1. Jacoby, Stangeland and Wajeeh, 20001 The Cost of Equity uThe Cost of Equity (CAPM): E(r S ) = r f +  s [E(r m ) - r f ] uEquity Beta:  S =  Sm /  m 2 Example: The following are U-Air stocks and TSE300 index returns for the 1994-1997 period: YearU-AirTSE300 19944.00%-0.18% 199530.0014.53 199642.0028.35 199734.0014.98 Case – Part 2 - Q1 Chapter 12

2. 2 Calculating the Equity Beta uCalculating average returns: uCalculating the covariance: uCalculating the market variance: uCalculating beta:

3. 3 uU-Air’s Cost of Equity (CAPM): Given a 5.09% average T-bill rate, the average historical market risk-premium for the 1994-1997 period is By the CAPM, if the current T-bill rate is 4%, then the cost of U-Air’s equity is given by: E(r s ) = r f +  s [E(r m ) - r f ] = Calculating the Cost of Equity Case – Part 2 – Q2

4. Jacoby, Stangeland and Wajeeh, 20004 uFor U-Air it is given that: YearDividend 0 $0.39 (1+g) 4 D -4 = D 0 -1 $0.37 (1+g) 4 0.33 = 0.39 -2 $0.36 => g = -3 $0.34 -4 $0.33Also: D 1 = D o (1+g) = 0.39 % 1.0427 = 0.41 Since P 0 = $3.65, by the dividend growth model: r s = (D 1 /P 0 ) + g = uFor the remainder of the case, we will assume that the Cost of Equity is that obtained by the CAPM, i.e. 16.6% An alternative Method for Calculating the Cost of Equity

5. 5 uSuppose that U-Air is an all equity firm. Recall that the new Bahamas project generates the following CFs ($Ks): YearCF 0(41,600) 1 4,740 IRR = 10.95% 2 11,180 3 15,185 4 25,954.375 Assume: uU-Air is an all equity firm uThe Bahamas project beta is the same as U-Air’s beta (1.35) Decision: uNPV = -$5,690.98 reject the project. Or: uSince by the CAPM (SML) the required return for beta of 1.35 is 16.6%, and IRR=10.95% reject the Bahamas project The Investment Decision Case – Part 2 – Q2

6. Jacoby, Stangeland and Wajeeh, 20006 The SML and the Investment Decision Expected Return (%) Beta 16.6 4 1.35 IRR = 10.95 * U-Air * Bahamas Project SML

7. Jacoby, Stangeland and Wajeeh, 20007 Determinants of Beta uFactors affecting Equity Beta: u Business Risk uCyclicity of Revenues uOperating Leverage u Financial Risk uFinancial Leverage

8. Jacoby, Stangeland and Wajeeh, 20008 Financial Leverage uWhen the firm is not “All Equity” uRecall: the beta of a portfolio (p) with N assets is given by: uThe Firm’s Assets are financed by Equity and Debt uFirm’s Assets = Portfolio with Equity and Debt:  ASSETS =  EQUITY [S/(S+B)] +  DEBT [B/(S+B)] AssetsEquity (S) Debt (B)

9. Jacoby, Stangeland and Wajeeh, 20009 The Cost of Capital of a Levered Firm uRecall: the return of a portfolio (p) with N assets is given by: uThe Weighted Average Cost of Capital(WACC): WACC = r ASSETS = r S [S/(S+B)] + r B (1 – Tc) [B/(S+B)] after-tax cost of debt

10. 10 uAssuming that a project has the same beta and financial leverage as the whole firm: u calculate the NPV of the project based on the firm’s WACC u compare the IRR of the project to its WACC It is given that: Equity/Assets = 0.53, and Debt/Assets = 0.47 uRecall: by the CAPM: r S = 16.6% uU-Air’s Long-Term bonds are traded with YTM = 6.04% uRecall that Tc = 0.4 uThen, U-Air’s Weighted Average Cost of Capital(WACC) is: WACC = r S [S/(S+B)] + r B (1 – Tc) [B/(S+B)] = Case – Part 2 – Q3

11. Jacoby, Stangeland and Wajeeh, 200011 WACC of the Bahamas Project uIf the Bahamas project has the same beta and financial leverage, then uAlso: IRR=10.95%>10.5% => accept the Bahamas project Case – Part 2 – Q4

12. 12 When the Firm’s beta Differs from the Project’s Beta uThe project and the firm may have different betas u when the project and the firm are not from the same line of business - use industry beta (not always available, e.g. Amazon.com) u when the project’s risk is inherently different (even if same industry ) uSuppose that the beta of the Bahamas line is 1.8 (higher than U-Air). By the CAPM: r BAHAMAS = r f +  s [E(r m ) - r f ] = uThen, the WACC of the Bahamas project is: WACC BAHAMAS = r BAHAMAS [S/(S+B)] + r B (1 – Tc) [B/(S+B)] = u uOr: IRR=10.95% reject the Bahamas project Case – Part 2 – Q5 & Q6