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Lecture 5
Advanced CAPM,
Analyzing Project
Risk and Beta
Determination
Learning Outcomes
to determine a firms cost of equity capital;
explain the impact of beta in determining the
firms cost of equity capital;
to determine the firms overall cost of capital;
to recalculate the cost of capital when the debt
ratio differs;
to explain the impact of floatation cost in capital
buudgeting.
2
Chapter Outline
The Cost of Equity Capital
Estimating the Cost of Equity Capital with the CAPM
Estimation of Beta
Determinants of Beta
The Dividend Growth Model (DGM) Approach
Cost of Fixed Income Securities/Bonds (Debt)
The Weighted Average Cost of Capital (WACC)
Cost of Capital for Divisions and Projects
Where Do We Stand?
Shareholders
Invest in project 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.
The Cost of Equity Capital (RE )
Good A
project
13.5% B
C Bad project
5%
Firms risk (beta)
1.5
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.
The Risk-Free Rate (RF )
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 firms beta cannot change.
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage
Using an Industry Beta
It is frequently argued that one can better estimate a
firms 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 firms beta.
Do not forget about adjustments for financial leverage.
Determinants of Beta ()
Business Risk
Cyclicality of Revenues
Operating Leverage
Financial Risk
Financial Leverage
Cyclicality of Revenues
Highly cyclical stocks have higher betas.
Empirical evidence suggests that high tech firms, retailers and
automotive firms fluctuate with the business cycle.
Transportation firms and utilities are less dependent on the
business cycle.
Note that cyclicality is not the same as variabilitystocks
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 may not
be especially dependent upon the business cycle.
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 cyclicality on
beta.
The degree of operating leverage is given by:
D EBIT Sales
DOL =
EBIT D Sales
Operating Leverage
D EBIT
Total
$ costs
Fixed costs
D Sales
Fixed costs
Sales
RE D 1
g
P0
The Dividend Growth Model Approach
Start with the dividend growth model formula and rearrange to
solve for RE
D1
P0
RE g
D1
RE g
P0
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Dividend Growth Model
RE D 1
g
P
The DGM is an alternative to the CAPM for calculating a firms
cost of equity.
The DGM and CAPM are internally consistent, but
academics generally favor the CAPM and companies seem
to use the CAPM more consistently.
The CAPM explicitly adjusts for risk and it can be used on
companies that do not pay dividends.
Project IRR Capital Budgeting & Project Risk
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF FIRM ( R M RF )
rate
Incorrectly rejected
rf positive NPV projects
Firms 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 firms beta is 1.3. (Using CAPM ; 4% + 1.3 10% = 17%)
This is a breakdown of the companys investment projects:
24%
Project IRR
Investments in hard
drives or auto retailing
17%
should have higher
10% discount rates.
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Example: Cost of Debt(RD )
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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:
RP = DP / P0
Example: Cost of Preferred Stock
Your company has preferred stock that has an annual dividend
of $3. If the current price is $25, what is the cost of preferred
stock?
RP = 3 / 25 = 12%
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Capital Structure Weights
Notation
E = market value of equity = # outstanding shares times price
per share
D = market value of debt = # outstanding bonds times bond
price
V = market value of the firm = D + E
Weights
wE = E/V = percent financed with equity
wD = D/V = percent financed with debt
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Example: Capital Structure Weights
Suppose you have a market value of equity equal to $500
million and a market value of debt = $475 million.
What are the capital structure weights?
V = $500 million + $475 million = $975 million
wE = E/D = $500 / $975 = .5128 = 51.28%
wD = D/V = $475 / $975 = .4872 = 48.72%
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The Weighted Average Cost of Capital
The Weighted Average Cost of Capital is given by:
Equity Debt
RWACC = REquity + RDebt (1 TC)
Equity + Debt Equity + Debt
E D
RWACC = RE + RD (1 TC)
E+D E+D
RE = RF + bi ( RM RF)
= 3% + 0.828.4%
= 9.89%
Example: International Paper
The yield on the companys debt is 8%, and the firm has a
37% marginal tax rate.
The debt to value ratio is 32%
E D
RWACC = RE + RD (1 TC)
E+D E+D
= 0.68 9.89% + 0.32 8% (1 0.37)
= 8.34%
8.34% is Internationals cost of capital. It should be used to
discount any project where one believes that the projects 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.
Quick Quiz
How do we determine the cost of equity capital?
How can we estimate a firm or project beta?
How does leverage affect beta?
How do we determine the weighted average cost of capital?
Review of assumptions
39 Lecture 5
Adjusting WACC when debt ratios differ
Consider the following:
Project debt ratio = 20 %
Company debt ratio = 40 %
40 Lecture 5
Adjusting WACC continued
41 Lecture 5
3 Steps in adjusting WACC
Step 1:
Calculate the opportunity cost of capital. This is the
expected rate of return that investors would want from the
project if it were all-equity financed. The opportunity cost
of capital depends only on business risk and is the WACC
at zero debt. This step is called unlevering the WACC.
43 Lecture 5
Adjusting WACC - 3-step Example
Step 1:
The firms current debt ratio is 40% so
r A= .06(.4) + .124(.6) =.0984
Step 2:
Assuming that that the debt cost remains @ 6 percent at the
new debt ratio of 20% Calculate revised rE
rE = .0984 + (.0984 -.06)(.25) = .108
D E
WACC rdebt (1 Tc) requity
DE DE
46 Lecture 4
Project Cost of Capital In Practice
47
Flotation Costs
Flotation costs represent the expenses incurred upon the issue, or float,
of new bonds or stocks.
These are incremental cash flows of the project, which typically reduce
the NPV since they increase the initial project cost (i.e., CF0).
49 Lecture 4