CHAPTER 13: RISK, COST OF

CAPITAL, AND CAPITAL

BUDGETING

How to determine a firm’s cost of equity capital

How to determine a firm’s overall cost of capital
COST OF CAPITAL

 Cost of capital and required return:

− Return to an investor = cost to the company
− Firms need to earn at least the required return to compensate the
investors
 The required return is the same as the cost of capital and is

used as a discount rate

 Cost of capital and risk:

− The return required on assets depends on the risk of those assets
− Thus, our cost of capital provides us with an indication of how the
market views the risk of our assets
COST OF EQUITY
COST OF EQUITY
 The cost of equity is the return required by equity investors given the
risk of the cash flows from the firm’s equity

 There are two major methods for determining the cost of equity
 Dividend Growth Model (DGM): Discussed in Chapter 9
 CAPM or SML: Discussed in Chapter 11

 For the dividend growth model approach, recall that:

 Start with the constant dividend growth model formula and
rearrange to solve for RE:

D1
P0 
RE  g
D1
RE  g
P0
DIVIDEND GROWTH MODEL VS. CAPM
 Dividend growth model approach
• Advantage: easy to understand and use
• Disadvantages:
− Only applicable to companies currently paying dividends
− Not applicable if dividends aren’t growing at a reasonably constant rate
− Extremely sensitive to the estimated growth rate
− Does not explicitly consider risk
 CAPM Approach
• Advantages:
− Explicitly adjusts for systematic risk
− Applicable to all companies, as long as beta is available
• Disadvantages
− Must estimate the expected market risk premium, which varies over time
− Must estimate beta, which also varies over time
− Relies on the past to predict the future, which is not always reliable
THE COST OF EQUITY CAPITAL USING
CAPM
 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
THE RISK-FREE RATE
 Treasury securities are close proxies for the risk-free rate.

 The CAPM is a one-period model. However, projects are

long-lived. Which treasury securities should be used as risk-
free assets?

 Current short-term T-bill

 Historical average yield of short-term T-bill
 Long-term T-bond
THE MARKET RISK PREMIUM
 Method 1: Use historical data
 Method 2: Use the Dividend Discount Model

R D 1
g
P

 Marketdata and analyst forecasts can be used to implement

the DDM approach on a market-wide basis
ESTIMATION OF BETA
Market Portfolio - Portfolio of all assets in the economy. In
practice, a broad stock market index, such as the S&P 500, 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 )
β
Var ( RM )
• Problems
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 is not to say that a firm’s beta cannot change.
 Changes in product line
 Changes in technology
 Deregulation
 Changes in financial leverage

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.
 Do not forget about adjustments for financial leverage.
CAPITAL BUDGETING & PROJECT RISK
Project IRR

SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF  βFIRM ( 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.
COST OF DEBT
COST OF DEBT
 Cost of debt:
• The cost of debt is the required return on our company’s debt
• We usually focus on the cost of long-term debt or bonds
• The required return is best estimated by computing the yield to
maturity on the existing debt (NOT the coupon rate).
Alternative method?
ESTIMATING THE COST OF DEBT
• The cost of debt is the rate at which you can borrow at
currently, It will reflect not only your default risk but also the
level of interest rates in the market.
• The two most widely used approaches to estimating cost of
debt are:
• Looking up the yield to maturity on a straight bond outstanding
from the firm. The limitation of this approach is that very few firms
have long term straight bonds that are liquid and widely traded
• Looking up the rating for the firm and estimating a default spread
based upon the rating. While this approach is more robust, different
bonds from the same firm can have different ratings. You have to
use a median rating for the firm
• When in trouble (either because you have no ratings or
multiple ratings for a firm), estimate a synthetic rating for
your firm and the cost of debt based upon that rating.
ESTIMATING SYNTHETIC RATINGS
 The rating for a firm can be estimated using the financial
characteristics of the firm. In its simplest form, the rating
can be estimated from the interest coverage ratio
Interest Coverage Ratio = EBIT / Interest Expenses
INTEREST COVERAGE RATIOS, RATINGS AND DEFAULT SPREADS
If Interest Estimated Default Spread
Coverage Ratio is Bond Rating (2003) (2014)
Large firm (>$5bn) small firm (<$5bn)
> 8.50 (>12.50) AAA0.75% 0.40%
6.50 - 8.50 (9.5-12.5) AA 1.00% 0.70%
5.50 - 6.50 (7.5-9.5) A+ 1.50% 0.85%
4.25 - 5.50 (6-7.5) A 1.80% 1.00%
3.00 - 4.25 (4.5-6) A– 2.00% 1.30%
2.50 - 3.00 (4-4.5) BBB 2.25% 2.00%
2.25- 2.50 (3.5-4) BB+ 2.75% 3.00%
2.00 - 2.25 ((3-3.5) BB 3.50% 4.00%
1.75 - 2.00 (2.5-3) B+ 4.75% 5.50%
1.50 - 1.75 (2-2.5) B 6.50% 6.50%
1.25 - 1.50 (1.5-2) B – 8.00% 7.25%
0.80 - 1.25 (1.25-1.5) CCC 10.00% 8.75%
0.65 - 0.80 (0.8-1.25) CC 11.50% 9.50%
0.20 - 0.65 (0.5-0.8) C 12.70% 10.50%
< 0.20 (<0.5) D 15.00% 12.00%

Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm
HOW ABOUT THE OVERALL COST
OF CAPITAL?
WEIGHTED AVERAGE COST OF CAPITAL
 If the firm has both debt and equity, then riskiness of cash flows is
reflected in the expected return on both debt and equity. What would be
the firm’s overall cost of capital?
− We can use the individual costs of capital to get our “average” cost
of capital for the firm.
− This “average” is the required return on the firm’s assets, based on
the market’s perception of the risk of those assets.
− The weights are determined by how much of each type of financing
is used.
market value of equity/debt
• Weighted Average Cost of Capital (WACC):
 Equity   Debt 
   Requity     Rdebt (1  Tc )
− WACC  Debt  Equity   Debt  Equity 
E  D  corporate tax rate
   Re     Rd (1  Tc )
V  V 
NOTES ON WACC
 We use market values of debt and equity, not book values.

 Taxes and WACC:

• We are concerned with after tax cash flows, so we need to consider the
effect of taxes on the costs of capital

• Interest expense reduces our tax liability

− This reduction in taxes reduces our cost of debt

− After tax cost of debt = R (1-T )

D C

• Dividends are not tax deductible, so there is no tax impact on the cost of
equity

 WACC is the overall return the firms must earn on its existing assets to
maintain the value of the stock – often called “hurdle rate.”
 WACC ESTIMATION
 Example: What is WACC for the following firm?
  D/E = 2/3, Rd = 15%, Tc = 34%, Rf =11%, Rm - Rf = 8.5%, E = 1.41.
 
Step 1- Calculate Re using CAPM
 
  Re = .11 + 1.41 × .085 = .22985
  Step 2- Calculate [D/(D + E)] and [E/(D + E)]
  
D/E = 2/3  D=2/3 × E  D/(D+E) = 2/5

Step 3- Use formula above to calculate WACC

WACC = [(2/5) × (.15) × (1-.34)]  + [(3/5) ×.22985] = .1775 or 17.75
%
 WACC ESTIMATION – WITH PREFERRED STOCKS

WACC = (E/V) × RE + (P/V) × RP + (D/V) × RD × (1- TC)

Where:

(E/V) = % of common equity in capital structure

Weights (P/V) = % of preferred stock in capital structure
(D/V) = % of debt in capital structure

RE = firm’s cost of equity

Component costs R = firm’s cost of preferred stock
P
RD = firm’s cost of debt

TC = firm’s corporate tax rate

EASTMAN CHEMICAL – 1
EQUITY

Source: http://finance.yahoo.com
 Eastman Chemical – 2
Dividend Growth

Source: http://finance.yahoo.com
 EASTMAN
CHEMICAL - 3

BETA AND
SHARES
OUTSTANDIN
G

Source: http://finance.yahoo.com
 Eastman Chemical – 4
Other Data
 Market Risk Premium = 7% (assumed)
 T-Bill rate = 0.07% (90 day)
 Tax rate (assumed) = 35%
 Beta (Reuters):

Source: http://www.reuters.com
EASTMAN CHEMICAL - 5
COST OF EQUITY - SML
 Beta: Yahoo.Finance 2.01
Reuters 1.92
Average 1.965

 T-Bill rate: 0.07%

 Market Risk Premium: 7%

 Cost of Equity (CAPM) = ?

= .07% + (7%)(1.965) = 13.83%
EASTMAN CHEMICAL - 6
COST OF EQUITY - DGM
 Growth rate: 7%
 Last dividend: $1.76
 Stock price: $52.99
D1
 Cost of Equity (DGM) = RE  g
P0
$1.76(1.07)
RE   .07  10.55%
52.99
EASTMAN CHEMICAL - 7
COST OF EQUITY

Cost of Equity In Textbook In Slideshow

CAPM Method 14.08% 13.83%
DGM Method 11.40% 10.55%
Average 12.74% 12.19%
 EASTMAN CHEMICAL - 8
BONDS

Source: http://finra-markets.morningstar.com/BondCenter
EASTMAN CHEMICAL - 9
BONDS

Coupon Face Value Price Market Value Weighted

Rate Maturity (millions) % Par ($ m) % YTM YTM
7.00% 2012 $154 100.5 154.8 11.0% 6.784 0.748
6.30% 2018 207 104.0 215.3 15.3% 5.729 0.878
7.25% 2024 497 107.0 531.8 37.9% 6.489 2.457
7.63% 2024 200 100.0 200.0 14.2% 7.623 1.086
7.60% 2027 298 101.5 302.5 21.5% 7.443 1.603
$1,356 1404.3 100.0% 6.772

• Since market values are deemed more relevant, we use only market value
weights.
• Average YTM = 6.772% versus 7.59% in the textbook
 EASTMAN CHEMICAL - 10
WACC
 Capital structure weights:
E = 72.67 million × $52.99 = $3.851 billion
D = 1.404 billion
V = $3.851 + 1.404 = 5.255 billion
E/V = 3.851 / 5.255 = .7328
D/V = 1.404 / 5.255 = .2672

 WACC = ?
 WACC = .7328(12.19%) + .2672(6.772%)(1-.35) = 10.11%
(versus 11.38% in text)
SUMMARY

 How do we determine the cost of equity capital?

 How can we estimate a firm or project beta?

 What determine beta?

 How do we estimate cost of debt

 How do we determine the weighted average cost of

capital?