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Unformatted text preview: 1 RISK, COST OF CAPITAL AND CAPITAL BUDGETING Ross, Westerfield & Jaffe “Corporate Finance” 7th ed. Chapter 12 Determinants of Beta 2 Business Risk Cyclicity of Revenues Operating Leverage Financial Risk Financial Leverage Financial Leverage and Beta 3 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: Debt Equity Asset = × Debt + × Equity Debt + Equity Debt + Equity Financial leverage always increases the equity beta relative to the asset beta. Financial Leverage and Beta: Example 4 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: Asset = 0.90 = 1 1 + 1 × Equity Equity = 2 × 0.90 = 1.80 Cost of Debt 5 The required rate of return on the rate that creditors demand on new borrowing. Usually the cost of long‐term debt or bonds Can be estimated by: computing the yield‐to‐maturity on the existing debt computing current rates based on the bond rating expected at the time of issue of new debt The cost of debt is NOT the coupon rate Cost of Preferred Stock 6 Preferred stock has a fixed dividend, paid indefinitely Therefore, we can use the formula for perpetuity and solve for Rp P0 D Rp Rp D P0 Weighted Average Cost of Capital 7 “Average” cost of capital for the whole firm Required rate of return based on market perception of the riskiness of firm’s assets Weights depend on the capital structure Tax‐adjustments 8 Interest payments are tax deductible and reduce the tax liability A firm borrows $1m at 9% interest. The corporate tax rate is 34%. The interest liability is reduced to 90000(.66)=59400. The after‐tax interest rate is therefore equal to 59400/1000000=5.94% After‐tax cost of debt = RD(1‐TC) WACC (Notations) 9 Market Value of Equity : E = # of shares outstanding x Share price Market Value of Debt : D = # of bonds outstanding x Bond price Total Market Value of the Firm V = E + D Percent financed by equity: we = E/V Percent financed by debt : wd = D/V Use market NOT book values Tax‐adjusted WACC 10 We can now compute the tax adjusted WACC: we Re wd Rd (1 Tc ) w p R p The WACC reflects i) the risk and ii) the capital structure of the firms existing assets as a whole. WACC is the appropriate discount rate only if the proposed investment falls under the same risk class as the firms existing operations WACC: Example I 11 Equity Information Debt Information 50 million shares $1 billion in $80 per share premium = 9% Risk‐free rate = 5% outstanding debt (face value) Current quote = 110 Coupon rate = 9%, semiannual coupons 15 years to maturity Tax rate = 40% Beta = 1.15 Market risk Summary of the WACC calculations 12 WACC: Example II 13 The industry average beta is 0.82; the risk free rate is 8% and the market risk premium is 8.4%. Thus the cost of equity capital is rS = RF + i × ( RM – RF) = 3% + 0.82×8.4% = 9.89% WACC: Example II 14 The yield on the company’s debt is 8% and the firm is in the 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 firm’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. The Firm versus the Project 15 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. What if the cash flows of the new investment are distinctly different in nature from the overall firm’s? When is WACC NOT to be used? 16 Company C is an all equity firm (the WACC is equal to the cost of equity).Rf= 7%, βe=1 and risk premium is equal to 8%. WACC=Re=Rf + βe(Rm‐Rf) = 15%. If we use WACC then accept all projects with returns greater than 15% Using WACC for all projects 17 Re(B) = 7% + 1.2(8%) =16.6% Re(A) = 7% + 0.6(8%) =11.8% βA = 0.6 βFirm = 1.0 βB = 1.2 Capital Budgeting & Project Risk Expected Return 18 SML : RF βFIRM ( R M RF )
The SML can tell us why: Incorrectly accepted negative NPV projects Hurdle rate Incorrectly rejected positive NPV projects RF FIRM beta A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value. Divisional and Project Costs of Capital 19 At times it may be appropriate to use different costs of capital for each division belonging to a different risk class. For example, a firm can have a different cost of capital for its low‐risk telecommunication division than its high‐risk electronics manufacturing division. Pure Play Approach 20 Look for other investments or companies that fall under the same risk class as the proposed project Compute the beta for each ‘comparable’ company Take an average Use that beta along with the CAPM to find the appropriate return for a project of that risk Often difficult to find pure play companies Subjective Approach 21 Involves making subjective adjustments in the overall WACC for each project A simple example: Category Example Discount Rate High risk New products WACC + 6% Moderate Risk Expansion of existing lines WACC + 0% Low risk Replacement of existing equipment WACC ‐ 5% Mandatory Pollution control equipment n/a Subjective Approach 22 Within each risk class or portioning, there may be some projects with more risk than others and thus requiring a higher discount rate. Within each partition, similar problems can exist: you may accept projects that u shouldn’t but the error rate is lower than using an overall WACC The SML and Subjective Approach 23 21%
WACC=15% B A High risk (+6%) 10% Moderate risk (0%) 7% Low risk (‐4%) βA = 0.6 βB = 1.2 Capital Budgeting & Project Risk 24 Example: 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 × [14% – 4%] This is a breakdown of the company’s investment projects: 1/3 Automotive retailer = 2.0 1/3 Computer Hard Drive Mfr. = 1.3 1/3 Electric Utility = 0.6 average of assets = 1.3 When evaluating a new electrical generation investment, which cost of capital should be used? Capital Budgeting & Project Risk 25 SML Project IRR/ Expected Return 24% Investments in hard drives or auto retailing should have higher discount rates. 17% 10% 0.6 1.3 2.0 Project’s risk () 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. 26 Reducing the Cost of Capital: 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 bid‐ask spread and market impact costs. Liquidity, Expected Returns and the Cost of Capital 27 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 Capital 28 Liquidity An increase in liquidity, i.e. a reduction in trading costs, lowers a firm’s cost of capital. Liquidity and Adverse Selection 29 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 bid‐ask spreads, and the higher the required return on equity. What the Corporation Can Do 30 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. What the Corporation Can Do 31 Companies can also facilitate stock purchases through the Internet. Direct stock purchase plans and dividend reinvestment plans handles on‐line 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 spreads. Conclusions 32 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 . A project’s required return depends on theproject’s . A project’s 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. ...
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This note was uploaded on 04/09/2012 for the course FINN 321 taught by Professor Farahsaid during the Spring '12 term at Alvin CC.
- Spring '12