Chapter 13. Risk, Cost of Capital, and Valuation 13-0

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1 Chapter 13 Risk, Cost of Capital, and Valuation 13-0

2 Key Concepts and Skills Know how to determine a firm s cost of equity capital Understand the impact of beta in determining the firm s cost of equity capital Know how to determine a firm s cost of debt Know how to determine the firm s overall cost of capital Understand how to find the appropriate cost of capital for any given capital project Understand the impact of flotation costs on capital budgeting 13-1

3 Chapter Outline 13.1 The Cost of Equity Capital 13.2 Estimating the Cost of Equity Capital with the CAPM 13.3 Estimation of Beta 13.4 Determinants of Beta 13.5 The Dividend Discount Model Approach 13.6 Cost of Capital for Divisions and Projects 13.7 Cost of Fixed Income Securities 13.8 The Weighted Average Cost of Capital 13.9 Valuation with R WACC Estimating Eastman Chemical s Cost of Capital Flotation Costs and the Weighted Average Cost of Capital 13-2

4 Where Do We Stand? Earlier chapters on capital budgeting focused on the identification of relevant (incremental) cash flows and their timing, evaluating, say, NPV using a given discount rate. This chapter discusses how to find the appropriate discount rate or required rate of return or the cost of capital when cash flows are risky. 13-3

5 13.1 The Cost of Equity Capital Firm with excess cash Pay cash dividend A firm with excess cash can either pay a dividend or make a capital investment Shareholder invests in financial asset Invest in project Shareholder s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk

6 Cost of Equity Capital Implication: Discount rate needs to be appropriate for project s risk (not necessarily the same as the firm s overall risk) Let s begin by considering how to estimate a firm s cost of equity capital. Two approaches for finding a firm s equity cost of capital: From last time, CAPM Dividend Discount Model (DDM)

7 The Cost of Equity Capital The cost of equity capital is the required return on the stockholders investment in the firm. CAPM can be used to estimate the required return. From the firm s perspective, the expected return is the Cost of Equity Capital: R i R β R M R ) F i ( F To estimate a firm s cost of equity capital, we need to know three things: 1. The risk-free rate, R F 2. The market risk premium, 3. The company beta, β i R M R F Cov( Ri, R Var( R ) M M ) σ σ i, M 2 M 13-6

8 Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 1.5. The firm is 100% equity financed. Assume a risk-free rate of 3% and a market risk premium of 7%. What is the appropriate discount rate for an expansion of this firm? R s Rs R F β( RM RF ) 3% 1.5 7% 13.5% Rs 13-7

9 Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project Project b Project s Estimated Cash Flows Next Year IRR NPV at 13.5% A 1.5 $125 25% $10.13 B 1.5 $ % $0 C 1.5 $105 5% -$

10 Project IRR Using the SML Good project A SML 30% B 5% C 2.5 Bad project Firm s risk (beta) An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. 13-9

11 The Risk-free Rate Treasury securities are close proxies for the risk-free rate. Although the T-Bill rate is theoretically risk free, it is frequently distorted by Fed Policy. The CAPM is a period model. However, projects are long-lived. So, average period (short-term) rates need to be used. The historic premium of long-term (20-year) rates over short-term rates for government securities is 2%. So, the risk-free rate to be used in the CAPM could be estimated as 2% below the prevailing rate on 20-year treasury securities. Or use short term T-Note rates instead, say, 10 years

12 The Market Risk Premium Method 1: Use historical data. Method 2: Use the Dividend Discount Model R D P 1 Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis. Will not be stable. Also subject to growth assumption Method 3. Use forecasts g 13-11

13 Historical Market Risk Premium From SBBI Data: Small Stocks: 12.22% S&P 500: 9.85% US LT Gov Bonds: 5.45% US 30 Day T Bills: 3.62% US Inflation: 3.04% Risk Premium: SP500-LT Bonds = 9.85%-5.45%= 4.4% SP500-T Bills = 9.85%-3.62%= 6.23% 13-12

14 Implied Risk Premium using the S&P D 1 /P is the dividend yield. Because firms also buyback shares, we can use in its place the dividend yield plus the buyback yield. 1.81%+2.08% = 3.88% g is the growth rate of dividends. For simplicity use the historic growth rate. Dividend in 2001 = 15.74, in 2010 = g=(22.73/15.74) (1/9) -1 = 4.2% 1 R D g P R 3.88% 4.2% R 8.08% R RF ERP ERP R RF 8.08% 2% 6.08% 13-13

15 Survey data on the risk premium Most survey data is of academics and industry professionals. Average is about 5.5%. Has fallen in recent years from above 6%

16 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

17 Estimation of Beta β Cov( Ri, R Var( R ) M M ) 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. (see Rolling Beta for TGT.xlsx) 13-16

18 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 13-17

19 Determinants of Beta Business Risk Cyclicality of Revenues Operating Leverage Financial Risk Financial Leverage Highly cyclical stocks have higher betas. Retailers, auto makers Less cyclical Utilities

20 Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100% equity financed. Assume a risk-free rate of 5% and a market risk premium of 10%. What is the appropriate discount rate for an expansion of this firm? 13-19

21 Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project Project b Project s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B 2.5 $130 30% $0 C 2.5 $110 10% -$

22 Project IRR Using the SML Good project A SML 30% 5% B C Bad project 2.5 Firm s risk (beta) An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital

23 What if project betas vary? If the firm has a single cost of capital, but considers projects of varying risk, adjustments should be made. Different risk adjusted costs of capital should be used for each project. Otherwise the firm will over invest in risky projects. Why? - See the following example

24 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 % = 4% % 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? 13-23

25 Project IRR Capital Budgeting & Project Risk SML 24% 17% 10% Investments in hard drives or auto retailing should have higher discount rates. Project s risk (b) R = 4% (14% 4% ) = 10% 10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project

26 Project IRR Capital Budgeting & Project Risk Hurdle rate r f The SML can tell us why: R F Incorrectly rejected positive NPV projects SML Incorrectly accepted negative NPV projects β FIRM ( R M RF ) Firm s risk (beta) b FIRM A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value

27 The Weighted Average Cost of Capital The Weighted Average Cost of Capital is given by: Equity R WACC = Equity + Debt Debt R Equity + Equity + Debt R Debt (1 T C ) S R WACC = S + B B R S + S + B R B (1 T C ) Because interest expense is tax-deductible, we multiply the last term by (1 T C )

28 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 In practice, finding new debt issuances is tricky. For companies with publicly traded debt, we can rely on the yield to maturity of the debt. Note that the coupon rate is NOT a measure of the cost of debt today

29 Example: Target Corp 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

30 Example: International Paper The industry average beta is 0.82, the risk free rate is 3%, and the market risk premium is 8.4%. Thus, the cost of equity capital is: R S = R F + b i (R M R F ) = 3% % = 9.89% 13-29

31 Example: International Paper The yield on the company s debt is 8%, and the firm has a 37% marginal tax rate. The debt to value ratio is 32% R WACC = S RS + S + B = % % (1 0.37) = 8.34% 8.34% is International s cost of capital. B S + B R B (1 T C ) 13-30

32 Financial Leverage and Beta Operating leverage refers to the sensitivity to the firm s fixed costs of production. Financial leverage is the sensitivity to a firm s fixed costs of financing. The relationship between the betas of the firm s debt, equity, and assets is given by: b Asset = Debt Debt + Equity b Debt + Equity Debt + Equity b Equity Financial leverage always increases the equity beta relative to the asset beta

33 Example Consider Grand Sport, Inc., which is currently all-equity financed and has a beta of 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 However, assuming a zero beta for its debt, its equity beta would become twice as large: 1 b Asset = 0.90 = b Equity b Equity = =

Cost of Capital (represents risk)

Cost of Capital (represents risk) Cost of Equity Capital - From the shareholders perspective, the expected return is the cost of equity capital E(R i ) is the return needed to make the investment = the