Risk and the Cost of Capital

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Presentation transcript:

Risk and the Cost of Capital Slides by Matthew Will

Company Cost of Capital A company’s cost of capital can be compared to the CAPM required return 5.7 2.0 SML Required return Company cost of capital 0.53 Project beta

Company Cost of Capital IMPORTANT E, D, and V are all market values of equity, debt and total firm value

Weighted Average Cost of Capital WACC is the traditional view of capital structure, risk and return

Capital Structure and Equity Cost Capital structure - the mix of debt & equity within a company Expand CAPM to include capital structure: r = rf + β(rm − rf) This becomes: requity = rf + β(rm - rf)

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

Measuring Betas

Estimated Betas

Company Cost of Capital Company cost of capital (COC) is based on the average beta of the assets The average beta of the assets is based on the % of funds in each asset Assets = debt + equity

Capital Structure and COC Expected returns and betas prior to refinancing requity= 9.8 rassets= 9.1 Expected return (%) rdebt= 4.2 βdebt βassets βequity

Company Cost of Capital: Simple Approach Company cost of capital (COC) is based on the average beta of the assets The average beta of the assets is based on the % of funds in each asset Example 1/3 New ventures β = 2.0 1/3 Expand existing business β = 1.3 1/3 Plant efficiency β = 0.6 Average β of assets = 1.3

Company Cost of Capital Category Discount Rate Speculative ventures 15.0% New products 8.0% Expansion of existing business 3.8% (Company COC) Cost improvement, known technology 2.0%

Asset/Revenue Betas

Allowing for Possible Bad Outcomes Example Project Z will produce just one cash flow, forecasted at $1 million at year 1. It is regarded as average risk, suitable for discounting at a 10% company cost of capital:

Allowing for Possible Bad Outcomes Example- continued But now you discover that the company’s engineers are behind schedule in developing the technology required for the project. They are confident it will work, but they admit to a small chance that it will not. You still see the most likely outcome as $1 million, but you also see some chance that project Z will generate zero cash flow next year.

Allowing for Possible Bad Outcomes Example- continued This might describe the initial prospects of project Z. But if technological uncertainty introduces a 10% chance of a zero cash flow, the unbiased forecast could drop to $900,000.

Correcting for Optimistic Forecasts

Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?

Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV?

Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV?