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Ross Chapter 12 Risk, Cost of Capital, and Capital Budgeting Additional Ref: Chapter 9 Smart (2010)
Ross Chapter 12
Risk, Cost of Capital, and Capital Budgeting
Additional Ref: Chapter 9 Smart (2010)

McGraw-Hill/Irwin

Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Key Concepts and Skills  Know how to determine a firm’s cost of equity capital 

Key Concepts and Skills

  • Know how to determine a firm’s cost of equity capital

  • Understand the impact of beta in determining the firm’s cost of equity capital

  • Know how to determine the firm’s overall cost of capital

Chapter Outline 12.1 The Cost of Equity Capital 12.2 Estimation of Beta 12.3 Determinants of Beta

Chapter Outline

  • 12.1 The Cost of Equity Capital

  • 12.2 Estimation of Beta

  • 12.3 Determinants of Beta

  • 12.4 Extensions of the Basic Model

  • 12.5 Estimating Eastman Chemical’s Cost of Capital

Where Do We Stand?  Earlier chapters on capital budgeting focused on the appropriate size and

Where Do We Stand?

  • Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows.

  • This chapter discusses the appropriate discount rate when cash flows are risky.

12.1 The Cost of Equity Capital Shareholder invests in financial asset Firm with excess cash Pay

12.1 The Cost of Equity Capital

Shareholder

invests in financial asset

Firm with excess cash Pay cash dividend Shareholder’s Invest in project Terminal Value
Firm with
excess cash
Pay cash dividend
Shareholder’s
Invest in project
Terminal
Value
12.1 The Cost of Equity Capital Shareholder invests in financial asset Firm with excess cash Pay

A firm with excess cash can either pay a dividend or make a capital investment

Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital budgeting project should be at least as

12-4

great as 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

The Cost of Equity Capital

  • From the firm’s perspective, the expected return is the Cost of Equity Capital:

Ri R

F

β

i

(

R

M

R

F

)

• To estimate a firm’s cost of equity capital, we need

to know three things:

  • 1. The risk-free rate, R F

  • 2. The market risk premium,

R M R

F

  • 3. The company beta, β

i

(

Cov R

i

,

R

M

)

Var R

(

M

)

σ

i M

,

σ

2

M

12-5

Example (1) Cost of Equity  Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint

Example (1) Cost of Equity

  • Suppose the stock of Stansfield Enterprises, a

publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100 percent equity financed.

  • Assume a risk-free rate of 5 percent and a market risk premium of 10 percent.

  • What is the appropriate discount rate for an expansion of this firm?

R R

F

β R

i

(

M

R

F

)

R 5% 2.510%

R 30%

12-6

Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one

Example

Suppose Stansfield Enterprises is evaluating the following

independent projects. Each costs $100 and lasts one year.

 

Project

   

Project b

   

Project’s

   

IRR

   

NPV at

   

Estimated Cash Flows Next

30%

Year

 

A

   
  • 2.5 $150

         

50%

   

$15.38

 
 

B

   
  • 2.5 $130

         

30%

   

$0

 
 

C

   
  • 2.5 $110

         

10%

   

-$15.38

 

12-7

Using the SML SML Good A project 30% B Bad project C 5% Firm’s risk (beta)

Using the SML

SML Good A project 30% B Bad project C 5% Firm’s risk (beta) Project IRR
SML
Good
A
project
30%
B
Bad project
C
5%
Firm’s risk (beta)
Project
IRR

2.5

An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects

whose IRRs fall short of the cost of capital.

12-8

12.2 Estimation of Beta Market Portfolio - Portfolio of all assets in the economy. In practice,

12.2 Estimation of Beta

Market Portfolio - Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P 500, is used to represent the market.

Beta - Sensitivity of a stock’s return to the return on the market portfolio.

12.2 Estimation of Beta • Problems β  ( Cov R i , R M )

12.2 Estimation of Beta

Problems

β

(

Cov R

i

,

R

M

)

(

Var R

M

)

  • 1. Betas may vary over time.

  • 2. The sample size may be inadequate.

  • 3. Betas are influenced by changing financial leverage and business risk.

Solutions

Problems 1 and 2 can be moderated by more sophisticated statistical techniques.

Problem 3 can be lessened by adjusting for changes in business and financial risk.

Look at average beta estimates of comparable firms in the industry.

12-10

Stability of Beta  Most analysts argue that betas are generally stable for firms remaining in

Stability of Beta

  • Most analysts argue that betas are generally stable for firms remaining in the same industry.

  • That’s not to say that a firm’s beta can’t change.

    • Changes in product line

    • Changes in technology

    • Deregulation

    • Changes in financial leverage

Using an Industry Beta  It is frequently argued that one can better estimate a firm’s

Using an Industry Beta

  • It is frequently argued that one can better estimate a firm’s beta by involving the whole industry.

  • If you believe that the operations 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 rest of the industry, you should use the firm’s beta.

  • Don’t forget about adjustments for financial leverage.

12.3 Determinants of Beta  Business Risk  Cyclicality of Revenues  Operating Leverage  Financial

12.3 Determinants of Beta

  • Business Risk

    • Cyclicality of Revenues

    • Operating Leverage

  • Financial Risk

    • Financial Leverage

  • Cyclicality of Revenues  Highly cyclical stocks have higher betas.  Empirical evidence suggests that retailers

    Cyclicality of Revenues

    • Highly cyclical stocks have higher betas.

      • Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle.

      • Utility companies are less dependent upon the business cycle.

  • Note that cyclicality is not the same as variabilitystocks with high standard deviations need not have high betas.

    • Movie studios have revenues that are variable, depending upon whether they produce ―hits‖ or ―flops,‖ but their revenues may not be especially dependent upon the business cycle.

  • 12-14

    Operating Leverage  The degree of operating leverage measures how sensitive a firm (or project) is

    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 cyclicality on beta.

    • The degree of operating leverage is given by:

    DOL =

    D EBIT

    EBIT

    ×

    Sales

    D Sales

    Operating Leverage $ Total Total costs costs Fixed costs Fixed costs Sales D EBIT D Sales

    Operating Leverage

    $

    Total Total costs costs Fixed costs Fixed costs Sales
    Total
    Total
    costs
    costs
    Fixed costs
    Fixed costs
    Sales
    D EBIT
    D EBIT

    D Sales

    Operating leverage increases as fixed costs rise and variable costs fall.

    Example (2) Operating Leverage Suppose a firm’s EBIT increases by 12% after sales change from $2.3

    Example (2) Operating Leverage

    Suppose a firm’s EBIT increases by 12% after sales

    change from $2.3 million to $2.507 million. What is the

    firm’s operating leverage? If the firm’s sales increase to $2.7577 million with EBIT increasing by only 11%, what is the new operating leverage for the firm? (Smart, Q-4, pg. 345)

    Answers 9- 4. Percentage change in sales: ($2.507 million − $2.3 million) ÷ $2.3 million =

    Answers

    9-4. Percentage change in sales: ($2.507 million − $2.3 million) ÷ $2.3 million = 9%

    Operating leverage = 12% ÷ 9% = 133.33%

    Percentage change in sales: ($2.7577 million − $2.507

    million) ÷ $2.507 million = 10% Operating leverage = 11% ÷ 10% = 110.00%

    STOP AND THINK  A certain firm has fixed costs of $4.5 million with variable costs

    STOP AND THINK

    • A certain firm has fixed costs of $4.5 million with variable costs of $295 per unit. If each unit sells for $450, what is the firm’s break- even point? Currently, the firm sells $32,000 units per year, but it believes that 60,000 units per year could be sold if the selling price were lowered to $385 per unit. What is the operating leverage for the firm, new breakeven point? (Smart 9-6)

    Financial Leverage and Beta  Operating leverage refers to the sensitivity to the firm’s fixed costs

    Financial Leverage and Beta

    • Operating leverage refers to the sensitivity to the firm’s fixed costs of production.

    • Financial leverage is the sensitivity to a firm’s fixed costs of financing.

    • The relationship between the betas of the firm’s debt, equity, and assets is given by:

    b Asset =

    Debt

    Debt + Equity

    × b Debt +

    Equity

    Debt + Equity

    × b Equity

    Financial leverage always increases the equity beta relative to the asset beta.

    12-20

    Example (4) Consider Grand Sport, Inc., which is currently all-equity financed and has a beta of

    Example (4)

    Consider Grand Sport, Inc., which is currently all-equity

    financed and has a beta of 0.90.

    The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity.

    Since the firm will remain in the same industry, its asset beta should remain 0.90.

    However, assuming a zero beta for its debt, its equity beta would become twice as large:

    b Asset = 0.90 =

    • 1 × b Equity

    1 + 1

    b Equity =

    2 × 0.90 = 1.80

    12-21

    Example (5)  ASIC Inc. has assets worth $6.9 million. Two million dollars is financed with

    Example (5)

    • ASIC Inc. has assets worth $6.9 million. Two million dollars is financed with debt that costs

    10% a year in interest. If ASIC’s contribution

    margin is $175 per unit, then how many units

    must be sold to cover the interest payments? If ASIC sells 2,500 units this year, how much

    return on a pre-tax basis (ie., a return based on

    earnings before taxes) do shareholders receive? How much pre-tax return would they receive if ASIC had no debt? (Smart 9-7)

    12-22

    Answers (5)  9-7. Interest payment: $2 million * 10% = $200,000  Debt coverage in

    Answers (5)

    • 9-7. Interest payment: $2 million * 10% = $200,000

    • Debt coverage in units sold: $200,000 ÷ $175.00 =

    1,142.86

    • Earnings prior to taxes: 2500*($175.00) − $200,000 = $237,500

    • Shareholders’ return: $237,500 ÷ [$6.9 million − $2 million] = 4.85%

    • Shareholders’ return assuming no debt: 2500*($175.00) ÷ $6.9 million = 6.34%.

    12.4 Extensions of the Basic Model  The Firm versus the Project  The Cost of

    12.4 Extensions of the Basic Model

    • The Firm versus the Project

    • The Cost of Capital with Debt

    The Firm versus the Project  Any project’s cost of capital depends on the use to

    The Firm versus the Project

    • Any project’s cost of capital depends on the use to which the capital is being putnot the source.

    • Therefore, it depends on the risk of the

    project and not the risk of the company.

    • The discount rate of a project should be the expected return on a financial asset of comparable risk.

    Capital Budgeting & Project Risk SML The SML can tell us why: Incorrectly accepted negative NPV

    Capital Budgeting & Project Risk

    SML The SML can tell us why: Incorrectly accepted negative NPV projects Hurdle R  β
    SML
    The SML can tell us why:
    Incorrectly accepted
    negative NPV projects
    Hurdle
    R  β
    (
    R
     R
    )
    M
    F
    FIRM
    F
    rate
    Incorrectly rejected
    R F
    positive NPV projects
    Firm’s risk (beta)
    Project IRR

    b FIRM

    A firm that uses one discount rate for all projects may over time

    increase the risk of the firm while decreasing its value.

    12-26

    Capital Budgeting & Project Risk Suppose the Conglomerate Company has a cost of capital, based on

    Capital Budgeting & Project 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 × 10% This is a breakdown of the company’s investment projects:

    1/3 Automotive Retailer b = 2.0

    1/3 Computer Hard Drive Manufacturer b = 1.3 1/3 Electric Utility b = 0.6 average b of assets = 1.3

    When evaluating a new electrical generation investment, which cost of capital should be used?

    12-27

    Capital Budgeting & Project Risk SML 24% Investments in hard 17% 10% drives or auto retailing

    Capital Budgeting & Project Risk

    SML 24% Investments in hard 17% 10% drives or auto retailing should have higher discount rates.
    SML
    24%
    Investments in hard
    17%
    10%
    drives or auto retailing
    should have higher
    discount rates.
    Project’s risk (b)
    0.6
    1.3
    2.0
    Project IRR

    R = 4% + 0.6×(14% 4% ) = 10%

    10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project.

    12-28

    The Cost of Capital with Debt  The Weighted Average Cost of Capital is given by:

    The Cost of Capital with Debt

    • The Weighted Average Cost of Capital is given by:

    R WACC

    =

    R WACC =

    Equity Equity + Debt

    The Cost of Capital with Debt  The Weighted Average Cost of Capital is given by:

    × R Equity +

    Debt

    Equity + Debt

    × R Debt ×(1 t C )

    S S + B

    × R S +

    B S + B

    × R B ×(1 t C )

    Because interest expense is tax-deductible, we multiply the last term by (1 t C ).

    Example (7) International Paper  First, we estimate the cost of equity and the cost of

    Example (7) International Paper

    • First, we estimate the cost of equity and the cost of debt.

      • We estimate an equity beta to estimate the cost of equity.

      • 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.

  • 12-30

    Example: International Paper  The industry average beta is 0.82, the risk free rate is 3%,

    Example: International Paper

    • The industry average beta is 0.82, the risk free rate is 3%, and the market risk premium is 8.4%.

    • Thus, the cost of equity capital is:

    R S = R F + b i × (R M R F )

    = 3% + 0.82×8.4% = 9.89%

    Example: International Paper  The yield on the company’s debt is 8%, and the firm has

    Example: International Paper

    • The yield on the company’s debt is 8%, and the firm has a 37% marginal tax rate.

    • The debt to value ratio is 32%

    R WACC =

    S S + B

    × R S +

    B S + B

    × R B ×(1 t C )

    = 0.68 × 9.89% + 0.32 × 8% × (1 0.37)

    = 8.34%

    8.34 percent is International’s cost of capital. It should be used to 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.

    12-32

    Flotation Costs  Flotation costs represent the expenses incurred upon the issue, or float, of new

    Flotation Costs

    • Flotation costs represent the expenses incurred upon the issue, or float, of new bonds or stocks.

    • These are incremental cash flows of the project, which typically reduce the NPV since they increase the initial project cost (i.e., CF 0 ).

    Amount Raised = Necessary Proceeds / (1-% flotation cost)

    The % flotation cost is a weighted average based on the average cost of issuance for each funding source and the

    firm’s target capital structure:

    f A = (E/V)* f E + (D/V)* f D

    Reading Assignment  ― Cost of capital, gearing and CAPM” By Ken Garrett (2009) Assessable at

    Reading Assignment

    • Cost of capital, gearing and CAPM” By Ken Garrett (2009)

    Assessable at

    http://www.accaglobal.com/pubs/students/publications/student_accou

    ntant/archive/sa_oct09_garrett2.pdf

    Quick Quiz  How do we determine the cost of equity capital?  How can we

    Quick Quiz

    • How do we determine the cost of equity capital?

    • How can we estimate a firm or project beta?

    • How does leverage affect beta?

    • How do we determine the cost of capital with debt?

    • What are the two factors affecting cost of equity? (ref: Ken Garrett 2009)