Principles of

Chapter 9 Corporate Finance

Tenth Edition

Risk and the Cost

of Capital

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 9-2

Topics Covered
Ø Company and Project Costs of Capital
Ø Measuring the Cost of Equity
Ø Analyzing Project Risk
Ø Certainty Equivalents
 9-3

Company Cost of Capital

Ø A firm’s value can be stated as the sum of
the value of its various assets

Firm value = PV(AB) = PV(A) + PV(B)

 9-4

Company Cost of Capital

Ø A company’s cost of capital can be compared
to the CAPM required return

SML
Required
return
3.8
Company Cost of
Capital
0.2

0
Project Beta
0.5
 9-5

Company Cost of Capital

rassets = COC = rdebt (VD ) + requity (VE )

V = D+E IMPORTANT
D = Market Value of Debt E, D, and V are all
E = Market Value of Equity market values of
Equity, Debt and
Total Firm Value

rdebt = YTM on bonds

requity = rf + B(rm − rf )
 9-6

Weighted Average Cost of Capital

Ü  WACC is the traditional view of capital

structure, risk and return.

WACC = (1 − Tc )rD (VD ) + rE (VE )

 9-7

Capital Structure and Equity Cost

Capital Structure - the mix of debt & equity within a company

Expand CAPM to include CS

r = rf + B ( rm - rf )
becomes

requity = rf + B ( rm - rf )
 9-8

Measuring Betas
Ø The SML shows the relationship between
return and risk
Ø CAPM uses Beta as a proxy for risk
Ø Other methods can be employed to
determine the slope of the SML and thus
Beta
Ø Regression analysis can be used to find Beta
 9-9

Measuring Betas
 9-10

Measuring Betas
 9-11

Measuring Betas
 9-12

Estimated Betas

Standard
Beta equity Error
Burlington Northern Santa
Fe 1.01 0.19
Canadian Pacific 1.34 0.23
CSX 1.14 0.22
Kansas City Southern 1.75 0.29
Norfolk Southern 1.05 0.24
Union Pacific 1.16 0.21
Industry portfolio 1.24 0.18
 9-13

Beta Stability
% IN SAME % WITHIN ONE
RISK CLASS 5 CLASS 5
CLASS YEARS LATER YEARS LATER

10 (High betas) 35 69

9 18 54

8 16 45

7 13 41

6 14 39

5 14 42
4 13 40

3 16 45

2 21 61

1 (Low betas) 40 62
Source: Sharpe and Cooper (1972)
 9-14

Company Cost of Capital

Company Cost of Capital (COC) is based on the average beta
of the assets

The average Beta of the assets is based on the % of funds in

each asset

Assets = Debt + Equity

⎛ D ⎞ ⎛ E ⎞
Bassets = BDebt × ⎜ ⎟ + Bequity × ⎜ ⎟
⎝ V ⎠ ⎝ V ⎠
 9-15

Capital Structure & COC

Expected Returns and Betas prior to refinancing

Expected 20
return (%)
Requity=15
Rassets=12.2

Rrdebt=8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
 Company Cost of Capital 9-16

simple approach

Company Cost of Capital (COC) is based on the average beta

of the assets

The average Beta of the assets is based on the % of funds in

each asset

Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6

AVG B of assets = 1.3

 9-17

Company Cost of Capital

Category Discount Rate

Speculative ventures 15.0%
New products 8.0%
Expansion of existing business 3.8% (Company COC)
Cost improvement, known technology 2.0%
 9-18

Asset Betas

PV(fixed cost)
Brevenue = Bfixed cost +
PV(revenue)
PV(variable cost) PV(asset)
+ B variable cost + Basset
PV(revenue) PV(revenue)
 9-19

Asset Betas

PV(revenue) - PV(variable cost)

Basset = Brevenue
PV(asset)

⎡ PV(fixed cost) ⎤
= Brevenue ⎢1 + ⎥
⎣ PV(asset) ⎦
 9-20

Allowing for Possible Bad Outcomes

Example
Project Z will produce just one cash flow, forecasted at $1 million at
year 1. It is regarded as average risk, suitable for discounting at a 10%
company cost of capital:

C1 1,000,000
PV = = = $909,100
1+ r 1.1
 9-21

Allowing for Possible Bad Outcomes

Example- continued
But now you discover that the company’s engineers are behind
schedule in developing the technology required for the project. They
are confident it will work, but they admit to a small chance that it will
not. You still see the most likely outcome as $1 million, but you also
see some chance that project Z will generate zero cash flow next year.
 9-22

Allowing for Possible Bad Outcomes

Example- continued
This might describe the initial prospects of project Z. But if
technological uncertainty introduces a 10% chance of a zero cash flow,
the unbiased forecast could drop to $900,000.

900,000
PV = = $818,000
1.1
 9-23

Table 9.2
 9-24

Risk,DCF and CEQ

Ct CEQt
PV = t
= t
(1 + r ) (1 + rf )
 9-25

Risk,DCF and CEQ

 9-26

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil
for each of three years. Given a risk free rate of
6%, a market premium of 8%, and beta of .75,
what is the PV of the project?
 9-27

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?

r = rf + B( rm − rf )
= 6 + .75(8)
= 12%
 9-28

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3
2 100 79.7
r = rf + B( rm − rf )
= 6 + .75(8) 3 100 71.2
= 12% Total PV 240.2
 9-29

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3 Now assume that the cash
2
3
100
100
79.7
71.2
flows change, but are
Total PV 240.2 RISK FREE. What is the
r = rf + B( rm − rf ) new PV?
= 6 + .75(8)
= 12%
 9-30

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash flows
change, but are RISK FREE. What is the new PV?

Project B
Project A Year Cash Flow PV @ 6%
Year Cash Flow PV @ 12%
1 94.6 89.3
1 100 89.3
2 100 79.7
2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2
 9-31

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash flows
change, but are RISK FREE. What is the new PV?

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

Since the 94.6 is risk free, we call it a Certainty Equivalent

of the 100.
 9-32

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project? DEDUCTION FOR RISK

Deduction
Year Cash Flow CEQ
for risk
1 100 94.6 5.4
2 100 89.6 10.4
3 100 84.8 15.2
 9-33

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash flows
change, but are RISK FREE. What is the new PV?

The difference between the 100 and the certainty equivalent

(94.6) is 5.4%…this % can be considered the annual
premium on a risky cash flow

Risky cash flow

= certainty equivalent cash flow
1.054
 9-34

Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?.. Now assume that the cash flows
change, but are RISK FREE. What is the new PV?

100
Year 1 = = 94.6
1.054

100
Year 2 = 2
= 89.6
1.054

100
Year 3 = 3
= 84.8
1.054