IEOR E4003 Industrial Economics Fall 2012

Professor Sadighian WACC Deterministic Capital Budgeting

Weighted Average Cost of Capital

Outline Why do we use WACC?

WACC tree

Guidelines for estimating WACC parameters

Cost of debt

Cost of equity and CAPM

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Why Do We Use WACC To compute the value of a project/company, we need to discount the FCFs (Free Cash Flows) with a rate that reflects the riskiness of the asset

Since this is more or less impossible to derive, we use the return that investors require for this asset as an approximation for the true discount rate

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Why Do We Use WACC Both creditors and shareholders expect to be compensated for the opportunity cost of investing their funds in one particular business instead of others with equivalent risk

The required rate of return for each class can be derived from observing the actual rate of return in the market or explicitly required returns (e.g. interest rates)

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Why Do We Use WACC WACC of an asset is the weighed opportunity cost of all investors for putting their money into the asset given the risk of the asset. It therefore reflects:

The riskiness of the asset, and

The way the asset is financed

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

WACC Tree

L B S P WACC = kd (1 t ) + ke + k p + kl (1 t ) V V V V
kd: cost of debt t: tax rate B: market value of debt V: market value of assets of company ke: cost of equity S: market value of stocks kp: cost of preferred stock P: market value of preferred stock kl: cost of leases L: market value of leases
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

WACC Tree

L B S P WACC = kd (1 t ) + ke + k p + kl (1 t ) V V V V
WACC determines the opportunity cost of any investment. A company creates value only if ROIC WACC > 0 We will focus on debt and equity

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

WACC Tree

S B WACC = k d (1 t ) + ke V V
WACC determines the opportunity cost of any investment. A company creates value only if ROIC WACC > 0 We will focus on debt and equity

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Announcements
Assignment #3 due now! Assignment #4 tomorrow! Extra class/Review session Sunday December 9th, IAB 417, 12:30 to 3:30 Sample Final will posted Final on Thursday December 13th

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

WACC Tree

S B WACC = kd (1 t ) + ke B+S B+S

Weighted cost of debt
+

Weighted cost of equity

x

x After tax cost of debt Market value of debt _________________ Market value of debt and equity Cost of equity

Market value of equity ___________________ Market value of debt and equity

CAPM ke=Risk free rate + (Market Risk Premium)*

IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Guidelines for Estimating WACC Parameters For any security (including corporate debt and equity), the nominal rate required by the investors is a function of:
The expected inflation over the life of the security The expected real rate over the life of the security The expected interest rate risk premium (if any) The expected risk premiums The expected illiquidity premium

E[r j ] = E[i ] + E[rreal ] + a j E[I ] + b j E[R ] + c j E[L ]

IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Guidelines for Estimating WACC Parameters Average rates of return of various securities, 1926-1997
(%/year)

Inflation Treasury Bills (3-month bills) Government Bonds Corporate Bonds Common Stocks (S&P 500) Small-firm Common Stocks

3.2% 3.8% 5.3% 5.8% 11.2% 12.9%

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Guidelines for Estimating WACC Parameters

Two risk premiums are needed for WACC calculation

Risk premium for the risky corporate debt

Risk premium for the common stock

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Debt Debt risk premiums
The term structure of government securities tells us the sum of the first three components in our security return decomposition For the corporate debt, we had to add the fourth component: the expected risk premium (for most of the corporate debt, we would also have to add the illiquidity premium but we will ignore this fact) The origin of the expected risk premium in the corporate bonds is naturally the default risk or credit risk

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Debt
Credit agencies rate corporate bonds Moodys
Aaa Aa A Baa

S&P
AAA AA A BBB

% of money raised in 1985

11.8% 30.4% 30.6% 14.5%

Investment grade bonds

Ba B Caa Ca C

BB B CCC CC C

2.7% 7.8% 2.2% 0.0% 0.0%

Junk bonds

These ratings try to objectively capture the expected credit risk of corporate bonds. The realized default risk is, of course, not perfectly correlated with the expected one
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Debt
Promised yields versus bond ratings
June 1999 (%)

Risk-free rate
3 months 4.90

AAA
5.18

AA
5.21

A
5.32

BBB
5.70

BB
6.18

B
7.39

6 months

5.00

5.53

5.56

5.70

6.04

6.64

7.78

1 year

5.34

5.74

5.78

5.90

6.30

6.86

7.99

2 years

5.67

6.03

6.06

6.18

6.66

7.47

8.43

5 years

5.92

6.39

6.43

6.61

7.03

8.00

8.83

10 year

6.19

6.64

6.73

6.82

7.33

8.74

9.86
Fall 2012, Prof. Sadighian & Kachani

IEOR E4003 Industrial Economics

Weighted Average Cost of Capital

Cost of Debt Debt risk premiums:
kd = riskless interest rate LT (10 years) + credit risk premium 0.5 4%

The riskless interest rate can be obtained from the term structure of government interest rates The riskless interest rate includes the first three components of the expected security return The fourth component is related to the credit risk a good proxy of this one is the credit rating

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Debt Capital leases: A Word on Leases and Preferred Stock

Can be seen as a substitute for normal borrowing. Thus, they are typically included in a companys long-term debt

Preferred stock:
Is a debt type instrument (although the preferred dividend is not tax deductible) whose expected return ( = cost to the company) is:

annual preferred dividend Div. kp = = market price of the preferred P

IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Equity and CAPM Capital Asset Pricing Model (CAPM) assumes:
Only variance (=risk) and expected return matter. This is true if stock returns are normally distributed All investors agree about variances, expected returns and correlations of all securities Investors can borrow and lend at the riskless rate No transaction costs No differential taxes

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Equity and CAPM Cost of equity:

ke = E[re ] = r f + e .( E[ rm ] r f ) Cov( Re , Rm ) where e = Var ( Rm )

It takes into account the first four components in our security return decomposition (riskless rate takes into account the first three) For the riskless rate, use a long-term government bond rate and for the market risk premium, use the long-term realized risk premium of 3.5-4% (McK)

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Cost of Equity and CAPM Example:
In March 1995, the riskless rate on 10-year government bonds was 7.1% and IBM had a beta of 1.3. What was IBMs cost of equity?

7.1% + 1.3 * 4% = 12.3%

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital

Summary

L B S P WACC = kd (1 t ) + ke + k p + kl (1 t ) V V V V
All cost variables (kd , ke , kp , and kl ) measure long-term costs of different sources of capital. Remember: we are using WACC to value an investment or a company today, not yesterday or tomorrow The tax rate tries to measure the expected tax shield of interest payments We use market value-based target capital structure ratios We should add a 1%-1.5% illiquidity premium in the case of small, illiquid companies (e.g. companies that are not even listed)
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure We calculated ke using the current beta of the company. This approach needs two assumptions:
We have the beta of the company. This is not the case if the company is not listed in the stock market. In that case, we use a so called industry beta which reflects the betas of comparable companies. But what happens when our company is more heavily leveraged than the comparables? The company is currently at its target capital structure. But what if you are asked to determine the WACC given a change in the companys target capital structure? For example, suppose the company wants to dramatically increase its long-term debt in its target capital structure

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure The basic idea to answer these questions is: The risk of the asset side must always equal the risk of the liability side

Mathematically:

assets =

w
i =1

i i

That is, the risk of the asset side is the weighted average beta of all the projects of the company, where the weights are the values of the different projects
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure On the liabilities side:

liabilitie s

B S = debt . + equity. V V

That is, the risk of the liability side is just the weighted average beta of debt and equity

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure By equating assets and liabilities:

B equity = assets + ( assets debt ). S

Or, more correctly, taking into account taxes:

B e = a + [ a d ](1 tc ). S
In most cases, we assume d=0

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Levering-Unlevering relationship: Cost of Equity and Capital Structure

B e = a + [ a d ](1 tc ). S
This is the crucial formula as now, we can compute a new e(and ke) if we want to use a new capital structure (B/S). This is true because:

assets stays the same even if the capital structure changes

as long as the projects (=assets) of the company do not change However, we should realize that in dramatic capital structure changes, assets changes
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure Example: The E4003 Corporation currently has a market value capital structure of 20% debt to total value Attakrit Asvanunt, the companys CFO believes more debt can be taken, up to a limit of 35% debt, without losing the companys ability to borrow at 7%, the prime rate, also assumed to be the risk-free rate The companys marginal tax rate is 50% The expected return on the market is 17% (hence the market risk premium is 10%) E4003 Corporations equity beta is currently 0.5
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure Questions: What are the companys current cost of capital and cost of equity? If the new capital structure is 35% debt to total value, what are the companys new cost of capital, cost of equity and beta of equity? Should a project with a 10% expected rate of return be accepted if it has the same business risk as the company as a whole?

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Cost of Equity and Capital Structure Solution:

k e0 = 12% WACC 0 = 1 0.3%

a 0.44 e1 0.56%
k e1 12 .6% WACC 1 9.44% < 10%
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Finer Points in CAPM Notice that if a companys projects have different betas, the company is making a mistake if it insists on using a company wide WACC. This situation often occurs in multibusiness companies

Extensive empirical research indicates that the CAPM is only approximately valid. In particular, small companies tend to have higher returns than predicted by the CAPM. This is most likely due to the missing illiquidity premium

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

Arbitrage Pricing Theory (APT) A competing model to the CAPM is APT, which is in a sense an extension of CAPM:

E[ R j ] = R f + j1.( E[ F1 ] R f ) + j 2 .( E[ F2 ] R f ) + ...
Possible factors can be: Unexpected inflation Changes in real interest rate Unexpected change in oil price Default risk premium $ / Euro exchange rate
IEOR E4003 Industrial Economics Fall 2012, Prof. Sadighian & Kachani

Weighted Average Cost of Capital (Finer Points)

CAPM vs. APT The CAPM is still an industry standard due to its parsimonious nature: one only has to estimate 2 variables market risk premium and beta

APT works very well in the bond markets but it has serious estimation problems in the stock markets

Naturally, APT can explain more than the CAPM

IEOR E4003 Industrial Economics

Fall 2012, Prof. Sadighian & Kachani