Cost of Capital

Spring / Summer 2007

BA 6323

Jeffrey Allen, Ph.D.

 Topics in this Section

Capital Market History

Measuring Risk in a Portfolio
Types of Risk
Diversification & Portfolio Theory
Risk and Return Relationships
Measuring the Cost of Equity
Capital Asset Pricing Model (CAPM) & Beta
Company-Specific Costs of Capital
 A $1 Investment in 190
$100,000

Common Stock 15,578

$10,000 US Govt Bonds
T-Bills
Dollars

$1,000

147
$100
61

$10

$1

2004
00

10

20

30

40

50

60

70

80

90

00
19

19

19

19

19

19

19

19

19

19

20
 A $1 Investment in 190

Real
$1,000
Returns 719
Equities
Bonds
Bills
$100
Dollars

$10
6.81

2.80

$1

2004
00

10

20

30

40

50

60

70

80

90

00
19

19
19

19

19

19

19

19

19

19

20
 0
1
2
3
4
5
6
7
8
9
10
Denmark 11

4.3
Belgium

4.7
Switzerland
Risk premium, %

5.1
Spain

5.3
Canada

5.8
Ireland
5.9
Germany
5.9

UK
6.3

Country
Average
6.4

Netherlands
6.6

USA
7.6

Sweden
8.1

South Africa
8.2

Australia
8.6

France
9.3

Japan
10

Italy
10.7
Average Market Risk Premia
 Rates of Return 1900-
2003
80% Stock Market Index Returns
Percentage Return

60%

40%

20%

0%

-20%
1900 1920 1940 1960 1980 2000
-40%

-60%

Year
Source: Ibbotson Associates
 0
4
8
12
16
20
24
# of Years
-50% to -40%

1
-40% to -30%

1
4
-30% to -20%

-20% to -10%
10
-10% to 0%
12

0% to 10%
19

10% to 20%
15

20% to 30%
Histogram of Annual Stock

30% to 40%
13

40% to 50%
3

50% to 60%
2
24Market Returns

Return %
Market Performance
 Types of risk
Unique Risk (also called “diversifiable risk”):
 Unique risk associated with the assets owned by the company
 Industry risks, e.g. competition, innovation, R&D dependence,
etc.
 Risk related to outstanding debt (financial leverage)
 Age, size and stability of the organization
Market Risk (also called “systematic risk”):
 Economic volatility
 Inflation
 Political or other events that impact stability or the value of
assets
 Changes in interest rates
 Measuring Risk

 Investors must be compensated for volatility

(likelihood of incurring a loss) due to any of the
risk factors on the previous slide
 Total risk is measured by variance or standard
deviation in stock returns.
 Unique risk, however, can be nearly
completely eliminated in a diversified
portfolio
 Portfolio Theory

Price changes vs. Normal distribution

Coca Cola - Daily % change 1987-2004
0.14

0.12
Proportion of

0.1

0.08

0.06
Days

0.04

0.02

0
-9 -7 -5 -3 -1 0 2 4 6 7
% daily change
 Portfolio Theory

Standard Deviation vs. Expected Return

20
Investment A
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 Portfolio Theory

Standard Deviation vs. Expected Return

20
Investment B
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 Portfolio Theory

Standard Deviation vs. Expected Return

20
Investment C
18
16
14
probability

12
10
8
%

6
4
2
0
-50 0 50

% return
 Portfolio Theory

Combining stocks into portfolios reduces the

portfolio standard deviation below the
weighted average of the individual stocks.
Covariance (also measured by correlation
coefficient) between assets makes this
possible.
The various weighted combinations of stocks
that create this standard deviations constitute
the set of “efficient portfolios” or efficient
frontier.
frontier
 Expected Return on a Portfolio

Portfolio rate
of return (
=
in first asset, w1 )(
fraction of portfolio
x
rate of return
on first asset, r1 )
+
(in second asset, w 2)(
fraction of portfolio
x
rate of return
on second asset, r2 )
 Measuring Risk
Calculating variance and standard deviation
(1) (2) (3)
Percent Ra te of Return Deviation from Mean Squared Deviation
+ 40 + 30 900
+ 10 0 0
+ 10 0 0
- 20 - 30 900
Variance = average of squared deviations = 1800/4 = 450
Standard deviation = square root of variance = 450 = 21.2%
Excel formulas: = var(…), =stdev(…)
 Reducing Volatility
Portfolio standard deviation

0
5 10 15
Number of Securities
 Diversification
Portfolio standard deviation

Unique
risk

Market risk
0
5Number of Securities
10 15
 Portfolio Risk

The total variance of a two stock portfolio is the sum of

these four boxes

Stock 1 Stock 2
w1w 2σ12 =
Stock 1 w12σ12
w1w 2ρ12σ1σ 2
w1w 2σ12 =
Stock 2 w 22σ 22
w1w 2ρ12σ1σ 2
 Portfolio Risk

Expected Portfolio Return = (w1 r1 ) + ( w 2 r2 )

Weighted average of expected returns

Portfolio Variance = w12σ12 + w 22σ 22 + 2( w1w 2ρ12σ1σ 2 )

 Portfolio Risk Example

Example
Suppose you invest 40% of your portfolio in
Exxon Mobil and 60% in Coca Cola. The
expected return on your Exxon Mobil stock is 15%
and 10% on Coca Cola. Your portfolio expected
return is:
Expected Return = (.40 × .15) + (.60 × .10) = 12.0%
 Portfolio Risk
Example
Suppose you invest 40% of your portfolio in Exxon Mobil (XOM) and 60% in
Coca Cola (KO). The expected return on XOM is 15% and 10% on KO. The
historical standard deviation of their annualized daily returns are 22.4%
and 16.7%, respectively. Assume a correlation coefficient of 0.6 and
calculate the portfolio variance (see XL solution).

XOM KO
w1w 2ρ12σ1σ 2 = .40 × .60
Exxon - Mobil w12σ12 = (.40) 2 × (.224) 2
x.6 × .224 × .167
w1w 2ρ12σ1σ 2 = .40 × .60
Coca - Cola w 22σ 22 = (.60) 2 × (.167) 2
× .6 × .224 × .167
 Efficient Frontier
Return

Low Risk High Risk

High Return High Return

Low Risk High Risk

Low Return Low Return

Risk
 Efficient Frontier
•Each half egg shell represents the possible weighted combinations for two
stocks.
•The composite of all stock sets constitutes the efficient frontier

Expected Return (%)

Efficient
Frontier

Standard Deviation
 Tangent Portfolio
Return

Market Portfolio (e.g.

NYSE Composite or
. Efficient Portfolio
S&P 500)

r
Risk Free Return f =

Risk
 New Efficient Frontier
Lending or Borrowing at the risk free rate (rf) allows us to exist outside the
efficient frontier. “New” Efficient Frontier
(SML)
Expected Return (%)
T o w ing
o rr
B

g
T = tangent point to the market
n din portfolio
Le

rf

Standard Deviation
 Lending vs. Borrowing

The optimal investment (highest risk / reward ratio) lies

on the security market line – a combination of the
risk-free asset and the market portfolio.
An investor can invest more than 100 percent of his or
her wealth by borrowing (margin) and increasing both
risk and expected return.
An investor wanting less risk would split his or her
investments between risk-free assets and the market
portfolio (lending portion of SML).
Return Security Market Line

SML

Slope =
Beta
rf
BETA
1.0 = market

SML Equation = rf + B ( rm - rf )
 Beta as a Measure of Risk

Beta - Sensitivity of a stock’s return

to the return on the market portfolio.
σ im
Bi = 2
σm
Covariance of asset
“i” with the market

Variance of the market

 Measuring Beta
Dell Computer

Dell return (%)

Price data: May 91- Nov 97

R2 = .10
B = 1.87

Slope determined from plotting the Market return (%)

line of best fit.
 Measuring Beta
Dell Computer

Dell return (%)

Price data: Dec 97 - Apr 04

R2 = .27
B = 1.61

Slope determined from plotting the Market return (%)

line of best fit.
 Measuring Beta
General Motors

GM return (%)
Price data: May 91- Nov 97

R2 = .07
B = 0.72

Market return (%)

Slope determined from plotting the
line of best fit.
 Measuring Beta
General Motors

GM return (%)
Price data: Dec 97 - Apr 04

R2 = .29
B = 1.21

Slope determined from plotting the Market return (%)

line of best fit.
 Measuring Beta
Exxon Mobil
Price data: May 91- Nov 97

Exxon Mobil return (%)

R2 = .23
B = 0.57

Slope determined from plotting the Market return (%)

line of best fit.
 Measuring Beta
Exxon Mobil
Price data: Dec 97 - Apr 04

Exxon Mobil return (%)

R2 = .18
B = 0.51

Slope determined from plotting the Market return (%)

line of best fit.
 Return Security Market Line

r SML

m
Slope =
Beta
rf

“Market Risk BETA

Premium” 1.0 = market

SML Equation = rf + B ( rm - rf )
 Capital Asset Pricing Model

R = rf + B ( rm - rf )

Capital Asset Pricing Model

(CAPM)
 Market Risk Premium

The market risk premium is the expected

return on the market portfolio less the
expected risk-free rate (rm – rf). The expected
premium at this point in time (Jeff Allen’s
number..) is 6.0 percent.
 Testing the CAPM

Avg Risk Premium

1931-2002
beta vs. average risk premium
30
Investor SML
returns
20

10
Market
Portfolio
rf
Portfolio Beta
1.0
 Testing the CAPM
Avg Risk Premium
1931-65 beta vs. averageSML
risk premium
30
Investor
Returns
20

10 Market
Portfolio
rf
Portfolio Beta
1.0
 Testing the CAPM
Avg Risk Premium
1966-2002 beta vs. average risk premium
30

Investor
20 returns SML

10
Market
rf Portfolio
Portfolio Beta
1.0
 CAPM and Cost of Capital

Let’s first assume that the company is

financed solely with equity.
A firm’s value can be stated as the sum of
the value of its various assets

Firm value = PV(AB) = PV(A) + PV(B), etc.

 Cost of Capital

A company’s cost of capital can be

compared to the CAPM required return
SML
Required
return
13
Company
Cost of
Capital
5.5

0
Project Beta
1.26
 Cost of Capital

Category Est. Discount Rate

Speculativ e Ventures 30%
New products 20%
Expansion of existing business 12.5% (Company COC)
Cost improvemen t, known technolog y 10%

Adjustments to the required

return are often ad hoc…we
can do better
 Calculating the cost of capital

Cost of Debt: After-tax yield of outstanding debt

rdebt = avg. yield to maturity
Cost of Equity: Risk-free rate + risk premium
requity = risk-free rate + beta (market risk premium)

WACC: rdebt (1-t)(D/V) + requity (E/V)

where V = D (total value of debt) + E (market value of equity)
(we use market values for the weights if available)
 Cost of capital (example)

 Suppose a firm has $3M debt outstanding

yielding 8.5 percent. The stock price is $35
and the firm has 200,000 shares
outstanding. The equity beta of the firm is
1.25, the current risk-free rate is 5 percent.
Assume the risk premium for holding the
market portfolio is expected to be 6
percent. At a tax rate of 34 percent, what
is the cost of capital?
 T. Medical Cost of Capital
Example: Technol Medical has 1M shares of stock outstanding
which currently trade at $12 per share. The company also has
100,000 shares of preferred stock outstanding which pay a $3
dividend and currently trade at $21.38 per share. The firm has
publicly traded bonds with 10 years remaining to maturity, 10%
coupon payments, a total face value of $5M which currently
trade at $985 per bond. The equity beta is estimated at 1.2,
the risk-free rate is seven percent, t = 34%, and the market risk
premium is six percent. What is the WACC for T.Medical?
 Nike, Inc. : Cost of Capital Case

Read through Exhibits 1-5 in the case

In groups of two, calculate the WACC for Nike
independently of the analysis by Ms. Cohen
Note any improvements you would make to
Ms. Cohen’s analysis
 PepsiCo Inc.: Cost of Capital

How has the company performed over the

past 10 years?
How have the segments performed?
What is your estimate of the cost of capital
for each division of the company (soft drinks,
restaurants & snack foods)