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

1. 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

2. 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?

3. 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.

4. 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,

5. 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.

6. 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

7. 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.

8. 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.

9. 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.

10. 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

11. 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

12. 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!)

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

15. 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.

16. 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.

17. 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.

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

19. 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)

20. 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.

21. 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.

22. 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% ×7%
= 14.82%

23. 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)
= × 14.82% × 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.

24. 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

25. 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.

26. 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 % = 4% × 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

27. 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.

28. 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!