shares = $3,000,000
Next summarize and calculate the component weights:
Debt
$2,365,100
42.3%
Preferred
Equity

230,760

4.1

3,000,000

53.6

$5,595,860

100.0%
28

Calculating Component
Costs of Capital

Begin with the market return received by new investors in

each capital component

kd, kp, and ke

Make adjustments for the effects of taxes and transaction

costs to arrive at cost to the issuing firm
Tax adjustment applies only to debt (Tax rate is T)

Interest is tax deductible to the paying firm

Cost of debt = kd (1 T)
Debt, the cheapest source, made even cheaper by tax adjustment

Flotation costs are a percentage of a securitys price (f)

Apply to preferred and new sales of common equity
Increases effective cost
Cost of component = kp / (1 f) or ke / (1 f)

29

Cost of Debt
Example 13.3

Example

Q. Blackstone Inc. has 12% coupon rate bonds outstanding that

yield 8% to investors buying them now. Blackstones marginal
tax rate including federal and state taxes is 37%. What is
Blackstones cost of debt?
A. First notice that kd is the current market yield of 8%, not the
coupon rate. To calculate the cost of debt we simply write
equation 13.1 and substitute from the information given.
cost of debt

= kd(1 - T)
= .08(1 - .37)
= 5.04%

30

The Cost of Preferred Stock

Example 13.4

Example

Q: The preferred stock of the Francis Corporation was issued several

years ago with each share paying 6% of a $100 par value. Flotation
costs on new preferred are expected to average 11% of the funds
raised.
(a) What is the cost of preferred if the return on similar
issues is now 9%?
(b) Calculate the cost of preferred if shares are selling at $75.
A: (a) and (b) ask the same question in different situations and with
different given information. In (a) we have the market return, and in
(b) we have the information needed to calculate it .
(a)

cost of preferred = kp / (1 - f)
= 9% / (1 - .11)
= 10.1%.

(b)

cost of preferred = Dp / (1 f) Pp
= $6 / (1 - .11) $75
= 9.0%
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September 16, 2014

THANK
YOU
Course No. ETZC414
Project Appraisal 25.07.13

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