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Unformatted text preview: Risk, Return, and Risk, Return, and Capital Budgeting
Chapter 13 of the Textbook Topics Topics
13.1 The Cost of Equity Capital 13.2 Estimation of Beta 13.3 Determinants of Beta 13.4 Extensions of the Basic Model 13.5 Estimating Bombardier’s Cost of Capital 13.6 Reducing the Cost of Capital 13.7 Summary and Conclusions What’s the Big Idea? What’s the Big Idea?
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. 13.1 The Cost of Equity Capital
Firm with excess cash Pay cash dividend Shareholder invests in financial asset A firm with excess cash can either pay a dividend or make a capital investment Invest in project Shareholder’s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capitalbudgeting project should be at least as great as the expected return on a financial asset of comparable risk. The Cost of Equity The Cost of Equity From the firm’s perspective, the expected return is the Cost of Equity Capital: R i = RF + βi ( R M − RF )
1. The riskfree rate, RF • To estimate a firm’s cost of equity capital, we need to know three things: − RF Cov( Ri , RM ) σ i , M =2 1. The company beta, βi = Var ( RM ) σM
1. The market risk premium, R M Example Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100percent equity financed. Assume a riskfree rate of 5percent and a market risk premium of 10percent. 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% Suppose Stansfield Enterprises is evaluating the following nonmutually exclusive projects. Each costs $100 and Project Project β NPV at lasts one year. Project’s Cash IRR Estimated 30%
A B C 2.5 2.5 2.5 Flows Next Year $150 $130 $110 50% 30% 10% $15.38 $0 $15.38 Example (continued) Example (continued) Using the SML to Estimate the Risk Using the SML to Estimate the Risk Adjusted Discount Rate for Projects
Project Good A projects B C Bad projects Firm’s risk (beta) 2.5 An allequity firm should accept an (investment type) project whose IRR exceeds the cost of equity capital and reject (investment type) projects whose IRRs fall short of the cost of capital. IRR SML 30% 5% 13.2 Estimation of Beta: Measuring 13.2 Estimation of Beta: Measuring Market Risk
Market Portfolio Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P/TSX index, is used to represent the market. Beta Sensitivity of a stock’s return to the return on the market portfolio. Theoretically, the calculation of beta is 2 straightforward: Cov ( Ri , RM ) σ i
Problems 13.2 Estimation of Beta 13.2 Estimation of Beta
β= Var ( RM ) = • 2 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 (above) 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 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 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. 13.3 Determinants of Beta 13.3 Determinants of Beta Business Risk Cyclicality of Revenues Operating Leverage Financial Risk Financial Leverage Highly cyclical stocks have high 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 are not especially Cyclicality of Revenues Cyclicality of Revenues Operating Leverage 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 cyclicity on beta. The degree of operating leverage is given by:
Change in EBIT Sales DOL = × EBIT Change in Sales Operating Leverage Operating Leverage
$
Total costs Fixed costs ∆ EBIT ∆ Volume Fixed costs Volume Operating leverage increases as fixed costs rise and variable costs fall. Financial Leverage and Beta 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:
β Asset Debt Equity = × β Debt + × β Equity Debt + Equity Debt + Equity • Financial leverage always increases the equity beta relative to the asset beta. Financial Leverage and Beta: Financial Leverage and Beta: Example
Consider Grand Sport, Inc., which is currently all equity 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:
βEquity Debt 1 = βAsset × 1 + Equity = 0.90 × 1 + 1 = 1.80 The Firm versus the Project 13.4 Extensions of the Basic 13.4 Extensions of the Basic Model The Cost of Capital with Debt The Firm versus the Project 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. Project IRR Capital Budgeting & Project Risk Capital Budgeting & Project Risk
The SML can tell us why: SML
Incorrectly accepted negative NPV projects Hurdle rate rf RF + βFIRM ( R M − RF )
Incorrectly rejected positive NPV projects Firm’s risk (beta) A firm that uses one discount rate for all projects may over time increase the risk of the firm β FI RM Capital Budgeting & Project Risk
Suppose the Conglomerate Company has a cost of capital, Suppose the Conglomerate Company has a cost of capital, based on the CAPM, of 17%. The riskfree rate is 4%, the market risk premium is 10%, and the firm’s beta is 1.3. 17% = 4% + 1.3 × [14% – 4%] This is a breakdown of the company’s investment projects:
1/3 Automotive retailer β = 2.0 1/3 Computer Hard Drive Mfr. β = 1.3 1/3 Electric Utility β = 0.6 average β of assets = 1.3 When evaluating a new electrical generation investment, which cost of capital should be used? Capital Budgeting & Project Capital Budgeting & Project Risk
Project IRR SML
Investments in hard drives or auto retailing should have higher discount rates. Firm’s risk (beta) 0.6 1.3 2.0
r = 4% + 0.6×(14% – 4% ) = 10% 24% 17% 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 Cost of Capital with Debt The Weighted Average Cost of Capital is given by:
rWACC S B = × rS + × rB × (1 − TC ) S+B S+B • It is because interest expense is taxdeductible that we multiply the last term by (1 TC) 13.5 Estimating Bombardier’s 13.5 Estimating Bombardier’s Cost of Capital We aim at estimating Bombardier’s cost of capital, as of January 31, 2004. 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. 13.5 Estimating Bombardier’s 13.5 Estimating Bombardier’s Cost of Capital
Bombardier’s beta is 1.48; the (current) riskfree rate is 4.61%, and the (historical) market risk premium is 3.84%. Thus the cost of equity capital is re = RF + βi ( R M − RF ) = 4.61% + 1.48 × 3.84% = 10.29% 13.5 Estimating Bombardier’s 13.5 Estimating Bombardier’s Cost of Capital The yield on the company’s 6.4% 22 December 2006 bond is 5.4%. Since this is a short bond, we add 1.2% to obtain a 6.6% cost of issuing longterm debt. The firm is in the 33.6% marginal tax rate. Thus the cost of debt is
rB × (1 − TC ) = 6.60% × (1 − 0.336) = 4.38% 13.5 Estimating Bombardier’s Cost of Capital
• To calculate the cost of capital, we need to estimate the value weights for equity and debt:
Market Value Weights for Bombardier (as of January 31, 2004) Security
Debt (book value) Preferred stock Class A Common Class B Common M arket Price 23.54 5.94 5.97 Shares Market Value Outstanding (millions) Weight (%) $ 8,074 42.47% 21,400,000 $ 504 2.65% 342,018,000 $ 2,032 10.69% 1,407,567,000 $ 8,403 44.20% Total $ 19,013 100.00% • We simplify, and combine preferred stock with common stock:
S B = 57.53%, and = 42.47% S+B S+B 13.5 Estimating Bombardier’s Cost of Capital
• Bombardier’s WACC as of January 31, 2004, is given by:
S B rWACC = × rS + × rB × (1 − TC ) S+B S +B = 0.5753 ×10.29% + 0.4247 × 6.6% × (1 − 0.336) = 7.78% 7.78percent is Bombardier’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. 13.6 Reducing the Cost of 13.6 Reducing the Cost of Capital
What is Liquidity? Liquidity, Expected Returns, and the Cost of Capital Liquidity and Adverse Selection What the Corporation Can Do What is Liquidity? What is Liquidity? The idea that the expected return on a stock and the firm’s cost of capital are positively related to risk is fundamental. Recently a number of academics have argued that the expected return on a stock and the firm’s cost of capital are negatively related to the liquidity of the firm’s shares as well. The trading costs of holding a firm’s shares include brokerage fees, the bidask spread, and market impact costs. Liquidity, Expected Returns, Liquidity, Expected Returns, and the Cost of Capital The cost of trading an illiquid stock reduces the total return that an investor receives. Investors thus will demand a high expected return when investing in stocks with high trading costs. This high expected return implies a high cost of capital to the firm. Liquidity and the Cost of Liquidity and the Cost of Capital
Cost of Capital
Liquidity An increase in liquidity, i.e., a reduction in trading costs, lowers a firm’s cost of capital. Liquidity and Adverse Selection Liquidity and Adverse Selection There are a number of factors that determine the liquidity of a stock. One of these factors is adverse selection. This refers to the notion that traders with better information can take advantage of specialists and other traders who have less information. The greater the heterogeneity of information, the wider the bidask spreads, and the higher the required return on equity. What the Corporation Can Do What the Corporation Can Do The corporation has an incentive to lower trading costs since this would result in a lower cost of capital. A stock split would increase the liquidity of the shares. A stock split would also reduce the adverse selection costs thereby lowering bidask spreads. This idea is a new one and empirical evidence is not yet in. What the Corporation Can Do What the Corporation Can Do Companies can also facilitate stock purchases through the Internet. Direct stock purchase plans and dividend reinvestment plans handled online allow small investors the opportunity to buy securities cheaply. The companies can also disclose more information, especially to security analysts, to narrow the gap between informed and uninformed traders. This should reduce 13.7 Summary and Conclusions 13.7 Summary and Conclusions The expected return on any capital budgeting project should be at least as great as the expected return on a financial asset of comparable risk. Otherwise the shareholders would prefer the firm to pay a dividend. The expected return on any asset is dependent upon β . A project’s required return depends on the project’s β . A project’s β can be estimated by considering comparable industries or the cyclicality of project revenues and the project’s operating leverage. If the firm uses debt, the discount rate to use is the rWACC. In order to calculate rWACC, the cost of equity and the cost of debt applicable to a project must be estimated. Review Questions # Review Questions # Review Questions #: 13.2, 13.3, 13.8, 13.15, 13.16 Assignment Questions # Assignment Questions # Assignment Questions # : 13.1, 13.11, 13.13 ...
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This note was uploaded on 01/17/2011 for the course ACTSC 372 taught by Professor Maryhardy during the Spring '09 term at Waterloo.
 Spring '09
 MARYHARDY

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