Risk, Return

Risk Return,
and Capital
Budgeting
g g

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Chapter
p Outline

12.1 The Cost of Equity Capital

12.2 Estimation of Beta
12 3 Determinants
12.3 D t i t off Beta
B t
12.4 Extensions of the Basic Model
12.5 Estimating Bombardier’s Cost of Capital
12 6 Reducing the Cost of Capital
12.6
12.7 Summary and Conclusions

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 Cost of Equity Capital

„ Earlier chapters on capital budgeting (7, 8, 9)

focused on the appropriate size and timing of
cash flows.
„ This chapter discusses the appropriate
discount rate when cash flows are risky.

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 12.1 The Cost of Equity Capital
Shareholder
Firm with i
invests
t in
i
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Vl
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
3

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 The Firm’s
Firm s Cost of Capital
„ Firm
Firm’ss cost of capital in a well
well-functioning
functioning
capital market is the same as rate of return on
investment of comparable risk;
„ NPV (Co, C1, …)=

C1 C2
C0 + + + ...
1 + r (1 + r ) 2

where, C1 , C2 ... are expected values

4

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 The Cost of Equity
q y
„ From firm’s p
perspective,
p the expected
p
return is the Cost of Equity Capital:
R i = RF + βi ( R M − RF )
„ To estimate a firm’s cost of equity capital, we
need to know three things: g
1. The risk-free rate, RF
2 The market risk
2. R M − RF
premium,
Cov ( Ri , RM ) σ i , M
3 The company
3. βi = = 2
Var ( RM ) σM
beta, 5

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„ Project: Return IRR
„ Financial markets:
„ Return: = R f + βi ( R m − R f )
Graphically, NPV>0 means project lies above the SML
j β,
Project
. .. Project E(IRR)
..
. .
.
E(Rm)
. . .
. .
..

. .
. .
.

Rf .. .

Firm’s risk (beta)6

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 Example
„ Example:
p Your company
p y wants to expand.
p Past
return’s ß = 1.3; Market risk premium = 8.5%, Rf =
7%
Q
Question:
i what
h isi the
h discount
di rate for
f new projects
j
A: 7% + (1.3)8.5%
„ Example:
E l project
j t $115

$100

$105 7

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 Example (continued):
ƒ ß = 0.5
ƒ RM – Rf = 8%
ƒ Rf = 2%
ƒ What is the NPV?
ƒ Discount factor: d = 2% + (0.5)8% = 6%

50%.115 + 50%.105
NPV = −100 + ≈ $4
1.06

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 Calculation of Beta
„ What do you need to know to calculate ß?

E (ri ) = rf + βi ⋅ (market
e risk
s ppremium)
e u )

rf, mkt.
mkt risk premium: information widely available
ß : they only difficult part here
Cov( Ri , RM ) σ 2
β= = i
Var ( RM ) σ 2
M
9

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 Example
p
„ Suppose the stock of Stansfield Enterprises, a
publisher of PowerPoint presentations, has a
beta of 2.5. The firm is 100-percent equity
financed.
financed
„ Assume a risk-free rate of 5-percent and a
market risk premium of 10-percent.
10 percent
„ What is the appropriate discount rate for an
expansion of this firm?
R = RF + βi ( R M − RF )
R = 5% + 2.5 × 10%
10

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 Example (continued)
Suppose Stansfield Enterprises is evaluating the
f ll i non-mutually
following t ll exclusive
l i projects.
j t Each
E h costst
$100 and lasts one year.
Project Project β Project s
Project’s IRR NPV at
Estimated Cash 30%
Flows Next
Year
A 2.5 $150 50% $15.38

B 25
2.5 $130 30% $0

C 2.5
. $110
$ 10%
% -$15.38
$ .

11

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Using the SML to Estimate the Risk-Adjusted
Discount Rate for Projects

SML
Projecct
IRR
R Good A
projects

30% B

C Bad projects
5%
Firm’s risk (beta)
2.5
An all-equity firm should accept a project whose IRR
exceeds the cost of equity capital and reject projects
whose IRRs fall short of the cost of capital.
12

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 Project
j Risk versus Firm Risk
Suppose the Conglomerate Company has a
cost of capital, based on the CAPM, of 17%.
The risk-free rate is 4%, the market risk
premium is 10%, and the firm’s beta is 1.3.
17% = 4% + 1.3 × [14% – 4%]
This is a breakdown of the company’s
investment projects:
1/3 Automotive retailer β = 2.0
1/3 Computer Hard Drive Mfr. β = 1.3
1/3 Electric Utility β = 0.6
average β of assets = 1.3
13

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 Project Risk versus Firm Risk
„ When evaluating a new electrical
generation investment, which cost of
capital should be used?
„ Any project’s cost of capital depends on
the use to
th t which
hi h th
the capital
it l iis b
being
i
put—not the source.
„ Therefore, it depends on the risk of the
project and not the risk of the company.
14

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 Capital Budgeting & Project Risk
Project
IRR SML
P

The SML can tell us why:

Incorrectly accepted
negative NPV projects
Hurdle RF + β FIRM ( R M − RF )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
βFIRM

A firm that uses one discount rate for all projects

may over time increase the risk of the firm while 15

decreasing
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 Capital
p Budgeting
g g & Project
j Risk

SML
Projecct
IRR
R

24% Investments in hard

drives or auto retailing
17%
should have higher
10% discount rates.

Firm’s risk (beta)

0.6 1.3 2.0
r = 4% + 0.6×(14% – 4% ) = 10%
10% reflects
fl t the
th opportunity
t it costt off capital
it l on an investment
i t t in
i
electrical generation, given the unique risk of the project. 16

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 Estimation of Beta: Measuring Market
Risk

Market Portfolio - Portfolio of all assets in the

economy. In practice a broad stock market
index such as the TSE 300 index
index, index, is used to
represent the market.

Beta - Sensitivity of a stock’s return to the return

on the market portfolio
portfolio.

17

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 Estimation of Beta
„ Theoretically, the calculation of beta is
straightforward:
Cov( Ri , RM ) σ 2
β= = i

ÆProblems Var ( RM ) σ 2
M

1 B
1. Betas
t may vary over time:
ti new projects
j t unlike
lik old
ld
projects
2 Too small sample: we may not have enough past
2.
data to reliably compute beta
3. Betas are influenced by changing financial leverage
and business risk.
18

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 Estimation of Beta
ÆSolutions
– Problems 1 and 2 (above) can be moderated by
more sophisticated statistical techniques.
– Problem 3 can be lessened by adjusting for
changes in business and financial risk.
– Using industry
ind str beta:
beta people look at average
a erage beta
estimates of comparable firms in the industry.

19

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 Stabilityy of Beta

„ Most analysts argue that betas are generally

stable for firms remaining in the same
industry.
y
„ That’s not to say that a firm’s beta can’t
change.
g
„ Changes in product line
„ Changes in technology
„ Deregulation
„ Changes in financial leverage
20

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 Usingg an Industryy Beta
„ If y
you believe that the operations
p of the firm are
similar to the operations of the rest of the
industry, you should use the industry beta.
„ If you believe that the operations of the firm are
fundamentally different from the operations of the
restt off the
th industry,
i d t you should
h ld use theth firm’s
fi ’
beta.
„ Don’t forget about adjustments for financial
leverage.

21

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 Determinants of Beta
„ Business Risk
„ Variability of revenues
„ Cyclicality of revenues
„ Operating leverage
„ Financial Risk
„ Financial Leverage
„ Revenue variability
- Highly variable/unpredictable: developing a new
product,
p oduct, e
entering
te g a newe market,
a et, looking
oo g for
o oil
o in
a new place or with a different technology, etc. 22

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 Determinants of Beta

- Low variability: projects where you deliver

standardized product or service; output
expansions i iin stable
t bl existing
i ti markets.
k t
„ Revenue cyclicality
- Luxuries
L i vs necessities
iti
- Natural resources vs manufacturing
(in Canada this works differently than elsewhere)
- Exporters vs importers
- Retailers, car manufacturers, construction
23
companies vs utilities, transportation.
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 Operating Leverage
„ The degree of operating leverage measures
how sensitive a firm (or project) is to its fixed
costs.
„ Operating leverage increases as fixed costs
rise and variable costs fall.
„ Operating leverage magnifies the effect of
cyclicity on beta.
„ The degree of operating leverage is given by:
Change in EBIT Sales
DOL = ×
EBIT Change in Sales
24

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Operating Leverage

Δ EBIT
Total
$ costs

Fixed costs
Δ Volume
Fixed costs
Volume

Operating leverage increases as fixed costs rise

and variable costs fall.
fall
25

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 Determinants of Beta

„ Operating leverage: fixed vs variable cost of

production
- Relatively high fixed, low variable, cost:
- Hotels
- Airlines
- Movie studios
- News industry

26

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 Determinants of Beta
- Small fixed, huge variable:
- Retail
- Services
„ Caveat: cost structure may vary within
industry.
y
- Renting an airplane vs buying an airplane (or
an office)
- Hiring a worker on a full-time basis vs part-
time
- I
Investing
i ini expensive,
i d
durable
bl equipment
i
versus cheap, disposable, less durable 27

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 Financial Leverage
g and Beta
„ Operating leverage refers to the sensitivity to the
firm’s fixed costs of production.
„ Financial leverage is the sensitivity of a firm’s fixed
costs of financing.
„ The relationship between the betas of the firm’s
d bt equity,
debt, it andd assets
t is
i given
i b
by:
Debt Equity
β Asset
sset = × β Debt
ebt + × β Equity
quity
D bt + Equity
Debt E it bt + Equity
Debt
D E it

• Financial leverage always increases the equity beta

relative to the asset beta.
28

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Equity risk (beta) increases with debt
„ Example: equity riskiness increases with debt
Your business project is as follows:

$125

$100
$115

Suppose you finance

S fi with
ith $90 d
debt
bt ((r=10%),
10%) $10
equity. 29

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 Example:

$99
D: $90

$99
$35
E: $10

30

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$25 © 2003 McGraw–Hill Ryerson Limited
 Financial Leverage and Beta
- Same absolute difference between value of equity
iin good
d andd bad
b d states
t t
- Difference in percentage terms varies
„ Equity is riskier when the company is in debt.
debt
„ It has to have greater expected return
„ Algebraically:
B S
rFIRM = rbonds + requity
B+S S+B
because, as an accounting identity,
because identity firm
firm’ss return has
to go to either bondholders or shareholders 31

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 Financial Leverage and Beta
D E
β FIRM = × β bonds + × β Equity
D+E D+E
„ When
βdebt = 0
Equity
E it
β FIRM = × β Equity
Debt + Equity
⎛ Debt ⎞
βEquity = βFIRM × ⎜⎜1 + ⎟⎟
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⎝ Equity ⎠ 32

© 2003 McGraw–Hill Ryerson Limited

 Financial Leverage and Beta
„ Interest: Tax deductible at the corporate level;
cost of debt after tax:

rbonds × (1 − Tc )
„ Average Capital Cost:

S B
rACC = × rs + × rβ × (1 − Tc )
B+S B+S
„ Example: BOMBARDIER
- get weights 33

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 Example: Estimating Bombardier’s
p
Cost of Capital
„ We aim at estimating Bombardier’s cost
p , as of June 15,, 2001.
of capital,
„ First, we estimate the cost of equity and
the cost of debt.
debt
„ We estimate an equity beta to estimate
th costt off equity.
the it
„ We can often estimate the cost of debt
by observing the YTM of the firm’s debt.
„ Second, we determine the WACC by
weighting these two costs appropriately. 34

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 Estimating Bombardier’s Cost of
Capital
„ Bombardier
Bombardier’s
s beta is 0
0.79;
79; the (current)
risk-free rate is 4.07%, and the
(historical) market risk premium is
6.89%.
„ Thus the cost of equity capital is

re = RF + βi ( R M − RF )
= 4.07% + 0.79 × 6.89%
= 9.51%
35

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 Estimating Bombardier’s Cost of
Capital
„ The yield on the company’s
company s 6
6.6%
6% 29
Nov 04 bond is 5.73% and the firm is
in the 40% marginal tax rate
rate.
„ Thus the cost of debt is
rB × (1 − TC ) = 5.73% × (1 − 0.40) = 3.44%

36

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 Estimating Bombardier’s Cost of Capital
• To calculate the cost of capital, we need to
estimate the value weights for equity and debt:
Market Value Weights for Bombardier (as of January 31, 2001)
Market Shares Market Value
Security Price Outstanding (millions) Weight (%)
Debt (book value) - - $ 6,131 16.07%
Preferred stock 25.75 12,000,000 $ 309 0.81%
Class A Common 23 09
23.09 347 426 000
347,426,000 $ 8 022
8,022 21 02%
21.02%
Class B Common 23.27 1,018,625,000 $ 23,703 62.10%
Total 3816547% 100.00%
• We simplify,
simplif and combine preferred stock with
ith
common stock:
S B
= 83.93%, and = 16.07%
S+B S+B 37

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 The Cost of Capital with Debt
„ As derived before
before, the weighted average
cost of capital is given by:

⎛ S ⎞ ⎛ B ⎞
rWACC =⎜ ⎟ × rS + ⎜ ⎟ × rB × (1 − TC )
⎝S +B⎠ ⎝S +B⎠

• It is because interest expense is tax-deductible that

we multiply
lti l the
th last
l t term
t by (1 TC)
b (1-

38

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 Estimating Bombardier’s Cost of Capital

• Bombardier’s WACC as of June 15, 2001, is given

by:
⎛ S ⎞ ⎛ B ⎞
rWACC = ⎜ ×
⎟ S ⎜
r + ⎟ × rB × (1 − TC )
⎝S+B⎠ ⎝S+B⎠
= 0.8393 × 9.51% + 0.1607 × 5.73% × (1 − 0.4)
= 8.53%

Bombardier’s
B b di ’ costt off capital
it l is
i 8.53%.
8 53% It should
h ld be
b usedd to
t
discount any project where one believes that the project’s risk
is equal to the risk of the firm as a whole, and the project has
the same leverage as the firm as a whole.
39

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 Other factors influencing cost of
capital
INFORMATION ASSYMETRY

„ Assume you have a business idea, need

financing
- Hypothetical investor knows less than you about
your industry/business
- The investor cannot tell apart your good project
from other bad projects
- The project is riskier to the investor than to you.

40

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Liquidity, Expected Returns, and the
Cost of Capital
- Project worth less to the investor than to you
- Difficult to find a buyer for such business in case
you need to sell out of it

ƒ How to mitigate the problem?

- Be transparent
- Detailed bookkeeping
- Establish a relationship with banks/investors who
are kept
p up
p to date with yyour work
41

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 Informational Asymmetry

„ In practice informational asymmetry is greatest

for:
- obscure projects
- young firms, startups
- win or lose
“win lose” type projects
- projects by firms/entrepreneurs with problematic
past
ƒ Standardized projects in establishes industries
should not have the problem
42

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 Liquidity
q y and Cost of Capital
p

„ What is Liquidity?
„ Liquidity, Expected Returns, and the
Cost of Capital
„ Liquidity and Adverse Selection

43

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 What is Liquidity?

„ Liquidity: if you hold an asset

asset, how
easy/cheap can yousell it off?
„ The trading costs of holding a firm’s
firm s
shares include brokerage fees, the bid-
ask spread
spread, and market impact costs
costs.

44

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 Liquidity, Expected Returns, and
the Cost of Capital
p

„ The cost of trading an illiquid stock

reduces the total return that an investor
receives.
receives
„ Investors thus will demand a high
expected return when investing in
stocks with high trading costs.
„ This
Thi hi
highh expected
t d return
t iimplies
li a hi
high
h
cost of capital to the firm.
45

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 Liquidity
q y and the Cost of Capital
p

Liquidity
An increase in liquidity, i.e
i e., a reduction in trading costs,
lowers a firm’s cost of capital. 46

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 Liquidity
q y and Adverse Selection

„ One of these factors is adverse

selection.
„ This refers to the notion that traders
with better information can take
advantage of specialists and other
traders who have less information.
„ The
Th greater
t theth heterogeneity
h t it off
information, the wider the bid-ask
spreads,
d and d th
the hi
higher
h ththe required
i d
47
return on equity.
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 What the Corporation
p Can Do

„ The corporation has an incentive to

lower trading costs since this would
result in a lower cost of capital
capital.
„ A stock split would increase the liquidity
of the shares
shares.
„ A stock split would also reduce the
adverse
d selection
l ti costs t th
thereby
b
lowering bid-ask spreads.
„ This idea is a new one and empirical 48

evidence is not yet in.

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 What the Corporation
p Can Do

„ Direct stock purchase plans and

dividend reinvestment plans handled
on-line
on line allow small investors the
opportunity to buy securities cheaply.
„ The companies can also disclose more
information, especially to security
analysts to narrow the gap between
analysts,
informed and uninformed traders. This
should reduce spreads
spreads.
49

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 Summary
y and Conclusions

„ The expected return on any capital budgeting

project should be at least as great as the
expected
p return on a financial asset of
comparable risk. Otherwise the shareholders
would prefer the firm to pay a dividend.
„ The expected return on any asset is
dependent upon β.
„ A project’s required return depends on the
project’s β.

50

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 Summary Conclusions
Summary,

ƒA j t’ β can be
A project’s b estimated
ti t d by b considering
id i
comparable industries or the cyclicality of project
revenues and the project
project’ss operating leverage.
leverage

ƒIf the firm uses debt, the discount rate to use is

the rWACC.

ƒIn
I order l l rWACC, the
d to calculate h cost off equity
i andd
the cost of debt applicable to a project must be
estimated
estimated.
51

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