Risk, Cost of Capital, and Capital Budgeting Chapter 12 Risk, Cost of Capital, and Capital Budgeting

Key Concepts and Skills Measure a firm’s cost of equity capital Grasp and interpret the impact of beta in determining the firm’s cost of equity capital Comprehend and calculate the firm’s overall cost of capital

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. Does it make any difference how the firm raises money? What is the proper discount rate when the firm uses both debt and equity? How do we do capital budgeting when the project has different risk and/or capital structure than the firm as a whole?

The Cost of Equity Capital Shareholder invests in financial asset Firm with excess cash Pay cash dividend Invest in project A firm with excess cash can either pay a dividend or make a capital investment Shareholder’s Terminal Value Therefore, the discount rate of a project should be the expected return on a financial asset of comparable risk. 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.

The Cost of Equity Capital From the firm’s perspective, the expected return is the Cost of Equity Capital: To estimate a firm’s cost of equity capital, we need to know three things: The risk-free rate, RF The market risk premium, The company beta,

Example 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? You may want to note that this example assumes expansion into projects that are similar to the existing nature of the business.

Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project Project b Project’s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B $130 30% $0 C $110 10% -$15.38

Using the CAPM and SML Good project 30% 2.5 A B C Project IRR Bad project 5% This, again, assumes independent projects. This is a good point at which to review the relation between IRR and NPV. Firm’s risk (beta) 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.

The Risk-free Rate Treasury securities are close proxies for the risk-free rate. The CAPM is a period model. However, projects are long-lived. So, average period (short-term) rates need to be used. As a practical matter, the one year Treasury Bill rate will be assumed as an accurate estimate of short term rates CAPM suggests that we should use a Treasury security whose maturity matches the time horizon of investors: No one agrees on what that horizon is! This approach follows Ibbotson.

The Market Risk Premium Method 1: Use historical data Method 2: Use the Dividend Discount Model Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis Expectations are not observable.

Estimation of Beta Market Portfolio - Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio. Is the project or a surrogate for it traded in financial markets? If so, gather data and run an OLS regression. 3

Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry. That is not to say that a firm’s beta cannot 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 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 adjusting for financial leverage. (COMING UP!)

Determinants of Beta Business Risk Financial Risk Cyclicality of Revenues Operating Leverage Financial Risk Financial Leverage

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 variability—stocks 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.

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: bAsset = Debt + Equity Debt × bDebt + Equity × bEquity Financial leverage always increases the equity beta relative to the asset beta.

Betas and Leverage (With Taxes!) If the firm uses debt, the equity beta is increased relative to the asset beta: implies: (1) equity holders will require a higher rate of return, (2) when surrogate firms are used to estimate beta, allowances for differing capital structures will be required.

Extensions of the Basic Model The Cost of Capital with Debt The Firm versus the Project

The Cost of Capital with Debt: The Weighted Average Cost of Capital or (WACC) When a firm has both debt and equity in its capital structure, the most frequent recommendation is to base the project discount rate on the weighted average cost of capital (WACC): where E is the market value of the firm’s equity D is the market value of the firm’s interest-bearing debt rE is the required rate of return on the firm’s stock rD is the required before tax rate of return on the firm’s debt TC is the firm’s marginal tax rate Because interest expense is tax-deductible, we multiply the last term by (1 – TC)

The Cost of Capital with Debt If the firm has debt in the capital structure, then two adjustments are required. Interest is tax deductible. Either allow for in cash flows or alter discount rate. We will do the latter and adjust the cost of capital accordingly! Financial leverage increases equity betas relative to the firm’s beta Does a regression estimate an equity beta or a firm’s asset beta? Calculation of the Cost of Debt The before tax cost of debt can be calculated as the yield to maturity on the firm’s existing debt. Can also be found from bond ratings of companies with comparable financial structure. – S&P or Moody’s The after tax cost of debt is the before tax cost of debt multiplied by (1-Tc), where Tc is the firm’s effective marginal tax rate.

Example: Eastman Chemical 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.

Example: Eastman Chemical Eastman’s beta on Reuters is 2.01, the risk free rate is .75%, and the market risk premium is 7%. Thus, the cost of equity capital is: RS = RF + bi × ( RM – RF) = .75% + 2.01×7% = 14.82%

Example: Eastman Chemical The yield on the company’s debt is 6.03%, and the firm has a 35% marginal tax rate. The debt to value ratio is 25.8% RWACC = S + B S × RS + B × RB ×(1 – TC) = 0.742 × 14.82% + 0.258 × 6.03% × (1 – 0.35) = 12% 12% is Eastman’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.

The Firm versus the Project Any project’s cost of capital depends on the use to which the capital is being put—not the source. Therefore, it depends on the risk of the project and not the risk of the company. What is the right discount rate for a company to use when evaluating potential investments in marketable securities? This relation is consistent with the separation principle discussed in a prior chapter. 16

Capital Budgeting & Project Risk The SML can tell us why: Project IRR Incorrectly accepted negative NPV projects Hurdle rate bFIRM Incorrectly rejected positive NPV projects rf Firm’s risk (beta) A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.

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? 17

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

Risk and Return -summary Equity Risk premiums are central to all models of risk and return in finance Risk is defined as variance around an expected return Risk is measured from the perspective of the marginal investor who is well diversified Therefore, only the risk that an investment adds to a portfolio should be compensated SYSTEMATIC RISK OF THE ASSET!