g P R D 1
30 Capital Budgeting & Project Risk A firm that uses one discount rate (hurdle rate) for all projects may over time increase the risk of the firm while decreasing its value.
31 Capital Budgeting & Project Risk Project IRR Firm’s risk (beta) SML r f b FIRM Incorrectly rejected positive NPV projects Incorrectly accepted negative NPV projects Hurdle rate ) ( F M FIRM F R R β R The SML can tell us why:
32 Capital Budgeting & Project Risk To estimate the cost of capital for a division, a “pure play” approach could be used, although finding exactly similar firms may be difficult, particularly considering underlying financial and operational structure.
33 The risk-free rate is 4% and the market risk premium is 10%. Suppose the Conglomerate Company has a beta of 1.3. 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 Capital Budgeting & Project Risk o Based on the CAPM, the firm has a cost of capital of: 4% + 1.3 × 10% = 17%. o When evaluating a new electrical generation investment, which cost of capital should be used?
34 Capital Budgeting & Project Risk Project IRR Project’s risk ( b ) 17% 1.3 2.0 0.6 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. 10% 24% Investments in hard drives or auto retailing should have higher discount rates. SML
35 Cost of Debt Interest rate required on new debt issuance (i.e., yield to maturity on outstanding debt) Adjust for the tax deductibility of interest expense Cost of debt (after corporate tax) = R B x (1 – t C )
36 Example Borrowing Rate ( R B )= 10% Tax Rate ( t C ) = 40% After tax cost of debt = R B x (1 – t C ) = 10% x (1 – 0.4) = 6%
Cost of Debts 37
38 Cost of Preferred Stock Preferred stock is a perpetuity, so its price is equal to the coupon paid divided by the current required return. Rearranging, the cost of preferred stock is: R P = C / PV