Finance& Financial Management

Risk, Cost of Capital & Capital

Budgeting

Lecture 6

Lecture slides are based on the textbook and accompanying slides of

Hillier, Ross, Westerfield, Jaffe, and Jordan “Corporate Finance”.
European Edition, 2nd Edition, McGraw-Hill, 2013, (Copyright © The
McGraw-Hill Companies 2013)
Risk, Cost of Capital & Capital Budgeting
- Be aware of the decisions a manager must make when
deciding to issue a dividend or authorize capital expenditure.
- Know how to calculate the beta of an equity using real data.
- Know what to do when calculating the cost of equity if the
risk of a new project is different from the risk of the firm.
- Be familiar with the main determinants of beta.
- Know when and how to use the weighted average cost of
capital.
The Cost of Equity Capital
 The Cost of Equity Capital

The discount rate of

a project should be
the expected return
on a financial asset
of comparable risk.
 The Cost of Equity Capital
From the firm’s perspective, the expected return is the cost
of equity capital. Under the CAPM, the expected return on
a security can be written as:

RS = RF + β × (RM - RF)

where RF is the risk-free rate and RM - RF is the difference

between the expected return on the market portfolio and
the riskless rate. This difference is often called the
expected excess market return or market risk premium.
 The Cost of Equity Capital

To Estimate Cost of Equity Capital

you need to know
The
The Risk- The
Market
Free Company
Risk
Rate Beta
Premium
 Example 1:
Cost of Equity
According to Reuters, the beta of the French bank
Société Générale SA is 2.05. Assume, for now, that
the firm is 100 per cent equity financed; that is, it has
no debt. Société Générale is considering a number of
expansion projects that will double its size. Because
these new projects are similar to the firm’s existing
ones, the average beta on the new projects is
assumed to be equal to Société Générale’s existing
beta. Assume that the risk-free rate is 1.5 per cent.
What is the appropriate discount rate for these new
projects, assuming a market risk premium of 5.2 per
cent?
 Example 1:
Cost of Equity
RS = 1.5% + (5.2% × 2.05)
= 1.5% + 10.66%
= 12.16%

Assumption 1 Assumption 2

• The beta risk • The firm is all

of the new equity
projects is the financed.
same as the
risk of the firm
 Example 2
Project Evaluation and Beta
Kazakhmys plc is a metal producer listed on the
London Stock Exchange. Suppose Kazakhmys is
an all-equity firm. According to Yahoo! Finance, it
has a beta of 1.57. Further, suppose the market risk
premium is 9.5 percent, and the risk-free rate is 5
percent. What is the expected return on the equity
of Kazakhmys?

5% + (1.57 × 9.5%) = 19.92%

 Example 2
Project Evaluation and Beta
Suppose Kazakhmys is evaluating the following non–
mutually exclusive projects in Kazakhstan:
Project Project’s Project’s Project’s Project’s NPV Accept or
Beta (β) Expected Internal When Cash Reject
Cash Flows Rate of Flows Are
Next Year Return Discounted
At 19.92%
A 1.57 £140 40% £16.8 Accept
B 1.57 120 20 0.1 Accept
C 1.57 110 10 -8.3 Reject
Each project initially costs £100. All projects are
assumed to have the same risk as the firm as a whole.
Because the cost of equity capital is 19.92 percent,
projects in an all-equity firm are discounted at this rate.
 Example 2:
Project Evaluation and Beta
 Estimation of Beta

Cov ( Ri , R M ) σi, M
Beta of security i =  2
Var( RM ) σM
 Estimation of Beta

Problems Solutions

• Betas may vary over • First 2 problems can be

time sorted by better statistics
• Sample Size may be • 3rd problem can be
inadequate lessened by adjusting for
• Betas are influenced by business and financial
changing financial risk
leverage and business • Look at average beta
risk estimates of several
comparable firms in
industry
Using an Industry Beta
 Determinants of Beta

Cyclicity of Operating
Revenues Leverage

Financial
Leverage
 Example 3:
Operating Leverage

Technology A Technology B
Fixed cost: Fixed cost: DKK2,000/year
DKK1,000/year
Variable cost: Variable cost: DKK6/unit
DKK8/unit
Price: DKK10/unit Price: DKK10/unit
Contribution margin: Contribution margin: DKK4
DKK2 (= £10 - £8) (= DKK10 - DKK6)
 Example 3
Operating Leverage
 Example 3
Operating Leverage
 Financial Leverage and
Beta

S B
β Asset = × βEquity + × βDebt
B+S B+ S
S
β Asset = × β Equity
B+S
 B
β Equity = β Assest 1 + S 
 
 Example 4
Asset versus Equity Betas
Consider a Swedish tree growing company, Rapid Firs,
which is currently all equity and has a beta of .8. The firm
has decided to move to a capital structure of one part debt
to two parts equity. Assuming a zero beta for its debt, what
is its new asset beta and equity beta?

 B
Asset Beta β Equity = β Asset 1 + S 
 
stays the
 1
same 1.2  .8 1  
 2
 Extensions of the Basic Model:
The Firm vs The Project
D. D. Ronnelley, a publishing firm, may accept a project in
computer software. Noting that computer software
companies have high betas, the publishing firm views the
software venture as more risky than the rest of its business.
What should the company do?
It should discount the project at a rate commensurate with
the risk of software companies. For example, it might use
the average beta of a portfolio of publicly traded software
firms. Instead, if all projects in D. D. Ronnelley were
discounted at the same rate, a bias would result. The firm
would accept too many high-risk projects (software
ventures) and reject too many low-risk projects (books and
magazines).
Extensions of the Basic Model:
The Firm vs The Project
 The Cost of Capital with
Debt
Suppose a firm uses both debt and equity to finance its
investments. If the firm pays RB for its debt financing and
RS for its equity, what is the overall or average cost of its
capital?
 S   B 
  × RS    × RB × (1  tc )
S  B S  B

This is called
the Weighted
Average Cost of
Capital (WACC)
 Example 6:
WACC
According to the ArcelorMittal website, the European steelmaker
has debt with a market value of €4.4 billion and equity with a
market value of €71.4 billion. ArcelorMittal has 8 different types of
bonds in issue, four of which were issued in Luxembourg
(denominated in euros) and the other four denominated in dollars.
For the purposes of this question, assume that the bonds are all
the same, denominated in dollars and pay interest of 6 percent
per annum. The company’s shares have a beta of 1.81. Because
of the range of countries and tax codes in regimes in which
ArcelorMittal operates, the effective tax rate for the company is
13.1 percent. Assume that the SML holds, that the risk premium
on the market is 9.5 percent [slightly higher than the historical
equity risk premium], and that the current Treasury bill rate is 4.5
percent. What is this firm’s RWACC?
 Example 6
WACC

To Compute WACC, You need

Proportions
After-tax
Cost of of Each in
Cost of
Equity Capital
Debt
Structure
 Example 6
WACC
• The pretax cost of debt is 6 percent, implying an
after-tax cost of 5.214 percent [6% × (1 - 0.131)].
We compute the cost of equity capital by using the SML:
RS = RF + β [RM - RF]
= 4.5% + 1.81 × 9.5%
= 21.695%

We compute the proportions of debt and equity from the

market values of debt and equity. Because the market
value of the firm is €75.8 billion (= €4.4 billion + €71.4
billion), the proportions of debt and equity are 5.8 and 94.2
percent, respectively.
Example 6
WACC
 Example 6
WACC
(1) (2) (3) (4) (5)
Financing Market Weight Cost of Capital Weighted
Components Values (after Corporate Tax) Cost
of Capital

Debt € 4.4 billion .058 6% x (1 - 0.131) = 5.214% 0.302%

Equity €71.4 billion .942 4.5% + 1.81 x 9.5% = 20.436%

21.695%
€75.8 billion 1.00 20.738%
 Example 7:
Project Evaluation and WACC
Suppose a firm has both a current and a
target debt–equity ratio of .6, a cost of debt
of 15.15 percent, and a cost of equity of 20
percent. The corporate tax rate is 34
percent. What is the WACC?
Suppose the firm is considering taking on a
warehouse renovation costing £50 million
that is expected to yield cost savings of £12
million a year for six years. What is the NPV
of this project?
 Example 7:
Project Evaluation and WACC

 S   S 
RWACC     RS     RB  (1  tC )
S  B S  B
 .625  20%  .375  15.15%  .66  16.25%

£12 £12
NPV   £50   ... 
(1  RWACC ) (1  RWACC )
6

  £50  £12  A.1625

6

  £50  (12  3.66)

  £6.07
 Estimating Carrefour
Group’s Cost of Equity
• Our first stop for Carrefour is
www.reuters.com. Search for the company
using its code (CARR.PA).
• As of January 2012, Carrefour has 679.34
million shares outstanding. The share
price is €16.95 and the market value of the
equity is (679.34 x €16.95 = ) €11,515
million.
 Estimating Carrefour
Group’s Cost of Equity
To estimate Carrefour’s cost of equity, we will assume a
market risk premium of 7 percent. This is a subjective
estimate based upon the sentiment of a number of
analysts.
Given that the rate on European T-bills is around 5 percent
(source: FT.Com), a market risk premium of 7 percent
implies that the market is expected to go up by 12 percent
in the next year.
Carrefour’s beta on Reuters is .71 and the industry average
beta is .64, which is a little bit lower than Carrefour’s beta.
 Estimating Carrefour
Group’s Cost of Equity
Using Carrefour’s own beta in the CAPM to estimate the
cost of equity, we find:
RS = .05 + .71(.07) = .0997 or 9.97%
If we use the industry beta, we would find that the estimate
for the cost of equity capital is:
RS = .05 + .64(.07) = .0948 or 9.48%
The decision of which cost of equity estimate to use is up
to the financial executive, based on knowledge and
experience of both the company and the industry. In this
case, we will choose to use the cost of equity using
Carrefour’s estimated beta.
Carrefour’s Cost of Debt
 Carrefour’s Cost of Debt
To make things simple, we will assume that
Carrefour issue their bonds so that the coupon rate
is equal to the yield to maturity. This means that
the cost of debt for Carrefour ranges between
3.825 per cent and 6.625 per cent. The actual
estimate we use will be based on an assessment
of the general risk of Carrefour debt and, for the
purposes of the present case, we will use an
estimate of 4 per cent since it is in the region of the
most recent Carrefour bond issues. Clearly, this is
subjective and a full analysis would consider a
variety of cost of debt estimates.
 Carrefour’s WACC
1) calculate the capital structure weights. Carrefour’s equity and
debt are worth €11,515 million and €9,665 million,
respectively. The capital structure weight for equity is €11,515
million/€21,180 billion = .544 and for debt, it is €9,665
million/€21,180 million = .456.

2) According to Carrefour’s page on www.reuters.com, the

effective tax rate for Carrefour is 36.66 percent.

RWACC = .544 × 9.97% + .456 × 4.00% × (1 - .3666) = 6.58%

Costs of Capital: International
Considerations
Costs of Equity and WACC
in Europe
How do Corporations Estimate
Cost of Capital in Practice?