Module 8 – Cost of Capital and Valuation

Module 8
Cost of Capital and Valuation

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.1
 Module 8 – Cost of Capital and Valuation

Module Outline

Topics
8.1) Cost of Capital for Levered Firms
8.2) Using Comparable Firms
8.3) Cost of Capital for a Division or Project
8.4) Multiple Method to Value a Project
Readings
Berk and DeMarzo, sections 12.4-12.5
Practice Problems
Problem Set #8

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Section 8.1
Cost of Capital for Levered Firms

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Cost of Capital and Sources of Financing

We can determine the cost of capital using the CAPM and information on beta.
We estimate the beta of equity (𝛽E ) using the CAPM regression.
Using the CAPM, we obtain the cost of equity capital rE .
If the firm is fully equity financed, this is the appropriate cost of capital.
In practice, firms are financed from two sources of capital.
Equity (cost rE ).
Debt (cost rD ).
◦ Loans: typically made by financial institutions (e.g., banks).
◦ Corporate bonds: purchased by investors in capital markets.
Corporate Debt vs. U.S. Government Debt.
Similar in that they promise (interest and principal) cash flows over time.
Different in that corporate debt is risky.
◦ Sometimes, firms default on their promised debt payments.
◦ Because they default more in bad times than in good times, 𝛽D > 0.
◦ This risk also implies that rD = rf + 𝛽D (rm − rf ) > rf .

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Free Cash Flows and Sources of Financing

The firm’s free cash flows will serve to repay both debt-holders and
equity-holders.

The presence of debt does not affect the size or risk of the free cash flows.
E.g., the source of financing does not affect how many iPhones Apple will sell.
Only the split between debt- and equity-holders is affected.
Thus, if one investor were entitled to all debt cash flows and all equity cash
flows from a firm, she would receive all the free cash flows that this firm
generates.

⇒ PV(Free Cash Flows) = PV(Debt Cash Flows) + PV(Equity Cash Flows)

Free Cash Flows = Debt Cash Flows + Equity Cash Flows

⇒ Value of Assets = Value of Debt + Value of Equity

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Debt, Equity, and the Cost of Capital

The last equality on page 8.7 is often represented as a market value balance sheet:
Debt (D )
Assets (A )
Equity (E )
A portfolio of the firm’s debt and equity is entitled to all the cash flows that the
firm’s assets (i.e., operations) produce.
The portfolio has the same risk and expected return as the firm’s assets overall.
Thus, using the portfolio results from Module 5, the expected return on the firm’s
assets must be equal to a weighted average of
◦ the expected return of its debt (rD ), and
◦ the expected return of its equity (rE ).
That is, the expected return on the firm’s assets is

r A = xD r D + xE r E .

Why is this useful?

We are looking for the rate rA at which to discount the firm’s free cash flows.
If we know rD , rE , and the weights, we will know rA .

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Debt, Equity, and the Cost of Capital (cont’d)

Portfolio of the firm’s debt and equity.

D: Value of the Debt
E: Value of the Equity
D + E: Value of the Portfolio
D E
Thus we have xD = D+E and xE = D+E , and the expected return of the portfolio is

D E
rA = rD + rE
D+E D+E

This quantity is known at the weighted average cost of capital.

This is the rate used to discount the free cash flows of a project to compute its NPV.
Since the above portfolio receives all of the firm’s CFs, its value is that of the
firm: V = D + E. We can therefore also write
D E
rA = rD + rE
V V

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Debt, Equity, and the Cost of Capital (cont’d)

Since the beta of a portfolio is a weighted average of the underlying securities’

betas (see page 7.27), we also have

𝛽A = 𝛽D + 𝛽E
D E
D+E D+E

To find the weighted average cost of capital, finance practitioners often proceed

Estimate the risk of the debt: 𝛽D

as follows.

Estimate the risk of the equity: 𝛽E

Use the above expression to calculate the risk of the firm’s assets: 𝛽A
Use the CAPM to find the WACC: rA = rf + 𝛽A (rm − rf )

𝛽A = 𝛽E .
Note that, when the firm has no debt outstanding (D = 0), we have rA = rE and

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Estimating the Cost of Capital for a Publicly Traded Firm

Suppose that a firm is publicly traded, and is looking to undertake a new project.

The estimation of the cost of capital (rA ), as expressed on page 8.9, then boils

⎫
down to estimating the following quantities.
⎪
⎪
⎪
⎪
Cost of equity capital: rE

⎬
⎪
Value of the firm’s equity: E
⎪
D E

⎪
rA = rD + rE
⎪
⎭
Cost of debt capital: rD D+E D+E
Value of the firm’s debt: D

As we show next, the data that are freely available about publicly traded firms
allow us to perform this estimation.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Example: Home Depot

Suppose that Home Depot is considering opening a new store in Durham, NC.

The CFO has already obtained free cash flow estimates for the project and is
now looking for the rate at which to discount them.

Let us use publicly available data to calculate this discount rate.

Overview: http://finance.yahoo.com/q?s=HD&ql=0.
Historical prices: http://finance.yahoo.com/q/hp?s=HD+Historical+Prices.
Balance sheet: http://finance.yahoo.com/q/ks?s=HD+Key+Statistics.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Cost of Equity Capital

Procedure to estimate rE .
Since the firm is publicly traded, we do this as in Module 7, i.e.,
◦ Regress firm’s historical excess returns on the market’s historical excess
returns to estimate 𝛽E .
◦ Use CAPM to calculate rE = rf + 𝛽E (rm − rf ).
Typically, we use 60 monthly returns (i.e., 5 years of data).

Regression

𝛽E = 1.01.
Details shown on pages 8.13-8.15.

CAPM.
10-year treasury rate: 1.11%.

Therefore, rE = rf + 𝛽E (rm − rf ) = 0.0111 + 1.01(0.065) = 7.68%.

Market risk premium: 6.5%.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Cost of Equity Capital (cont’d)

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Cost of Equity Capital (cont’d)

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Value of Equity

The market value of equity (a.k.a. the firm’s market capitalization, or “market
cap”) is given by
E = Price per share × # of shares.

Home Depot.
Share price = $275.59.

# of shares outstanding = 1.08B.

Therefore, E = 275.59 × 1.08B = 297.64B.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Cost of Debt Capital

Procedure to estimate rD .
In theory, we could also estimate rD using regressions and the CAPM (like we did
for rE ).
Problems.
◦ Debt betas are difficult to estimate because corporate bonds are traded
infrequently.
◦ There is no publicly available data on private (e.g., bank) debt, so it is often
impossible to run a regression at all.
Solution: Use credit ratings.
◦ Three rating agencies: Moody’s, Standard & Poor’s, Fitch (see page 8.17).
◦ A better rating means a lower cost of debt (see page 8.19).

Home Depot.
Credit rating: A (see pages 8.19-8.21)
Using page 8.19 (with a 10-year horizon), we have rD = 2.47%.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Rating Agencies

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Yields on Investment-Grade Corporate Bonds

The following data were obtained from Vanguard’s website:

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Credit Rating

From Standard & Poor’s and Moody’s:

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Credit Rating (cont’d)

Fitch’s rating is also consistent with those by Standard & Poor’s and Moody’s, as the
following commentary shows:

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Value of Debt

We are looking for the market value of debt.

This number is rarely available.
◦ The firm’s debt is typically not all publicly traded (e.g., bank debt).
◦ This implies that there is no market price of debt.
Solution: We approximate the market value of debt by the book value of debt.
◦ Use the firm’s publicly available balance sheet.
◦ The approximation is better when interest rates have been stable.
◦ Often, the firm’s cash is subtracted from this number (as it could be used to
retire some debt at any point in time).
Home Depot: D = 41.04B.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Weighted Average Cost of Capital

We are now ready to calculate Home Depot’s weighted average cost of capital.
From page 8.13: Cost of equity capital = rE = 7.68%.
From page 8.15: Value of equity = E = 297.64B.
From page 8.17: Cost of debt capital = rD = 2.47%.
From page 8.21: Value of debt = D = 41.04B.
Weighted average cost of capital:
D E
rA = rD + rE
D+E D+E
41.04B 297.64B
= (0.0247) + (0.0768)
41.04B + 297.64B 41.04B + 297.64B

= 12.1% × 0.0247 + 87.9% × 0.0768 = 7.05%.

This is the discount rate that should be applied to the free cash flows of the
project.

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 Module 8 – Cost of Capital and Valuation 8.1 Cost of Capital for Levered Firms

Home Depot: Asset Beta and WACC

Equity: From page 8.13, we have 𝛽E = 1.01.

Practitioners often perform the previous calculations using betas.

Debt: From page 8.17, we have rD = 2.47%.

◦ On page 8.13, we used rf = 1.11% and rm − rf = 6.5%.
◦ Thus, using the CAPM:
rD = rf + 𝛽D (rm − rf ) ⇔ 0.0247 = 0.0111 + 𝛽D (0.065) ⇒ 𝛽D = 0.21
Asset Beta.
Recall from page 8.23 that E = 297.64B and D = 41.04B.
Home Depot’s asset beta is

𝛽A = 𝛽D + 𝛽E
D E
D+E D+E
41.04B 297.64B
= (0.21) + (1.01) = 0.91.
41.04B + 297.64B 41.04B + 297.64B

rA = rf + 𝛽A (rm − rf ) = 0.0111 + 0.91(0.065) = 7.05%.

We can now use the CAPM to calculate Home Depot’s WACC:

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Section 8.2
Using Comparable Firms

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Estimating the Cost of Capital: The Process

In order to value the free cash flows of a project (or a firm), we must
find the risk of the assets being valued (𝛽A ), and

◦ This is where the CAPM is very useful: rA = rf + 𝛽A (rm − rf ).

compute the rate that investors can obtain in capital markets for this risk.

◦ If the project’s IRR exceeds this rate, then it is a good project.

In general, this process takes one of two forms.
Use firm’s own data. This applies only to a publicly owned firm with just one
segment, looking to value a project in that same line of business (as in the Home
Depot example).
Use comparable firms’ data. This applies to all other situations, including
◦ a publicly owned multi-division firm looking to find the correct discount rate
for one of its divisions;
◦ a privately owned firm looking to start a new project;
◦ the valuation of a firm looking to go public through an initial public offering
(IPO);
◦ a firm looking to value another company that is being considered for an
acquisition.

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Estimating the Cost of Capital: Comparable Firms

Comparables.
Objective: find publicly traded firms with projects whose risk is similar to that of
the project or firm that we are trying to value (e.g., same industry).
Tradeoff: more firms will lead to
◦ better statistical estimates,
◦ but they tend to be less comparable.
Challenge: Only observe data on financial claims (i.e., equity and debt) of
comparable firm i, not on assets.

◦ Regression and CAPM: 𝛽Ei and rEi .

Equity. Comparable Firm i

◦ E i = price per share × # of shares. Debt (𝛽Di )

◦ Ratings and CAPM: 𝛽Di and rDi .

Debt. Assets (𝛽Ai )
Equity (𝛽Ei )
◦ Di = (book) value of debt.

For each comparable firm i, we have 𝛽Ai = 𝛽 𝛽i .

Di i Ei
D +
Di + E i Di + E i E

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Estimating the Cost of Capital: Comparable Firms (cont’d)

We use the average of the 𝛽Ai ’s to estimate the project’s risk:

Putting it all together.

𝛽A = ∑ 𝛽i .
N
1
N i=1 A

The project’s discount rate can then be found using the CAPM:

rA = rf + 𝛽A (rm − rf ).
5%-8% using historical data (Module 7)
Treasury bonds (Module 4)

This rate is used to discount the project’s free cash flows to obtain the project’s
NPV.

Conclusion: undertake project if and only if NPV > 0.

The FCFs are estimated as in Module 2.

Question: Why does this process of using “comps” work?

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Industry Asset Betas

Although equity betas can vary a lot from one firm to the next within an
industry, asset betas do not vary much.
The asset risk within an industry is comparable across firms.
This allows us to use “comparables” to estimate the cost of capital for a project.

Example. Here are some data about American Airlines and Delta Airlines.
Company Equity Beta D/V Debt Beta
American Airlines (AAL) 2.03 0.64 0.35
Delta Airlines (DAL) 1.34 0.31 0.21
AA’s equity is a lot riskier than Delta’s.
This does not mean that its operations/assets are riskier than Delta’s, though.
As we show next, this greater equity risk is driven by the fact that AA is more
highly levered than Delta.
◦ The promise to debt-holders is greater, making the equity riskier.

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Industry Asset Betas (cont’d)

Let us calculate the asset beta of each firm.

𝛽AAAL = 𝛽 𝛽 AAL = (0.64)(0.35) + (0.36)(2.03) = 0.95.

D AAL AAL
E AAL
+
D AAL + E AAL D D AAL + E AAL E
𝛽ADAL 𝛽 DAL + DAL 𝛽 DAL = (0.31)(0.21) + (0.69)(1.34) = 0.99.
D DAL E DAL
= DAL DAL D
D +E D + E DAL E
We can now see that the business risk of AA and Delta is quite comparable.

As the figure on page 8.31 shows, this extends to most firms in any given
industry.
Note the low asset betas for less cyclical industries (such as utilities) and the high
asset betas for more cyclical industries (such as durable goods manufacturers).

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 Asset Beta

Industry Asset Betas (cont’d)

0.00
0.20
0.40
0.60
0.80
1.00
1.20
1.40
1.60
1.80
2.00

This figure shows the range of asset betas for firms in various industries.
Finance Core – Fall 1 2022

Utilities
Household Products
Tobacco
Packaged Foods
Gold
Soft Drinks
Food Retail
Superstores
Cable and Satellite

Module 8 – Cost of Capital and Valuation

Telecommunication Services
Airlines
Pharmaceuticals
Biotechnology
Automotive Retail
Healthcare Services
Healthcare Equipment
Trucking
Restaurants
Computer and Electronics Retail
Duke University – Fuqua School of Business

Railroads
IT Consulting and Services
Movies and Entertainment
Aerospace and Defense
Publishing
Homebuilding
Casinos and Gaming

Managed Healthcare

8.2 Using Comparable Firms

Education Services
Leisure Products
Chemicals
Steel
Household Appliances
Advertising
Internet Retail
Department Stores

Hotels, Resorts and Cruise Lines

Building Products
Application Software
Apparel Retail
Construction Machinery
Computer Hardware
Apparel and Luxury Goods
Internet Software and Services
Home Furnishings
Construction and Engineering
Page 8.29

Oil and Gas Equipment

Home Furnishing Retail

Footwear
Communications Equipment
Computer Storage and Peripherals
Automobile Manufacturers
Auto Parts and Equipment
Semiconductors
 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Business Risk and Leverage Determine Risk of Equity and Debt

Starting from 𝛽A = D+E 𝛽D D+E 𝛽E ,

The business risk of the firm’s industry determines the asset beta.
D E
+ we see that equity beta is affected by the

𝛽E 𝛽A (𝛽A − 𝛽D )
firm’s leverage:

⏟⏟⏟
D
⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏞⏟
= +
E
Business risk
(from operations) Financial risk
(due to leverage)

D E
Similarly, rA = D+E rD + D+E rE implies the expected return on equity:

D
rE = rA + (rA − rD )
E
Bottom line: Increasing D/E increases 𝛽E and rE , and possibly 𝛽D and rD , but
the firm’s business and hence 𝛽A and rA (and valuation) are unaffected.
rD < rE does not mean financing the firm with debt is cheaper, because raising
more debt makes equity more risky and hence more expensive.
The Corporate Finance course considers when the capital structure affects
valuation.
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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Example: Valuing a Department Store

It is July 1, 2015. Sycamore Partners, a private equity firm, is considering the

acquisition of Belk, one of the 10 largest department store companies in the U.S.
Belk’s headquarters are located in Charlotte, NC, and the company is
family-owned.
The company operates about 300 department stores in 16 contiguous southern
states
Most of the Belk stores are anchor tenants in major regional malls or in open-air
shopping centers in medium and smaller markets.
Belk’s annual sales (in $billions) for the last 5 fiscal years have been as follows.
2011 2012 2013 2014 2015
Annual Sales 3.58 3.78 3.96 4.04 4.11

How should we proceed to find the discount rate that should be applied to its
free cash flows to estimate its value?

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Example: Valuing a Department Store (cont’d)

An analyst has produced estimates of the following quantities for 7 comparable
companies that are publicly traded.
Equity betas: regression of past (excess) returns on past market (excess) returns.
Debt-to-value ratios: use market value of equity and book value of debt.
Debt ratings from Moody’s.
Equity Debt
Company Beta D/V Rating
Dillard’s 2.38 0.59 B
J.C. Penney Company 1.60 0.17 BB
Kohl’s 1.37 0.08 BBB
Macy’s 2.16 0.62 BB
Nordstrom 1.94 0.35 BBB
Saks 1.85 0.50 CCC
Sears Holdings 1.36 0.23 BB
The equity betas of these firms are different, but so are their leverage (D/V ).
We need to calculate their asset beta.
Firms in the same industry should have similar business risk, so asset betas should
be similar for firms in the same industry (as illustrated in the figure on page 8.31).
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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

The Debt Cost of Capital: Using Average Beta by Rating

to find the 𝛽D of one firm.

As mentioned on page 8.17, it is typically impossible to use regression analysis

A potential alternative is to pool all the bonds of firms with a specific debt
rating and run a regression of their overall return on the return of the market
(e.g., S&P500).

𝛽D is needed.
One can then take the beta estimate from the rating category of the firm whose

≥A
< 0.05
Rating: BBB BB B CCC
Average Beta 0.10 0.17 0.26 0.31

As in the case of the equity cost of capital, this 𝛽D can then be fed into the
CAPM to produce an estimate of the debt cost of capital:

rD = rf + 𝛽D (rm − rf ).

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Example: Valuing a Department Store (cont’d)

Let us add two columns to the table on page 8.33.
Using page 8.35’s table of average betas for each rating, we can estimate the debt
beta of each comparable firm
Using the fact that a portfolio of a firm’s entire debt and equity is entitled to all the
cash flows generated by the firm’s assets, we have

𝛽Ai = 𝛽Di + 𝛽i
(V ) (Vi ) E
Di Ei
i

as an estimate of each firm i’s asset beta.

Equity Debt Debt Asset
Company Beta D/V Rating Beta Beta
Dillard’s 2.38 0.59 B 0.26 1.13
J.C. Penney Company 1.60 0.17 BB 0.17 1.36
Kohl’s 1.37 0.08 BBB 0.10 1.27
Macy’s 2.16 0.62 BB 0.17 0.93
Nordstrom 1.94 0.35 BBB 0.10 1.30
Saks 1.85 0.50 CCC 0.31 1.08
Sears Holdings 1.36 0.23 BB 0.17 1.09
Average 1.16

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 Module 8 – Cost of Capital and Valuation 8.2 Using Comparable Firms

Example: Valuing a Department Store (cont’d)

risk of Belk’s operations: 𝛽A = 1.16.

The average of the comparable firms’ asset betas gives us a good estimate of the

The yield on the 10-year Treasury bond is 1.7%, and the market risk premium is
estimated to be 6.5%.
Using the CAPM, a good estimate of the discount rate for Belk’s free cash flows is

rA = rf + 𝛽A (rm − rf ) = 0.017 + (1.16)(0.065) = 9.2%.

The present value of these FCFs is our estimate of Belk’s value.

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 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

Section 8.3
Cost of Capital for a Division or Project

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 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

A Project’s Risk and the Cost of Capital

So far, we have only considered firms whose projects are similar to each other in
terms of their risk.
When that is the case, the firm’s weighted average cost of capital can be used to
value all of its projects.
A good example is Home Depot, which has only one type of project.

The notion that “one discount rate fits all projects” does not apply to firms that
have projects with different risk characteristics.
Multi-division firms that operate in multiple industries.
Conglomerate mergers or acquisitions that expand the set of industries that a firm
operates in.

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 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

A Project’s Risk and the Cost of Capital (cont’d)

For example, 3M operates in several industries, including healthcare equipment

and semiconductors.
Sales of healthcare equipment are not affected much by business cycles, but the
semiconductors industry is highly pro-cyclical.
In fact, their asset betas are roughly 0.9 and 1.9, respectively (see page 8.31).
Thus, for well-diversified investors, investing in a semiconductors project is riskier
than investing in a project related to healthcare equipment.
As a result, investors demand a higher return for the semiconductors project.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.38
 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

A Project’s Risk and the Cost of Capital (cont’d)

More generally, a project’s cost of capital does not depend on the risk of the
firm undertaking it, but on the risk of the project itself.
The CAPM tells us how to measure that risk.
Undertaking a project adds an investment to our shareholders’ portfolio.
Diversified investors only care about the systematic risk of their investments, as the
diversifiable risk can be eliminated.
Consequently, we should accept a project only if its return (IRR) exceeds what
investors can get in capital markets for the same systematic risk.
Projects with a higher beta should provide a higher expected rate of return.
Some implications.
The notion of corporate “hurdle rate” that applies to all projects is wrong, except for
firms that have only one division and/or whose projects are all similar in risk.
Acquisitions should not be evaluated using bidder’s cost of capital, but use target’s
cost of capital.
While a new investment project may have high idiosyncratic risk, its systematic
risk can be low, and therefore a low discount rate should be used.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.39
 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

Example: Marriott

Marriott International (MAR) has two operating divisions.

The hotel division accounts for 60% of the firm’s value.
The restaurant division accounts for 40% of the firm’s value.
The values of Marriott’s equity and debt (which is rated BB) are as follows.
Equity: E = 44B.
Debt: D = 11B.
A regression of the excess return of Marriott’s stock on the excess return of the
S&P500 yields a slope of 1.35.
The current risk-free rate is rf = 2% and the market risk premium is
rm − rf = 6.5%.
Answer the following questions.
Q1: Using the information from page 8.31, estimate the cost of capital for each
division.
Q2: How do the asset betas of the two divisions relate to Marriott’s equity beta?
What beta and cost of Marriott’s debt does this imply?

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.40
 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

Example: Marriott (Q1)

From page 8.31, we can estimate the average asset beta of firms in the hotel and
restaurant industries, respectively.
Hotel: 1.25.
Restaurant: 0.90.

We can then use these values in the CAPM.

The cost of capital for Marriott’s hotel division is

rAhotel = 0.02 + (1.25)(0.065) = 10.1%.

Similarly, the cost of capital for Marriott’s restaurant division is

rArest = 0.02 + (0.90)(0.065) = 7.9%.

Thus, because the cash flows in Marriott’s hotel division are more affected by
business cycles, they should be discounted at a higher rate than those in its
restaurant division.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.41
 Module 8 – Cost of Capital and Valuation 8.3 Cost of Capital for a Division or Project

Example: Marriott (Q2)

Notice that Marriott’s debt-to-value and equity-to-value ratios are
D 11B E
xD = = = 0.20 and xE = = 1 − xD = 0.80.
D+E 11B + 44B D+E
Let us take a look at Marriott’s (market-value) balance sheet:
𝛽Ahotel = 1.25 (xAhotel = 0.60) 𝛽D = ? (xD = 0.20)

𝛽Arest = 0.90 (xArest = 0.40) 𝛽E = 1.35 (xE = 0.80)

The beta of Marriott’s total assets (i.e., hotels and restaurants) is the weighted
average of the asset betas of its divisions:

𝛽A = xAhotel 𝛽Ahotel + xArest 𝛽Arest = 0.60(1.25) + 0.40(0.90) = 1.11.

The asset beta in turn is the weighted average of the debt beta and equity beta:

𝛽A = xD 𝛽D + xE 𝛽E
⇔ 1.11 = 0.20𝛽D + 0.80(1.35) ⇒ 𝛽D = 0.15.

This is consistent with the beta estimate of 0.17 for BB-rated debt on page 8.35.
Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.42
 Module 8 – Cost of Capital and Valuation 8.4 Multiple Method to Value a Project

Section 8.4
Multiple Method to Value a Project

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 Module 8 – Cost of Capital and Valuation 8.4 Multiple Method to Value a Project

Multiples Method to Value a Project

Just like the perpetual growth method can be used for

pricing a stock (by estimating the growth rate of dividends)
and valuing a project (by estimating the growth rate of FCFs),
multiples can also be used for both.
When valuing a project, the multiples method works as follows.
Find a set of comparable companies (risk, industry, etc.).
For each comparable, divide the total firm value by an operating statistic. Examples
include:
◦ Firm Value ÷ EBITDA [most popular]
◦ Firm Value ÷ EBIT
◦ Firm Value ÷ Sales Revenue
Multiply the average ratio across comparables by your estimate of the same
operating statistic for the project (or firm) you are valuing.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.44
 Module 8 – Cost of Capital and Valuation 8.4 Multiple Method to Value a Project

Terminal Value Using Multiples: Example

Let us return to the example of Coca-Cola’s new energy drink from Module 2.
Recall that Coca-Cola most likely expects to keep selling the new energy drinks
past year 5.
The same pages show how to use the perpetual growth method to estimate the
project’s terminal value at that point.
We now show how to use multiples to perform this estimation.

We seek to value the project at the end of year 5.

That is, we are looking for an estimate of the value (at that point) of all the FCFs
coming in year 6 and beyond.
In what follows, we use the ratio of Firm Value to Sales Revenue to do this.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.45
 Module 8 – Cost of Capital and Valuation 8.4 Multiple Method to Value a Project

Terminal Value Using Multiples: Example (cont’d)

The first step of the method involves finding comparable firms.

Keurig Dr Pepper Inc.: operates as a beverage company in the United States and
internationally.
Nestlé S.A.: together with its subsidiaries, provides nutrition, health, and wellness
products worldwide.
PepsiCo, Inc.: operates as a food and beverage company worldwide.

The second step is to extract the Firm Value and Sales Revenue of these publicly
traded firms (available on Yahoo!).

Firm Value Revenue Firm Value

Revenue
Keurig Dr Pepper 59.69B 11.43B 5.22
Nestlé 367.20B 88.48B 4.15
PepsiCo 230.26B 68.56B 3.36
Average 4.24

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.46
 Module 8 – Cost of Capital and Valuation 8.4 Multiple Method to Value a Project

Terminal Value Using Multiples: Example (cont’d)

Finally, we can apply this multiple to get an estimate of the value of the project
in year 5.
In that year, sales revenue is projected to be $7.00 million (see page 2.15).
Thus, using the multiple of 4.24 obtained on page 8.47, the terminal value is
estimated to be
TV5 = 4.24 × $7.00 million = $29.68 million.

We can restate the project’s free cash flows as follows (the FCFs are from
page 2.45).
0 1 2 3 4 5
FCF (years 0-5) -5,000 612 1,397 1,844 2,302 1,198
Terminal Value 29,680
Total FCF -5,000 612 1,397 1,844 2,302 30,878

The project’s NPV (at 10%) is then 18,841.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.47
 Module 8 – Cost of Capital and Valuation

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.48
 Module 8 – Cost of Capital and Valuation

Module 8: Main Takeaways

To discount the free cash flows of a firm’s assets or projects, we need to

determine the appropriate cost of capital.
The assets of the firm can be thought of as a portfolio of the debt and equity.
The cost of capital is thus the weighted average of the cost of equity and debt.
Similarly, the asset beta is the weighted average of the beta of equity and debt.

To estimate the cost of capital of a private firm or project, we need data on

comparable firms.
The firm’s assets are a portfolio of all its divisions or projects.
The firm should use the cost of capital of the division, not the firm overall.
The cost of capital for the division depends on the beta of the assets in the
division.

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.49
 Module 8 – Cost of Capital and Valuation

Module 8: Formulas
Firm’s assets as a portfolio of debt and equity.
D E
Expected return: rA = rD + rE
D+E D+E

Asset beta: 𝛽A = 𝛽D + 𝛽E
D E
D+E D+E

Comparables i = 1, … , N
Using comparable firms to estimate cost of capital.

⎫
⎪
◦ 𝛽Ei : regression of excess returns on ⎪
⎪
⎪
⎪
⎪
⎪ i
market excess returns
◦ E i = price per share × # of shares ⎬ 𝛽A = i 𝛽i + i 𝛽i
⎪
Di Ei

◦ 𝛽Di : ratings ⎪
⎪
⎪
i D + Ei E
⎪
D + E D

⎪
⎪
◦ Di = (book) value of debt ⎭
Cost of capital: 𝛽A = ∑ 𝛽 and rA = rf + 𝛽A (rm − rf )
1 N i
N i=1 A

Asset beta of a firm with multiple divisions (i = 1, ..., N): 𝛽A = ∑ xADiv i 𝛽ADiv i
N

i=1

Finance Core – Fall 1 2022 Duke University – Fuqua School of Business Page 8.50