Risk and Discount Rates

Professor Pavle Radicevic

PhD UNSW, Sydney
From a Corporate Perspective
• We have cash from owners/investors.

• Should we use this cash on our projects, or should we return

it to owners/investors to invest elsewhere?

• What would make our investors voluntarily want us, the

corporate managers, invest on their behalves?

2
Cost of Equity Capital

Shareholder
Firm with Pay cash dividend invests in
excess cash
financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Invest in Shareholder’s
a 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.
If investors can do better elsewhere, you should return the money!
3
From a Corporate Perspective
• The expected return on a financial asset of comparable
risk is the opportunity cost of capital of investing in a
capital-budgeting project (or in your firm).

• This opportunity cost of capital is the minimum your

project/firm should deliver in order to make your
investors invest in your company voluntarily.

• Therefore, if you use it as the discount rate and get

NPV>0, this means that the return on investing in this
project is higher than alternatives available in the
market, and this is why you decide to take in this
project.
4
From a Corporate Perspective
• Whether our investors’ want to invest with us depends
on their opportunity cost of capital.
• But we can’t ask them. Therefore, we’ll have to make
certain assumptions about our (marginal) investors:
• (A1) Presumably, they like more to less and are risk-averse:
– Like high expected return and do not like risk.
– The cost of equity should be higher for riskier investments and lower for
safer investments.
• (A2) Presumably, they hold a well-diversified portfolio.
– The only risk that they perceive in an investment is the risk that cannot be
diversified away (i.e. market or non-diversifiable risk).
• Thus, they care about how your project/firm will impact their overall portfolio
in terms of risk and reward.

5
Historical Risk and Return 1926-2004

Risky assets, on, average earn a “risk-premium”: offer a reward for

bearing risk. Higher risk -> higher potential reward. -> A1
6
Not all risk is the same
• BUT:

• Total risk of an asset (its return standard deviation)

does not determine expected returns for stocks, because
not all risks are compensated.
– Risk that can be freely diversified within a portfolio is not
compensated.
– We can understand asset pricing only within a portfolio
framework. Can’t price an asset stand alone, only in a
portfolio. (Markowitz, 1952)

7
Diversification: combining risks

• Although all 3 stocks have same average return and volatility, they do
not have the same pattern.
• By combining stocks into a portfolio, we reduce risk through
diversification.
• The amount of risk that is eliminated in a portfolio depends on the
degree to which the stocks face common risks and their prices move
together.

8
Portfolios vs Individual Stocks

By mixing assets in a portfolio we create “assets” with superior risk-

reward characteristics: imperfect correlation allows for diversification.
9
Diversification: combining risks

Consider a portfolio of n stocks: 𝑅𝑝 = 𝑥𝑖 𝑅𝑖

𝑖

𝑉𝑎𝑟(𝑅𝑝 ) = 𝑉𝑎𝑟 𝑥𝑖 𝑅𝑖 = 𝑥𝑖 𝑥𝑗 𝐶𝑜𝑣(𝑅𝑖 , 𝑅𝑗 )

𝑖 𝑖 𝑗

For an equally-weighted portfolio, xi=1/n:

1 1
𝑉𝑎𝑟(𝑅𝑝 ) = 2 𝑉𝑎𝑟(𝑅𝑖 ) + 2 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 =
𝑛 𝑛
𝑖 𝑖≠𝑗

1 1 2
= 2 𝑛 𝑉𝑎𝑟(𝑅𝑖 ) + 2 𝑛 − 𝑛 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 =
𝑛 𝑛
1 1
= 𝑉𝑎𝑟(𝑅𝑖 ) + (1 − ) 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗 → 𝐶𝑜𝑣 𝑅𝑖 , 𝑅𝑗
𝑛 𝑛
as n→∞
10
Risk as a Function of # of Stocks in the Portfolio

In a large portfolio the variance terms are effectively

 diversified away, but the covariance terms are not.

Diversifiable Risk
= Non-systematic Risk
= Firm-Specific Risk
= Idiosyncratic Risk
Portfolio risk
Non-diversifiable risk
= Systematic Risk
= Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities.
CAPM in 3 steps
• Diversification allows to get rid of the non-systematic
risk at no cost:
• Investors hold portfolios to eliminate diversifiable risk.

• Because investors are risk-averse, in equilibrium they hold

a fully-diversified portfolio (A2):
• This portfolio is essentially the whole market.

• If investors care how your project will impact their

(fully-diversified market) portfolio, then its required
return depends on the risk it adds to this portfolio, i.e.
on how much systematic risk there is in this project.

12
(Treynor, Sharpe, Lintner, Mossin, Black,… in 1960s)

• This measure of systematic risk is “beta”:

– You can show mathematically that when such an asset is added to your
well-diversified portfolio, its risk (volatility) increases by bim.
Cov( Ri , RM ) σ i , M
βi   2
Var ( RM ) σM
• The CAPM formula says the expected rate of return is linearly
related to a project’s beta by the following formula:
( Ri )  rF  bi  RM   rF 
– Think of the CAPM formula as a line, which relates a project’s beta to an
appropriate expected rate of return.
– Projects that add more (systematic) risk to our (fully-diversified market)
portfolio, i.e. that have a high beta, have to offer a higher reward
(expected rate of return).

• (Assumptions: Perfect markets. Risk-aversion. All assets for sale.)

13
The CAPM Graph: SML

E(R) = Rf + (Rm – Rf) β

Expected
Rate
Security
Market Line

Movements along the curve

that reflect changes in the
RFR risk of the asset

Risk
(business risk, etc., or systematic risk-beta)

14
Project vs firm

• Any project’s cost of capital depends on the use to which the

capital is being put — not the source.
• So in general to value a project you want to know project’s beta,
which is not necessarily equal to firm’s beta (if riskiness is
different).

• Now for simplicity assume (will relax later):

– New project has the same riskiness as past projects:
bproject=bfirm
– No leverage: bfirm=bequity

• Hence, we can use CAPM to calculate bequity and use it to value

new projects.

15
Cost of Equity

• From the firm’s perspective, the expected return is the Cost of

Equity Capital:

rE  E ( Ri )  rF  βi [ E ( RM )  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: E ( RM )  rF

Cov( Ri , RM ) σ i , M
3. The company beta: βi   2
Var ( RM ) σM

16
 Cost of Equity: Example
• Suppose the stock of Technology Enterprises, has a
beta of 2.5. The firm is 100%-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?

rE  rF  βi [ E ( RM )  rF ]
rE  5%  2.5 10%  30%

17
Cost of Equity: Example (continued)

Suppose Technology Enterprises is evaluating the

following non-mutually exclusive 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

18
 Using SML to estimate RADR for projects
An all-equity firm should accept a project whose IRR
exceeds the cost of equity capital and reject projects
whose IRRs fall short of the cost of capital
(subject to all caveats of the IRR of course!).
Project
IRR

Good SML
projects
A

30% B
Bad
5% C projects

2.5 Firm’s risk (beta)

19
Project vs firm again

• In general to value a project you want to know project’s beta,

which is not necessarily equal to firm’s beta (if riskiness is
different).

• Still for simplicity assume (will relax later):

– No leverage: bfirm=bequity

• What to do if the new projects are not same risk as the firm:
bproject≠bfirm ?
• Select industry where the new investment would be considered average risk
• Separate cost of capital for each division within firm
• Ad hoc

20
Project vs firm again

• Select industry where the new investment would be

considered average risk:
– E.g. pharmaceutical company contemplates a biotech
investment.
– A reasonable rate is cost of capital to existing biotech
companies.
– Identify industry, estimate cost of capital for several
companies in that industry, use some average to evaluate your
investment.
• Which companies to include?
– Want “pure-plays”: undiversified firms that compete in this
business only. Otherwise cost of capital of a diversified
company represent risks to all its businesses.

21
Project vs firm again

• Multidivisional companies may calculate costs of capital

separately for each division.
• To calculate cost of capital for each division, identify competitors
(hopefully including “pure-plays”) in each division.

• What if a multidivisional company values all projects

using a single corporate-wide cost of capital?
– In low-risk divisions may reject some positive NPV projects
for lack of expected return.
– In high-risk divisions may accept some negative NPV projects
for a big expected return.

22
 Project vs firm again

The SML can tell us why:

IRR SML
Project

Incorrectly accepted
negative NPV projects
Corporate cost
rF  β FIRM [ E ( RM )  rF ]
of capital
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.
23
Project vs firm again
• Ad hoc method: define risk buckets and assign different costs of
capital to each bucket.
– E.g. figures for a virtual company (not the ones you should use):

Type of Investment Discount rate, %

Replacement or repair 6.5
Cost reduction 7.0
Expansion 8.2
New product 14.0
– Investments to expand capacity are “copies” of the firm, so may use firm’s
cost of capital.
– Others – relative to it: more/less risky?
– Replacement is probably safest: cash flows are known from past
experience
– Cost reduction is somewhat riskier: the magnitudes of potential savings
are uncertain.
– New-product investments are most risky: both revenues and costs are
uncertain. 24
Inputs into CAPM

rE  E( Ri )  rF  βi [ E( RM )  rF ]
• If we want to estimate the company’s cost of equity, we need to
find the inputs:
– The equity beta
– The risk-free rate
– The expected return on the market index (a diversified
portfolio)

• As often, the formula is easy, but what to put in requires some

assumptions (“art”).
• Many helpful details:
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/AppldCF/derivn/ch4deriv.html

25
Estimating Beta

• The standard procedure for estimating betas is to regress stock

returns (Rj) against market returns (Rm) -
Rj = a + b Rm
– where a is the intercept and b is the slope of the regression.

• The slope of the regression corresponds to the beta of the stock,

and measures the riskiness of the stock.
• This beta has three main problems:
1. This is a backward-looking estimate and betas may vary over
time -> may try rolling windows
2. The sample size may be inadequate, resulting in high
standard errors -> longer window, but see (1)
3. Betas are influenced by changing financial leverage and
business risk -> for leverage we can adjust

26
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
(we’ll do it when we study capital structure).

27
Stability of Beta

• Most analysts argue that betas are generally stable for firms
remaining in the same industry
– Although the estimated ones may look very time-varying

• That’s not to say that a firm’s beta can’t change.

– Changes in business risk
• Changes in product line
• Changes in technology
• Deregulation
– Changes in financial leverage

28
Determinants of Beta

• Business Risk
– Cyclicality of Revenues
– Operating Leverage

• Financial Risk
– Financial Leverage

29
Cyclicality of Revenues

• Highly cyclical stocks have high betas:

– High-beta (>1.5) stocks – fluctuate a lot with the business
cycle
• Semiconductor, Auto parts, Metal fabricating and mining, retail
– Low-beta (<0.6) stocks – fluctuate little with the business
cycle
• Utilities, telecom, retail/wholesale food, medical services

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html

• Note that cyclicality is not the same as variability, as 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 are not especially dependent upon the business
cycle. 30
Financial Leverage and Beta

• Operating leverage refers to the sensitivity to the firm’s

fixed costs of production.
• Financial leverage is the sensitivity of a firm’s fixed
costs of financing.
• The relationship between the betas of the firm’s debt,
equity, and assets is given by:

b Asset = Debt × b Debt + Equity × b Equity

Debt + Equity Debt + Equity

Or assuming bDebt=0:

• Financial leverage always increases the equity beta relative

to the asset beta (magnifies the business risk).
31
Equity Premium: Estimation

There are three main methods of estimating equity premium:

1. Survey of subset of investors
– Individual and institutional investors
– Managers
– Academics
Unfortunately, more likely to reflect current past, than predict the future...

2. Estimating a historical premium

– Practitioners never seem to agree even on this one! It is sensitive to:
How far back you go in history, what risk-free rates you use, whether
you use geometric or arithmetic averages, etc

3. Estimating implied premiums

– A version of a (differential) dividend growth model
– Use forecasts of dividends on e.g. S&P500
– Solve for r that makes it equal to current price of index
– Subtract the risk-free rate

32
Risk-free rate

• On a risk-free asset, the actual return is equal to the expected return.

Therefore, there is no variance around the expected return.
• Risk-free rate is determined solely by time preferences of investors.
• For an investment to be truly risk-free, it has to have :
– No default risk
– No reinvestment risk
• Treasury bills may be default free but there is reinvestment risk when they are used as
riskless rates for longer-term cash flows. A 6-month T-Bill is not riskless when looking
at a 5-year cash flow.
• Would a 5-year treasury be risk-free? Not really. The coupons would still expose you to
reinvestment risk. Only a 5-year zero-coupon treasury would be risk-free for a 5-year
cash flow.
• Thus, the risk-free rates in valuation will depend upon when the cash flow is
expected to occur and will vary across time.
• If you are a purist, you should match the risk-free rate to the period of the
cash flow: 1-year rate for the 1-year cash flow, etc.
• In valuation, the time horizon is generally infinite, leading to the conclusion
that a long-term risk-free rate will be preferable to a short-term rate, if you
have to pick one.
33
Risk-free rate

• Risk-free rate should be truly free of risk

– Government bond rates in many countries cannot be used as
risk-free rates without adjustment for default spread.
• Approach 1: Subtract default spread (based on the rating or CDS)
from local government bond rate
• Approach 2: Use cost of debt of largest and safest corporations and
reduce a bit by a small default spread.
• Approach 3: Use forward rates or currency swaps and the risk-less rate
in an index currency (say Euros or dollars) to estimate the risk-less rate
in the local currency.
• Approach 4: Do the analysis in a currency where you can get a risk-
free rate, say US dollars.

34
Why (not) use the CAPM?

• Often reasonable cost of capital estimates.

• Good intuition.
• No clear better alternatives
• Multifactor models and characteristics-based models
• Everyone is using it: 73% of all firms (CFOs) use it. Next best
measure is “ad-hoc historical returns” with 39%, then various
modified CAPM’s with 34%. Then you get down to 15%
(“Gordon model,” and “Whatever Our Investors are Telling
Us”)

• Don’t expect accuracy.

• Don’t use it for investments, but only for capital budgeting
ballpark figures.

35
Summary

• Estimating discount rate correctly is an extremely important part

of valuation.
• The expected return on any asset is dependent upon risk free
rate, equity risk premium, and b.
• Each of the ingredients is essential, so you should be very
careful.
• There are different ways of estimating these parameters, but for
the developed markets they usually produce estimates that are
not that different.
• For the developing markets the task is much harder and there is
no “right” solution. You should use your own judgment in each
particular case.

36