1. Risk, Cost of Capital, and Capital Budgeting

2. Valuing a Project When valuing a project you need two things: 1. 2. Initially you were given both (Unit 1), then you learned how to find the cash flows (Unit 2), so what are we learning know? 2

3. 3 Method 1: Matching Basic Idea: Find another project with the same systematic risk characteristics, and use that project’s return as the discount rate

4. 4 Example Assume you need to find the discount rate for an apple picking machine, and you find that a pear picking machine offers a return of 15%.  Assume that pears and apples have the same systematic risk The appropriate discount rate for the apple picking machine is _____%.

5. 5 Method 2: CAPM CAPM: E(r i ) = r f + β i (r M - r f ) CAPM gives the expected return for a given level of systematic risk  The expected return is what an investment with this much risk should earn

6. 6 Project β Example Think of the project’s β being like the β of a portfolio, and how did we find the portfolio β? The project/firm can be thought of as a portfolio of its components: Financing, Assets, Divisions, etc

7. 7 Firm β Example  f represents the systematic risk associated with the firm assets If the firm is all equity financed then β f If the firm is all debt financed then β f If the firm is financed with both

8. 8 Using β a Once we have our estimate of β a, we can plug it into the CAPM and find the appropriate discount rate r a = r f + β a (r M - r f )

9. 9 Method 3: Weighted Average Cost of Capital (WACC) Here we are going to work with the returns required by the firms investors (Equity, Debt, etc) to find the company’s/projects cost of capital

10. 10 Weighted Average Cost of Capital (WACC) If you own all of the debt and equity you own the whole firm, and the return you receive is simply the weighted average of the return on debt (r d ) and equity (r e ) r a = WACC =

11. 11 Weights General Market Value of the Firm = E + D  E: Market Value of Equity = Price * # of shares outstanding Equals the PV of the cash flows to all equity holders  D: Market Value of Debt = Price * # of bonds outstanding Equals the PV of the cash flows to all debt holders

12. Weights Examples What is the firm’s debt and equity weight  If debt-to-equity = 0.8  If debt-to-value = 0.8 12

13. Equity and Debt’s Expected Return We will generally use CAPM to get r e We will use the YTM to get r d  Why do we use the YTM? If the firm has no debt but it has plans to issue debt why do we use the coupon rate as r d, Why? 13

14. 14 Example Suppose a firm is worth $100m and its equity is worth $40m. Given that the return on equity is 20% and the return on debt is 10%, calculate the firm’s WACC. WACC = r a = What does WACC represent?

15. 15 Example Continued What would be the asset beta if we assume that  d = 0.5, and  e = 1.5? What will r a be according to CAPM?  r f = 5%, r m = 15%

16. 16 Alternative WACC Calculations Using Returns:  WACC= D/V * r d + E/V * r e Using Beta’s (Similar To CAPM):  Use  e and  d to get  a, then use CAPM to get WACC   a = D/V *  d + E/V*  e  WACC = R f +  a * E(R m - R f ) Both methods give the same result

17. 17 Alt Formula Proof: Not on Test WACC = R f +  a *(R m –R f ) WACC= WACC = D/V*r d + E/V*r e

18. 18 What happens to WACC as the Firm’s Capital Structure Changes Going back to our WACC example. Investor’s required a 14% return on the whole firm. If the firm decides to issue debt and buyback equity, what will happen to the return required by:  An investor owning the entire company  Equity investors  Debt investors

19. 19 Why are Equity and Debt Cash Flows Riskier? As a firm takes on more debt, it is more likely that the firm will not be able to meet it debt obligations, and declare bankruptcy  This is known as Default or Financial Risk As a firm issues more debt what will happen to default risk?

20. 20 Default Risk and Required Returns As default risk increases, increasing the required return for equity and debt, how can the firms required return remain constant?

21. 21 WACC Graph

22. 22 Changing Leverage: WACC = 13% E/VReRdE/VReRd 113.0%0.5018.0%8.0% 0.9513.5%3.5 %0.4518.5 %8.5 % 0.9014.0%4.0%0.4019.0%9.0% 0.8514.5 %4.5 %0.3519.5 %9.5 % 0.8015.0%5.0%0.3020.0%10.0% 0.7515.5 %5.5 %0.2520.5 %10.5 % 0.7016.0%6.0%0.2021.0%11.0% 0.6516.5 %6.5 %0.1521.5 %11.5 % 0.6017.0%7.0%0.1022.0%12.0% 0.5517.5 %7.5 %0.0522.5 %12.5 %

23. 23 Default Risk and  What happens to the company’s  as the company’s capital structure changes?

24. 24 What will happen Suppose the firm decides to alter its capital structure by raising $20m in equity and using the cash to pay down debt. What should happen to β d & β e ? Explain

25. 25 Boeing Example Boeing is planning to increase its capacity so that it can cater to increased demand. The firm currently has no debt What is the appropriate discount rate for its expansion?  R f = 5%, R m - R f = 10%,  e = 1.5.

26. 26 Levered Boeing Now, assume Boeing has debt in the capital structure.  Assume that  e remains the same even though we know this is not true. It’s target debt-equity ratio is 30%, and it’s debt has a beta of 0.2. Now, what is the appropriate discount rate?

27. 27 Lubbock Brewing Example Lubbock Brewing’s common stock has a market value of $40m, and its debt has a market value of $10m. Assume these values reflect the target D/E ratio.  The beta of the stock is 1.2 and the expected risk premium on the market is 10%.  The current T-bill rate is 5%.  Assume debt is risk free.

28. 28 Calculate The required return on Lubbock Brewery equity and debt  r e =  r d = Asset beta   a = WACC using both methods  WACC = Discount rate for an expansion project

29. 29 Apparel Expansion Lubbock Brewery is considering diversifying into the apparel business. There are two apparel companies that are similar to the project being considered. These firms are not involved in any other business.  Fashion Clothing, which has no debt in the capital structure, with an equity beta of 0.9.  Tempe Trends has a debt-value ratio of 0.1, an equity beta of 0.9 and a debt beta of 0.1. What is the appropriate discount rate?

30. 30 Lingo Example Lingo Co. is currently involved in the manufacture of steel. It has a modernization plan which is expected to save $10m in cash flows each year over the next 3 years. The investment required is $20m. Should it take up the project? The following details are available: Firm's current equity beta and debt beta are 1.2 and 0.3 respectively. Risk free rate is 4%. Expected market risk premium is 10%. Firm's target debt- equity ratio is 0.5.

31. 31 Lingo Computer Expansion Lingo Co is planning to diversify further into computers. It has identified two competitors While Compaq manufactures only computers, Toshiba manufactures other products as well. What is the discount rate for this diversification project? ee D/VCouponYTM Compaq1.20.38%6% Toshiba1.50.49%7%

32. 32 Discounting Projects with WACC The WACC is the discount rate for the entire company True/False:  Since we now have the company’s WACC, are we able to value all of the firm’s potential investments

33. So why all this work to find WACC A firm’s WACC is a benchmark Determining how risky a project is can be difficult Determining how risky a project is compared to what you currently do is easy  We can adjust the firm’s WACC to account for the riskiness of the new project 33

34. 34 Relative Discount Rates Project with same risk as firm  Discount rate will ________ firm’s WACC Project with more risk than firm  Discount rate will ________ firm’s WACC Project with less risk than firm  Discount rate will ________ firm’s WACC

35. 35 What about TAXES Without taxes all of a firm’s cash goes to investors, equity or debt holders With taxes the firm also needs to payoff the government As some of the firm’s cash flows are needed to payoff non-investors (Uncle Sam) what will happen to firm value compared to the no tax world

36. 36 Who is paid first? In a world with taxes the firm needs to payoff, equity, debt and Uncle Sam. What is the order of payments? 1. 2. 3. What does this order of payments imply?

37. 37 WACC with TAXES No Taxes: WACC= E/V * r e + D/V * r d With taxes WACC =

38. Using WACC with Taxes To find the value of a firm using WACC we either: 1. Use pre-tax cash flows and tax adjusted WACC 2. Use after-tax cash flows and WACC without tax adjustments We cannot use after-tax cash flows and adjusted WACC → Double counting tax effects 38

39. 39 Summary The company’s cost of capital is not the expected return on it’s stock or debt The company cost of capital is a weighted average of the returns that investors expect from the debt and equity issued by the firm. The company cost of capital is related to the firm’s asset beta, not to the beta of the common stock.

40. 40 Summary Continued The asset beta can be calculated as a weighted average of the betas of the various securities. When the firm changes its financial leverage, the risk and expected returns of the individual securities change. The asset beta and the company cost of capital do NOT change.

41. 41 Quick Quiz How do we determine the cost of equity capital? How can we estimate a firm or project beta? How does leverage affect beta? How do we determine the cost of capital with debt?

42. Why We Care Refinement of the time value of money, learning how to get the proper discount rate 42