Chapter 6 Estimating the Project Cost of Capital

6.1 The relationship between a projects riskiness and its cost of capital. 6.2 How to calculate a firms overall cost of capital for the special case where the project risk and the firm risk are identical. 6.3 The concept and calculation of a divisional cost of capital What is the Cost of capital: for a project is the minimum risk-adjusted return required by shareholders of the firm for undertaking the project. Unless the investment generates sufficient funds to repay suppliers of capital, the firms value will suffer.
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Each project has its own required return, reflecting 3 elements:

The real or inflation-adjusted risk-free rate An inflation premium approximately equal to the amount of the expected inflation A premium for risk Hurdle Rate: the minimum or required return for a projects cost of capital

Equ 6.1:
Cost of capital = Risk-free + For project i interest rate Project risk premium

ri =

rf + i (rm rf)

ri = cost of capital for project i rf + i (rm rf) = risk premium on project i

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Market Risk Premium: also known as the equity risk premium. Ordinarily assumed to equal the average historical difference between the return on the stock market and the average return on long-term Treasury bonds. One argument against the use of historical equity risk premium is that it does not allow for changes in investors perceptions of the relative risks of holding stocks versus bonds. It has been found that the 10 year Treasury bond yield is stable and equal to approximately 3.8%. Expected equity risk premium between 4% and 6% seems reasonable.
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The type of information we need to estimate project betas directly (a history of past project returns or future project returns relative to the predicted market returns) does not exist. The way to get around this is to find a firm, or a portfolio of firms that share similar risk characteristics and use the firms beta to proxy for the project beta.

Assumption is that firms finance their investments on an all equity basis, which is not true. Equity Beta: the beta for the firms common stock Asset Beta: the beta for the firms existing assets Many firms finance with a combination of both debt and equity. Debt holders have first claim on the firms cash flows. Need to know both the asset and equity betas to get an accurate cost of capital.

Well take a look at how the cost of equity capital, debt capital, and preferred stock can be calculated individually and then combined into an overall cost of capital for the firm, known as the weighted average cost of capital. Target Capital Structure: the proportions of debt and equity the firm plans to use in the future. These proportions should be selected so as to maximize shareholder wealth. Thus the target capital structure and the optimal capital structure should be one and the same.

Flotation Costs: the costs associated with the selling of new common stock, preferred stock, and debt. These include: legal, accounting, printing, marketing, and other expenses associated with new security issue. Can range from 1% to 15%. Can compensate by raising the cost of capital to cover these costs.

6.3 The Cost of Capital for a Division

In multiproduct firms, the requirement that projects be of similar risk is more likely to be met for divisions than the company as a whole. The use of a divisional cost of capital may be valid. Estimating the cost of capital for a division is a 3 stage process: 1. Identifying corporate proxies whose business closely parallels the divisions operations. 2. The cost of capital must be estimated for each of the proxy firms. 3. Average the resulting estimates of the individual asset betas.
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WACC: weighted average cost of capital APV: adjusted present value

LE: levered equity

DDM: Dividend Growth Model

(Appendix B text)

Used to value stocks based on NPV of dividends

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A calculation of the cost of capital that weights each category proportionately.

Preferred Stock Common Stock Debt

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APV = NPV of project + all-equity financed

NPV of financing side effects caused by project acceptance

An alternative & more flexible procedure, is to discount cash flows at a rate that reflects only the business risks of the project and abstracts from the effects of financing.

This approach discounts the levered cash flows the projects cash flows net of debt paymentsat the levered cost of equity capital.
The 3 different methods summarized on page 165 of the text.

The cost of capital or required rate of return for a specific project rather than for the firm as a whole. The rate reflects 3 elements: 1. The real or inflation adjusted rate of interest 2. An inflation premium approximately equal to the expected rate of inflation 3. A premium for risk