Risk, Cost of Capital, and Capital Budgeting

BUILDING LONG-TERM SHAREHOLDER VALUE

Two critical components
• (1) revenue growth and (2) return on invested capital (“ROIC”) in
excess of the cost of capital.
• The cost of capital, which is generally referred to as the weighted
average cost of capital (“WACC”), is determined by weighting the
company’s after-tax cost of debt with its cost of equity.
• ROIC is calculated by dividing the company’s after-tax net operating
profits by the sum of working capital and fixed assets.
• Since earning a return in excess of the company’s WACC is necessary
to increase value, management should understand and use it as a
benchmark for strategic decision making.
WACC
• WACC is a combination of the company’s cost of debt and cost of equity.
• The cost of debt is the interest rate the company pays on its long-term debt.
Banks and other lending institutions charge an interest rate that reflects the
risk of nonpayment.
• The cost of equity is the rate of return necessary to compensate shareholders
for their investment in the company.
• Unfortunately, many business owners often overlook the cost of equity. This
is a big mistake from an individual wealth-accumulation perspective.
• Business owners, just like other investors, have a choice—they can either
keep their capital in the company or move it to an alternative investment. If
the capital stays invested, its return should reflect the risk of doing so.
Cost of equity
• Equity returns from investments in privately held companies are not
readily observable, valuation practitioners generally use return data
from similar publicly traded companies as a proxy.
• If investors in similar public companies are earning an average annual
return of 15%, investors in the privately owned company should
probably be earning at least that much or they would be better off
investing in the public company.
• In reality, the proxy rate derived from public company data must be
adjusted up or down to reflect the private company’s actual risk
profile.
Key Concepts and Skills
• Know how to determine a firm’s cost of equity capital
• Understand the impact of beta in determining the firm’s cost of
equity capital
• Know how to determine the firm’s overall cost of capital
 Outline
The Cost of Equity Capital
Estimation of Beta
Determinants of Beta
Extensions of the Basic Model
Estimating Eastman Chemical’s Cost of Capital
 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.
The Cost of Equity Capital
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
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.
The Cost of Equity Capital
• From the firm’s perspective, the expected return is
the Cost of Equity Capital:

R i  RF  βi ( R M  RF )
• To estimate a firm’s cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M  RF
Cov ( Ri , RM ) σ i , M
3. The company beta, βi   2
Var ( RM ) σM
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?

R  RF  βi ( R M  RF )
R  5%  2.5 10%
R  30%
Example
Suppose Stansfield Enterprises is evaluating the following
independent projects. Each costs $100 and lasts one year.
Project Project b Project’s IRR NPV at
Estimated Cash 30%
Flows Next Year

A 2.5 $150 50% $15.38

B 2.5 $130 30% $0

C 2.5 $110 10% -$15.38

Using the SML
Good SML

IRR
Project
A
project

30% B

C Bad project
5%
Firm’s risk (beta)
2.5
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.
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.
Estimation of Beta
Cov ( Ri , RM ) σ i2
β  2
• Problems Var ( RM ) σM
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business
risk.

• Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and
financial risk.
– Look at average beta estimates of comparable firms in the industry.
 Stability of Beta
• Most analysts argue that betas are generally stable for firms
remaining in the same industry.
• That’s not to say that a firm’s beta can’t change.
• Changes in product line
• Changes in technology
• Deregulation
• Changes in financial leverage
 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 adjustments for financial leverage.
 Determinants of Beta
• Business Risk
• Cyclicality of Revenues
• Operating Leverage
• Financial Risk
• Financial Leverage
Cyclicality of Revenues
• Highly cyclical stocks have higher betas.
• Empirical evidence suggests that retailers and automotive
firms fluctuate with the business cycle.
• Transportation firms and utilities 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 especially dependent upon
the business cycle.
Operating Leverage
• The degree of operating leverage measures how
sensitive a firm (or project) is to its fixed costs.
• Operating leverage increases as fixed costs rise and
variable costs fall.
• Operating leverage magnifies the effect of cyclicality on
beta.
• The degree of operating leverage is given by:

DOL = D EBIT Sales

×
EBIT D Sales
Operating Leverage
Total
 EBIT
$ costs

Fixed costs
 Sales
Fixed costs
Sales

Operating leverage increases as fixed costs rise

and variable costs fall.
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 × bDebt + Equity × bEquity

Debt + Equity Debt + Equity
• Financial leverage always increases the equity beta relative
to the asset beta.
 Example
Consider Grand Sport, Inc., which is currently all-equity financed and
has a beta of 0.90.
The firm has decided to lever up to a capital structure of 1 part debt to
1 part equity.
Since the firm will remain in the same industry, its asset beta should
remain 0.90.
However, assuming a zero beta for its debt, its equity beta would
become twice as large:
1
bAsset = 0.90 = × bEquity
1+1
bEquity = 2 × 0.90 = 1.80
 Extensions of the Basic Model
• The Firm versus the Project
• The Cost of Capital with Debt
 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.
Capital Budgeting & Project Risk

Project IRR
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF  β FIRM ( R M  RF )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.
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 1.3.
17% = 4% + 1.3 × 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?
Capital Budgeting & Project Risk
SML

24% Investments in hard

Project IRR

drives or auto retailing

17%
should have higher
10% discount rates.

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.
The Cost of Capital with Debt
• The Weighted Average Cost of Capital is given by:
Equity Debt
rWACC = × rEquity + × rDebt ×(1 – TC)
Equity + Debt Equity + Debt

S B
rWACC = × rS + × rB ×(1 – TC)
S+B S+B

• Because interest expense is tax-deductible, we

multiply the last term by (1 – TC).
 Example: International Paper
• 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.
Example: International Paper
• The industry average beta is 0.82, the risk free rate is
3%, and the market risk premium is 8.4%.
• Thus, the cost of equity capital is:

rS = RF + bi × ( RM – RF)

= 3% + 0.82×8.4%
= 9.89%
Example: International Paper
• The yield on the company’s debt is 8%, and the
firm has a 37% marginal tax rate.
• The debt to value ratio is 32%
S B
rWACC = × rS + × rB ×(1 – TC)
S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
8.34 percent is International’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.
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?