Last Study Topics Qualification of Statements. Examples. CAPM APT Three Factors Model

Today’s Study Topics Company and Project Costs of Capital Measuring the Cost of Equity

Chapter 9 Capital Budgeting and Risk Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Chapter 9 Capital Budgeting and Risk McGraw Hill/Irwin

Introduction LONG BEFORE THE development of modern theories linking risk and expected return, smart financial managers adjusted for risk in capital budgeting. How they should treat the element of risk with respect to each and every projects of different class?

Continue Various rules of thumb are often used to make these risk adjustments. For example, many companies estimate the rate of return required by investors in their securities and then use this company cost of capital to discount the cash flows on new projects.

COMPANY AND PROJECT COSTS OF CAPITAL The company cost of capital is defined as the expected return on a portfolio of all the company’s existing securities. It is used to discount the cash flows on projects that have similar risk to that of the firm as a whole.

Continue We estimated that investors require a return of 9.2% from Pfizer common stock. If Pfizer is contemplating an expansion of the firm’s existing business, it would make sense to discount the forecasted cash flows at 9.2 %. The company cost of capital is not the correct discount rate if the new projects are more or less risky than the firm’s existing business..

Company Cost of Capital A firm’s value can be stated as the sum of the value of its various assets. Each project should in principle be evaluated at its own opportunity cost of capital. For a firm composed of assets A and B, the firm value is;

Continue Here PV(A) and PV(B) are valued just as if they were mini-firms in which stockholders could invest directly. Investors would value A by discounting its forecasted cash flows at a rate reflecting the risk of A. They would value B by discounting at a rate reflecting the risk of B. The two discount rates will, in general, be different.

Continue This means that Pfizer should accept any project that more than compensates for the project’s beta. In other words, Pfizer should accept any project lying above the upward-sloping line that links expected return to risk in Figure 1. If the project has a high risk, Pfizer needs a higher prospective return than if the project has a low risk.

Company Cost of Capital A company’s cost of capital can be compared to the CAPM required return 13 5.5 SML Required return Company Cost of Capital Project Beta 1.26

Understanding In terms of Figure1, the rule tells Pfizer to accept any project above the horizontal cost of capital line, that is, any project offering a return of more than 9.2%. The company cost of capital rule, which is to accept any project regardless of its risk as long as it offers a higher return than the company’s cost of capital.

Understanding It is clearly silly to suggest that Pfizer should demand the same rate of return from a very safe project as from a very risky one. If Pfizer used the company cost of capital rule, it would reject many good low-risk projects and accept many poor high-risk projects. Many firms require different returns from different categories of investment.

Understanding For example, discount rates might be set as follows:

Perfect Pitch and the Cost of Capital The true cost of capital depends on project risk, not on the company undertaking the project. So why is so much time spent estimating the company cost of capital? First, many (maybe, most) projects can be treated as average risk, that is, no more or less risky than the average of the company’s other assets. For these projects the company cost of capital is the right discount rate.

Continue Second, the company cost of capital is a useful starting point for setting discount rates for unusually risky or safe projects. It is easier to add to, or subtract from, the company cost of capital than to estimate each project’s cost of capital from scratch. Anyone who can carry a tune gets relative pitches right.

Business People are used to, but not about absolute risk or required rates of return. Therefore, they set a companywide cost of capital as a benchmark. This is not the right hurdle rate for everything the company does. But adjustments can be made for more or less risky ventures.

MEASURING THE COST OF EQUITY Suppose that you are considering an across-the-board expansion by your firm. Such an investment would have about the same degree of risk as the existing business. Therefore you should discount the projected flows at the company cost of capital. Companies generally start by estimating the return that investors require from the company’s common stock.

Continue Used the capital asset pricing model to do the working. This states; Expected stock return =rf + Beta(rm – rf) An obvious way to measure the beta (B) of a stock is to look at how its price has responded in the past to market movements.

Measuring Betas The SML shows the relationship between return and risk. CAPM uses Beta as a proxy for risk. Other methods can be employed to determine the slope of the SML and thus Beta. Regression analysis can be used to find Beta.

Dell Computer Stock Calculated monthly returns from Dell Computer stock in the period, after it went public in 1988, is given on the next slide. Also plotted returns against the market returns for the same month, is given too. We have fitted a line through the points. The slope of this line is an estimate of beta.

Measuring Betas Slope determined from plotting the line of best fit. Dell Computer Price data – Aug 88- Jan 95 R2 = .11 B = 1.62 Dell return (%) Slope determined from plotting the line of best fit. Market return (%)

Measuring Betas Slope determined from plotting the line of best fit. Dell Computer Price data – Feb 95 – Jul 01 R2 = .27 B = 2.02 Dell return (%) Slope determined from plotting the line of best fit. Market return (%)

Other Stocks The next diagram shows a similar plot for the returns on General Motors stock, and the Third shows a plot for Exxon Mobil. In each case we have fitted a line through the points. The slope of this line is an estimate of beta. It tells us how much on average the stock price changed for each additional 1% change in the market index.

Measuring Betas Slope determined from plotting the line of best fit. General Motors Price data – Aug 88- Jan 95 R2 = .13 B = 0.80 GM return (%) Market return (%) Slope determined from plotting the line of best fit.

Measuring Betas Slope determined from plotting the line of best fit. General Motors Price data – Feb 95 – Jul 01 R2 = .25 B = 1.00 GM return (%) Slope determined from plotting the line of best fit. Market return (%)

Measuring Betas Slope determined from plotting the line of best fit. Exxon Mobil Price data – Aug 88- Jan 95 R2 = .28 B = 0.52 Exxon Mobil return (%) Slope determined from plotting the line of best fit. Market return (%)

Measuring Betas Slope determined from plotting the line of best fit. Exxon Mobil Price data – Feb 95 – Jul 01 R2 = .16 B = 0.42 Exxon Mobil return (%) Slope determined from plotting the line of best fit. Market return (%)

Understanding Diagrams show plots for the three stocks during the subsequent period, February 1995 to July 2001. Although the slopes varied from the first period to the second, there is little doubt that Exxon Mobil’s beta is much less than Dell’s or that GM’s beta falls somewhere between the two. If you had used the past beta of each stock to predict its future beta, you wouldn’t have been too far off.

Understanding Only a small portion of each stock’s total risk comes from movements in the market. The rest is unique risk, which shows up in the scatter of points around the fitted lines in Diagrams. R-squared (R2) measures the proportion of the total variance in the stock’s returns that can be explained by market movements.

Table 1 Estimated betas and costs of (equity) capital for a sample of large railroad companies and for a portfolio of these companies. The precision of the portfolio beta is much better than that of the betas of the individual companies—note the lower standard error for the portfolio.

Summary Company and Project Costs of Capital Beta As a Proxy