Chapter 9

Risk and the Cost of Capital

Why Cost of Capital Is Important
 The return to an investor is the same as the cost to the company

 The firm’s cost of capital is defined as the expected return on a

portfolio of all the company’s outstanding debt and equity
securities
 If the firm is an all equity firm (no debt outstanding), then the cost of
capital is just the expected rate of return on the firm’s stock

 We know that the return earned on assets depends on the risk of

those assets
 Our cost of capital provides us with an indication of how the market
views the risk of our assets

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 Why Cost of Capital Is Important
 Knowing our cost of capital can also help us determine our required
return for capital budgeting projects
 It is the appropriate discount rate for the firm’s average-risk projects (projects
neither more nor less risky than the average of the firm’s other assets)

 It is not the correct discount rate if the new projects are more or less risky than
the firm’s existing business

 Using the cost of capital as the discount rate for analyzing project of different
risk is problematic
 This means that the firm is requiring the same return from a very safe
project as from a very risky project  Wrong
 Firm would reject many good low-risk projects and accept many poor
high-risk projects  Wrong
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Company Cost of Capital
 A company’s cost of capital can be compared to the CAPM
required return
SML
Required return

5.7
Company cost
of capital

2.0

0
0.53
Project beta
 Capital Budgeting & Project Risk
Hurdle rate: Minimum acceptable rate of return

Project IRR

SM L
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF  βFIRM ( R M  RF )
rate
Incorrectly rejected
RF positive NPV projects
Firm’s risk (beta)
FIRM
A firm that uses one discount rate for all projects may over time increase the 12-5
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 firm’s beta is 1.3.
17% = 4% + 1.3 × 10%
This is a breakdown of the company’s investment projects:
1/3 Automotive Retailer = 2.0
1/3 Computer Hard Drive Manufacturer  = 1.3
1/3 Electric Utility  = 0.6
average  of assets = 1.3

When evaluating a new electrical generation investment,

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which cost of capital should be used?
Capital Budgeting & Project Risk
SML

24% Investments in hard

Project IRR

drives or auto retailing

17%
should have higher
10% discount rates.

Project’s risk ()

0.6 1.3 2.0
R = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment 12-7
in electrical generation, given the unique risk of the project.
 Why Cost of Capital Is Important
 The firm’s cost of capital may be useful as a benchmark for
setting discount rates for high risk or low risk projects
 We compare the project’s risk relative to the firm’s risk and adjust the cost
of capital accordingly

 It is easier to adjust the company’s cost of capital (upwards for

projects of higher risk and downwards for projects of lower risk)
than to estimate each project’s cost of capital from scratch

14-8
Cost of Equity
 The cost of equity is the return required by equity
investors given the risk of the cash flows from the
firm

 There are two major methods for determining the

cost of equity
 SML, or CAPM: Most large U.S. companies use the
CAPM to estimate the cost of equity
 Dividend growth model

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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 Example
 Suppose that your company is expected to pay a
dividend of $1.50 per share next year. There has been
a steady growth in dividends of 5.1% per year and the
market expects that to continue. The current price is
$25. What is the cost of equity?

1 .5 0
RE   .0 5 1  .1 1 1  1 1 .1 %
25

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The SML Approach
 To estimate a firm’s cost of equity capital,
we need to know three things:
1. The risk-free rate, RF
2. The market risk premium, E (RM )  RF
3. The company beta, βi

E (Ri)  RF  βi(E (RM )  RF )

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Example - SML
 Suppose your company has an equity beta of .58, and
the current risk-free rate is 6.1%. If the expected
market risk premium is 8.6%, what is your cost of
equity capital?
 RE = 6.1 + .58(8.6) = 11.1%

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 Risk Free Rate
 CAPM is a short term model  works period by period and calls for a
short term interest rate

 BUT could a 0.03% 3-month T-bill rate give the right discount rate for
cash flows for 10 or 20 years?  Probably not  Two ways to address
this problem:

1) Use a long-term risk free rate to compute CAPM => Market risk premium is
calculated as the average difference between market returns and return on long-term
treasuries

2) Retain the usual definition of the market risk premium as the difference between
market returns and returns on short-term T-bill rates BUT we need to forecast the
expected return from holding T-bills over the life of the project  Estimate the
expected average future (long-term) return on T-bills
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 Risk Free Rate – Expected long-term T-bills return
 Data shows that between 1900 and 2014 the risk premium for holding long-term
government bonds rather than T-bills has averaged about 1.5% (investors require a
risk premium for holding long-term bonds rather than bills)

 To get a rough (but reasonable) estimate of the expected long-term return from investing in
T-bills, we subtract 1.5% from the current yield on long-term bonds

 Assume the current yield on long-term (20-year) government bonds is 2.6%

Expected long-term return from bills = current yield on long-term gov. bonds – historical average of long-term
gov. bonds risk premium

 Expected long-term return from bills = 2.6% - 1.5% = 1.1%

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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  Measures
SYSTEMATIC risk

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 Estimation of Beta
 In principle we are interested in the future beta (future systematic
risk) of the company’s stock, but since this is very difficult, we
use historical beta (based on historical price movements) to
estimate future beta

 However, there is always a large margin for error when

estimating the beta for individual stocks
 Betas are not stable and do change overtime  This might lead to an error
in estimation
 There might be changes in market, technology, firm industry, firm fundamentals, firm
capital structure, etc…
 Noise in returns can obscure the true beta  For example, estimates of beta may be
distorted (upward or downward) if there are extreme returns in one or two months due
to special or extraordinary events

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 Using an Industry Beta
 The estimation errors tend to cancel out when we estimate betas of portfolios

 It is frequently argued that one can better estimate a firm’s beta by involving
the whole industry  Error in beta estimation on a single stock is generally
significantly higher than the error for a portfolio of securities

 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 as it is generally more
reliable

 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 firm’s beta

12-18
Financial Leverage and Beta
 Financial leverage is the sensitivity to a firm’s fixed
costs of financing  Debt β is a measure of the risk of
a firm’s defaulting on its debt.

 The relationship between the betas of the firm’s debt,

equity, and assets is given by:

Asset = Debt × Debt + Equity × Equity

Debt + Equity Debt + Equity

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Financial Leverage and Beta
 βEquity is the beta of the levered firm. It is multiplied by the percentage of equity in
the capital structure.

 βDebt is multiplied by the percentage of debt in the capital structure.

 The asset beta can also be viewed as the equity beta had the firm been all equity.

 The beta of debt is very low in practice. If we make the commonplace assumption
that the beta of debt is 0:

βAsset = (E/D+E) βEquity

=> βEquity = βAsset (1+(D/E))
 Given a positive Beta, Equity Beta is always greater than asset beta in a levered firm
 As debt increases => Equity beta increases => Difference between Equity beta and asset beta
increases
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Asset Beta (Unlevered Beta) vs.
Equity Beta (Levered Beta)
 Financial leverage always increases the equity beta relative to the asset beta
 As the firm’s debt increases, more earnings are committed towards
servicing this debt (repayment of principle and interest payments)
 Uncertainty of future earnings increase
 Riskiness of the firm’s stock increases
 Equity Beta increases
 The increase in risk is due to the firm’s choice of debt and is not associated with
market risk

 We look at asset beta whenever we want to investigate the riskiness of the firm
irrespective of its capital structure or compare the riskiness of different firms
without having this comparison affected by their choices of capital structure
 Asset beta measures the risk of just the firm’s assets (irrespective of debt)

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Asset Beta (Unlevered Beta) vs.
Equity Beta (Levered Beta)
 Equity Beta shows the volatility of the firm’s returns relative to the market
while taking into account the firm’s capital structure
 If firm increases debt => Equity beta will increase
 This is the beta that is generally reported and calculated in finance journals and
websites
 Affected by the firm’s choice of capital structure

 Asset Beta shows the volatility of the firm’s returns relative to the market
regardless of the firm’s capital structure  Change in firm’s choice of debt
does not affect asset beta
 If firm increases or decreases debt => Asset beta will not be affected by the
firm’s choice of capital structure
 Unlevered Beta is also known as Beta of Assets since the riskiness of the firm
without any debt is the consequence of only its assets
   12-22
Example
Consider Grand Sport, Inc., which is currently all-equity
financed and has a beta of 0.90.
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 0.90.
However, assuming a zero beta for its debt, its equity
beta would become twice as large:
1
Asset = 0.90 = × Equity
1+1
Equity = 2 × 0.90 = 1.80 12-23
Cost of Debt
 The cost of debt is the required return on our company’s 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
 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. What
is the cost of debt?
 N = 50; PMT = 45; FV = 1000; PV = -908.72; CPT I/Y =
5%; YTM = 5(2) = 10%

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Cost of Preferred Stock
 Reminders
 Preferred stock generally pays a constant dividend each
period
 Dividends are expected to be paid every period forever

 Preferred stock is a perpetuity, so we take the

perpetuity formula, rearrange and solve for RP

 RP = D / P0
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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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The Weighted Average Cost of Capital
 We can use the individual costs of capital that we have
computed to get our “average” cost of capital for the
firm.

 This “average” is the required return on the firm’s assets,

based on the market’s perception of the risk of those
assets

 The weights are determined by how much of each type

of financing is used
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Capital Structure Weights
 Notation
 E = market value of equity = # of outstanding shares times
price per share
 D = market value of debt = # of 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 equal to $475 million.

 What are the capital structure weights?

 V = 500 million + 475 million = 975 million
 wE = E/V = 500 / 975 = .5128 = 51.28%
 wD = D/V = 475 / 975 = .4872 = 48.72%

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Taxes and the WACC
 We are concerned with after-tax cash flows, so we also need to
consider the effect of taxes on the various costs of capital

 Interest expense reduces our tax liability

 This reduction in taxes reduces our cost of debt
 After-tax cost of debt = RD(1-TC)

 Dividends are not tax deductible, so there is no tax impact on the

cost of equity

 WACC = wERE + wDRD(1-TC)

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Would WACC Decrease by Increasing Debt-Equity Ratio
 Cost of debt is less than the cost of equity

 Looking at WACC formula, it might suggest that the average cost of capital could be
reduced by substituting cheap debt for expensive equity  It doesn’t work that way!

 As the percentage of debt in the firm’s capital structure increases, the cost of the
remaining equity also increases, offsetting the apparent advantage of more cheap debt
 An increase in debt increases the firm’s bankruptcy risk and financial constraints since it
increases the firm’s obligations and earnings commitments towards principle and interest
payments  Risk of equity increases

 However, debt has a tax advantage since interest is tax deductible

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Problem
 Given the following information for Morgan
Co., find the WACC. Assume a 35% tax rate.

 Debt: 5,000 9.4% coupon bonds outstanding, 1000

par value, 25 yrs to maturity, trading at 109% of par
with semiannual payments.
 Common stock: 165,000 shares outstanding selling
for $62. Beta is 1.15.
 Market: 6.5% market risk premium and 5.5% risk
free rate.
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 Allowing for Possible Bad Outcomes
 Example: Project Z will produce just one cash flow, forecasted at
$1 million at year 1. It is regarded as average risk, suitable for
discounting at a 10% company cost of capital:

C1 1,000,000
PV    $909,100
1 r 1.1
Allowing for Possible Bad Outcomes
 But now you discover that the company’s engineers are
behind schedule in developing the technology required for
the project. They are confident it will work, but they admit
to a small chance that it will not. You still see the most
likely outcome as $1 million, but you also see some
chance that project Z will generate zero cash flow next
year.
Allowing for Possible Bad Outcomes
 This might describe the initial prospects of project Z. But if
technological uncertainty introduces a 10% chance of a zero
cash flow, the unbiased forecast could drop to $900,000.

900,000
PV   $818,000
1.1
 Correcting for optimistic forecasts
 Example: The CFO of EZ Corp. is disturbed to find that the cash flow
forecasts for its investment projects are almost always optimistic. On
average they are 10% too high. He therefore decides to adjust by adding
10% to EZ ‘s WACC, increasing it from 12% to 22%  10% added to
the discount rate is said to be a fudge factor

 Suppose the CFO is right about the 10% upward bias in cash flow
forecasts. Can he just add 10% to the discount rate?

 Answer: The CFO should correct the CF forecasts instead of adjusting

the discount rate (by adding the 10% fudge factor). Fudge factors in
discount rates are dangerous because they displace clear thinking about
future cash flows.
 Correcting for optimistic forecasts
 Line 5 shows the correct adjustment for optimism (10%). Line 7 shows what happens
when a 10% fudge factor is added to the discount rate.
 The effect on the first year’s CF is a PV reduction of about 8% (2% less than the CFO
expected). But later present values are knocked down by much more than 10% because
the fudge factor is compounded in the 22% discount rate. By years 10 and 15, the PV
reductions are 57% and 72%, far more than the 10% bias the CFO started with.
 Adding a 10% fudge factor to the discount rate understates PV dramatically. The fudge
factor also makes long-lived project look much worse than quick payback projects.