QDai for FEUNL Finanças November 7

QDai for FEUNL Topics covered  CAPM for cost of capital  Estimation of beta

QDai for FEUNL Risk and cost of capital  Previously: Determine the timing and the size of cash flows  Now: determine the discount rate for risky cash flows  The discount rate can be computed from the CAPM

QDai for FEUNL Invest in project Choices of a firm with extra cash Firm with excess cash Shareholder’s Terminal Value Pay cash dividend Shareholder invests in financial asset A firm with excess cash can either pay a dividend or make a capital investment

QDai for FEUNL Capital budgeting rule  The discount rate of a project  The expected return

QDai for FEUNL Cost of capital  Example Suppose the stock of a company 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?

QDai for FEUNL Example (continued) Suppose the company is evaluating the following non-mutually exclusive projects. Each costs $100 and lasts one year. Project Project  Project’s Estimated Cash Flows Next Year IRRNPV at 30% A2.5$15050%$15.38 B2.5$13030%$0 C2.5$11010%-$15.38

QDai for FEUNL Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects Project IRR Firm’s risk (beta) 5%

QDai for FEUNL Estimation of beta  Beta: Sensitivity of a stock’s return to the return on the market portfolio.  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. 

QDai for FEUNL Stability of Beta  Many 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.

QDai for FEUNL 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,  If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry  Adjustments

QDai for FEUNL Determinants of beta  Cylicality of revenues

QDai for FEUNL Determinants of beta  Operating leverage how sensitive a firm is to its fixed costs.

QDai for FEUNL Operating Leverage Volume $  EBIT  Volume

QDai for FEUNL Determinants of beta  Financial leverage Operating leverage Financial leverage The relationship between the betas of the firm’s debt, equity, and assets is given by: The beta of debt

QDai for FEUNL Financial Leverage and Beta: Example Consider a company which is currently all-equity and has a beta of 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 However, assuming a zero beta for its debt, its equity beta would become:

QDai for FEUNL Financial leverage and beta  Conclusion

QDai for FEUNL Extension of the basic model  The firm vs the project The risk of a project The project should be discounted with

QDai for FEUNL The firm vs the project A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value. Project IRR Firm’s risk (beta) rfrf  FIRM Hurdle rate

QDai for FEUNL 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 % = 4% × [14% – 4%] This is a breakdown of the company’s investment projects: 1/3 Automotive retailer  = 2.0 1/3 Computer Hard Drive Mfr.  = 1.3 1/3 Electric Utility  = 0.6 average  of assets = 1.3 When evaluating a new electrical generation investment, which cost of capital should be used? The firm vs the project

QDai for FEUNL Capital Budgeting & Project Risk Project IRR Project’s risk (  ) 17% 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. 10% 24% Investments in hard drives or auto retailing should have higher discount rates. SML

QDai for FEUNL Extention of the basic model  The Weighted Average Cost of Capital  It is because interest expense is tax- deductible that we multiply the last term by

QDai for FEUNL WACC  Example: a firms with a debt-equity ratio of 0.6, a cost of debt of 15.15%, and a cost of equity of 20%. The corporate tax rate is 34%.  Debt to value ratio=6/(10+6)=0.375  Equity to value ratio= =0.625  r wacc =0.625*20%+0.375*15.15%*(1-0.34) =16.25%

QDai for FEUNL Steps to calculate WACC Cost of equity Cost of debt Calculate WACC