Advanced Corporate Finance

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.

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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?

Earlier chapters on capital budgeting

focused on the appropriate size and timing
of cash flows.
This chapter discusses the appropriate
discount rate when cash flows are risky.
The Cost of Equity Capital
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

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 )

From the firms perspective, the expected return is the

Cost of Equity Capital:
Market Risk Premium
R E RF ( R M RF )
To estimate a firms cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M RF
Cov( Ri , RM ) i , M
3. The company beta, i 2
Var ( RM ) M
 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 E RF ( R M RF )
R E 3% 1.5 7%
R E 13.5%
Example
Suppose Stansfield Enterprises is evaluating the following
independent projects. Each costs $100 and lasts one year.

Project Project b Projects IRR NPV at

Estimated Cash 13.5%
Flows Next
Year
A 1.5 $125 25% $10.13

B 1.5 $113.5 13.5% $0

C 1.5 $105 5% -$7.49

Using the Security Market Line (SML)
SML
IRR
Project

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 )

Treasury securities are close proxies for the risk-free

rate.
The Capital Asset Pricing Model (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.
 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, Bursa Malaysia,
Nikkei etc. are used to represent the market.

Beta - Sensitivity of an individual stocks return to the return on the

market portfolio.
 Estimation of Beta()
Cov ( Ri , RM )

Problems Var ( RM )
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.

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

Operating leverage increases as fixed costs rise

and variable costs fall.
 Financial Leverage and Beta
Operating leverage refers to the sensitivity to the firms
fixed costs of production.
Financial leverage is the sensitivity to a firms fixed costs
of financing.
The relationship between the betas of the firms debt,
equity, and assets is given by:

bAsset = Debt bDebt + Equity bEquity

Debt + Equity Debt + Equity
Financial leverage always increases the equity beta
relative to the asset beta.
 Example
Consider Grand Sport, Inc., which is currently all-equity
financed and has a beta of 0.90.
Since the firm will remain in the same industry, its asset
beta should remain 0.90.
The firm has decided to lever up to a capital structure of 1
part debt to 1 part equity.
However, assuming a zero beta for its debt, its equity beta
would become twice as large:
1
bAsset = 0.90 = bEquity
1+1
bEquity = 2 0.90 = 1.80
 Cost of Equity
Method 1: Use historical data
Method 2: Use the Dividend Growth Model (DGM)

Market data and analyst forecasts can be used to implement

the DGM approach on a market-wide basis

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

Dividend Yield Capital Yield

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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:

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 = (2 + 1.3 +0.6) /3 =1.3
When evaluating a new electrical generation investment, which
cost of capital should be used?
 Capital Budgeting & Project Risk
SML

24%
Project IRR

Investments in hard
drives or auto retailing
17%
should have higher
10% discount rates.

Projects risk (b)

0.6 1.3 2.0
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.
 Cost of Debt(RD )

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(RD )

The cost of debt is the required return on

our companys debt
The required return is best estimated by
computing the yield to maturity on the
existing debt
The cost of debt is NOT the coupon rate

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 Example: Cost of Debt(RD )

Suppose we have a bond issue currently outstanding that

has 25 years left to maturity. The coupon rate is 9% and
coupons are paid semiannually. The bond is currently selling
for $908.72 per $1,000 bond. Marginal tax rate is 32%.
Calculate the after-tax cost of debt?
N = 50; PMT = 45; FV = 1,000;
PV = -908.72; CPT I/Y = 5%;
YTM = 5(2) = 10%
After-tax YTM = 10% (1 0.32) = 6.8%

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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

Because interest expense is tax-deductible, we

multiply the last term by (1 TC).
 Example: International Paper
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 firms debt.
Second, we determine the WACC by
weighting these two costs appropriately.
 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:

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

The WACC formula works for a project offering perpetual

cash flows or for any cash-flow pattern if the firm adjusts its
borrowing to maintain a constant debt ratio over time

When these assumptions are violated, discounting cash

flows by the WACC is only approximately correct

Only permanent, material change in the firms debt ratio are

adjusted in the WACC formula

39 Lecture 5
 Adjusting WACC when debt ratios differ
Consider the following:
Project debt ratio = 20 %
Company debt ratio = 40 %

Adjustment to WACC only if the project requires a

permanent change in the companys overall debt
policy

A different debt ratio changes financing weights and

the costs of debt and equity

40 Lecture 5
 Adjusting WACC continued

When debt ratio decreases lower financial risk

rE decreases WACC temporarily increases
due to lower tax shields on debt interest payments

Recalculating WACC at a new debt ratio assumes

the firm to rebalance its capital structure to maintain
that same market-value debt ratio in the future

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.

Opportunity cost of capital

D E
rA rD rE
V V
Note : Do not adjust for tax in this case only
42 Lecture 5
 3 Steps to adjust WACC continued
Step 2:
Estimate the cost of debt, rD, at the new debt ratio, and
calculate the new cost of equity:
D
rE rA (rA - rD)
E
Step 3:
Recalculate the WACC at the new financing weights

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

Step 3: Recalculate WACC

WACC = .06(1 - .35)(.2) + .108(.8) = .0942
44 Lecture 5
 Divisional Weighted Average Cost of Capital
Companies with divisions operating in unrelated
industries (e.g. conglomerate companies) should not
use a single company WACC

Need to estimate a different benchmark WACC

(such as industry WACC) for each operating division

Divisional WACC is adjusted for business risk and

financing before being used as the discount rate for
a new project
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 Debt and the company cost of capital
If the company does not have any debt, it only has business
risk rA = rE where D=0
D
rE rA (rA - rD)
E
As a company starts to borrow, the WACC reflects both
business and financial risk reflected by a combination of the
cost of debt (the interest rate) and the cost of equity

D E
WACC rdebt (1 Tc) requity
DE DE
46 Lecture 4
 Project Cost of Capital In Practice

Every conglomerate company has its own policy in

determining cost of capital
Depending on the policy, benchmark can be company or
divisional WACC

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 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).

Amount Raised (1 - % floatation cost) = Necessary Proceeds

The % flotation cost is a weighted average based on the average

cost of issuance for each funding source and the firms target capital
structure:
fA = (E/V)* fE + (D/V)* fD
 Example: Floatation Cost
Suppose your company needs $50 million to build an
assembly line. Your target debt-equity ratio is 0.80. The
floatation cost for the new equity is 6%, but the floatation
cost for the debt is only 4%. (i) Calculate the weighted
average floatation cost. (ii) What is the true cost of
equipment after taking into account the floatation cost?

(i) fA = (E/V)* fE + (D/V)* fD

fA = .06(1/1.80) + .04(0.8/1.80) = .0511, or 5.11%

(ii) The total cost of the equipment including

flotation costs is:
Amount raised (1 .0511) = $50,000,000
Amount raised = $50,000,000/(1 .0511) = $52,692,591

49 Lecture 4