Topic 6 Supplement (Cost of Capital, Capital Structure and Risk)

7/29/2019 Topic 6 Supplement (Cost of Capital, Capital Structure and Risk)

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Risk, Cost of Capital, and Capital Budgeting

Additional Ref: Chapter 9 Smart (2010)

Ross Chapter 12

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.


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12-1

Key Concepts and Skills Know how to determine a firms cost of equity

capital

Understand the impact of beta in determiningthe firms cost of equity capital

Know how to determine the firms overall cost

of capital


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12-2

Chapter Outline12.1 The Cost of Equity Capital

12.2 Estimation of Beta

12.3 Determinants of Beta

12.4 Extensions of the Basic Model

12.5 Estimating Eastman Chemicals Cost ofCapital


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12-3

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.


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12-4

Invest in project

12.1 The Cost of Equity Capital

Firm with

excess cash

ShareholdersTerminal

Value

Pay cash dividend

Shareholder

invests in

financial

asset

Because stockholders can reinvest the dividend in risky financial assets,

the expected return on a capital budgeting project should be at least asgreat as the expected return on a financial asset of comparable risk.

A firm with excess cash can either pay adividend ormake a capital investment


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12-5

The Cost of Equity Capital From the firms perspective, the expected

return is the Cost of Equity Capital:

)( FMiFi RRRR

To estimate a firms cost of equity capital, we needto know three things:

1. The risk-free rate,RF

FM RR 2. The market risk premium,

2

,

)(

),(

M

Mi

M

Mi

i

RVar

RRCov 3. The company beta,


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12-6

Example (1) Cost of Equity Suppose the stock of Stansfield Enterprises, a

publisher of PowerPoint presentations, has a beta

of 2.5. The firm is 100 percent equity financed.

Assume a risk-free rate of 5 percent and a market

risk premium of 10 percent.

What is the appropriate discount rate for an

expansion of this firm?

)(FMiF

RRRR

%105.2%5 R

%30R


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12-7

ExampleSuppose Stansfield Enterprises is evaluating the following

independent projects. Each costs $100 and lasts one year.

Project Project b ProjectsEstimated Cash

Flows Next

Year

IRR NPV at30%

A 2.5 $150 50% $15.38

B 2.5 $130 30% $0

C 2.5 $110 10% -$15.38


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12-8

Using the SML

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.

Project

IRR

Firms risk (beta)

SML

5%

Good

project

Bad project

30%

2.5

A

B

C


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12-9


Market Portfolio - Portfolio of all assets in the

economy. In practice, a broad stock market

index, such as the S&P 500, is used torepresentthe market.

Beta - Sensitivity of a stocks return to the return

on the market portfolio.


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12-10


)(

),(

M

Mi

RVar

RRCov

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.

Solutions

Problems 1 and 2 can be moderated by more sophisticated statisticaltechniques.

Problem 3 can be lessened by adjusting for changes in business andfinancial risk.

Look at average beta estimates of comparable firms in the industry.


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12-11

Stability of Beta Most analysts argue that betas are generally

stable for firms remaining in the same

industry. Thats not to say that a firms beta cant

change.

Changes in product line Changes in technology

Deregulation

Changes in financial leverage


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12-12

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 aresimilar 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 therest of the industry, you should use the firms beta.

Dont forget about adjustments for financial

leverage.


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12-13

12.3 Determinants of Beta

Business Risk

Cyclicality of Revenues

Operating Leverage

Financial Risk

Financial Leverage


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12-14

Cyclicality of Revenues

Highly cyclical stocks have higher betas.

Empirical evidence suggests that retailers and

automotive firms fluctuate with the business cycle.

Utility companies are less dependent upon the business

cycle.

Note that cyclicality is not the same as

variabilitystocks with high standard deviationsneed 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.


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12-15

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 riseand variable costs fall.

Operating leverage magnifies the effect of

cyclicality on beta.

The degree of operating leverage is given by:

DOL =

EBIT D Sales

SalesD EBIT


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12-16

Operating Leverage

Sales

$

Fixed costs

Total

costs

DEBIT

DSales

Operating leverage increases as fixed costs rise

and variable costs fall.

Fixed costs

Total

costs


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Example (2) Operating Leverage

12-17

Suppose a firms EBIT increases by 12% after sales

change from $2.3 million to $2.507 million. What is the

firms operating leverage? If the firms sales increase to$2.7577 million with EBIT increasing by only 11%,

what is the new operating leverage for the firm?

(Smart, Q-4, pg. 345)


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Answers

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9-4. Percentage change in sales: ($2.507 million $2.3

million) $2.3 million = 9%

Operating leverage = 12% 9% = 133.33%

Percentage change in sales: ($2.7577 million $2.507

million) $2.507 million = 10%

Operating leverage = 11% 10% = 110.00%


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STOP AND THINK

A certain firm has fixed costs of $4.5 million

with variable costs of $295 per unit. If each

unit sells for $450, what is the firms break-even point? Currently, the firm sells $32,000

units per year, but it believes that 60,000 units

per year could be sold if the selling price were

lowered to $385 per unit. What is the

operating leverage for the firm, new

breakeven point? (Smart 9-6)12-19


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12-20

Financial Leverage and Beta Operating leverage refers to the sensitivity to the

firms fixed costs ofproduction.

Financial leverage is the sensitivity to a firms

fixed costs offinancing.

The relationship between the betas of the firms

debt, equity, and assets is given by:

Financial leverage always increases the equity beta relative

to the asset beta.

bAsset=Debt + Equity

DebtbDebt+

Debt + Equity

EquitybEquity


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12-21

Example (4)Consider Grand Sport, Inc., which is currently all-equityfinanced 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 equitybeta would become twice as large:

bAsset= 0.90 =1 + 1

1bEquity

bEquity = 2 0.90 = 1.80


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Example (5)

ASIC Inc. has assets worth $6.9 million. Two

million dollars is financed with debt that costs

10% a year in interest. If ASICs contributionmargin is $175 per unit, then how many units

must be sold to cover the interest payments?

If ASIC sells 2,500 units this year, how much

return on a pre-tax basis (ie., a return based on

earnings before taxes) do shareholders

receive? How much pre-tax return would they

receive if ASIC had no debt? (Smart 9-7) 12-22


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Answers (5) 9-7. Interest payment: $2 million * 10% = $200,000

Debt coverage in units sold: $200,000 $175.00 =

1,142.86

Earnings prior to taxes: 2500*($175.00) $200,000

= $237,500

Shareholders return: $237,500 [$6.9 million $2

million] = 4.85% Shareholders return assuming no debt:

2500*($175.00) $6.9 million = 6.34%.

12-23


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12-24

12.4 Extensions of the Basic Model

The Firm versus the Project

The Cost of Capital with Debt


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12-25

The Firm versus the Project Any projects cost of capital depends on

the use to which the capital is being

putnot the source. Therefore, it depends on the risk of the

project and not the risk of the company.

The discount rate of a project should be

the expected return on a financial asset

of comparable risk.


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12-26

Capital Budgeting & Project Risk

A firm that uses one discount rate for all projects may over time

increase the risk of the firm while decreasing its value.

ProjectIRR

Firms risk (beta)

SML

RF

bFIRM

Incorrectly rejected

positive NPV projects

Incorrectly accepted

negative NPV projects

Hurdle

rate)(

FM

FIRMFRRR

The SML can tell us why:


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12-27

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.

17% = 4% + 1.3 10%

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 = 1.3

When evaluating a new electrical generation investment,

which cost of capital should be used?



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12-28


ProjectIRR

Projects risk (b)

17%

1.3 2.00.6

R = 4% + 0.6(14%4% ) = 10%

10% reflects the opportunity cost of capital on an investmentin electrical generation, given the unique risk of the project.

10%

24%

Investments in harddrives or auto retailing

should have higher

discount rates.

SML


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12-29

The Cost of Capital with Debt

The Weighted Average Cost of Capital is given by:

Because interest expense is tax-deductible, wemultiply the last term by (1tC).

RWACC =

Equity + Debt

Equity REquity +

Equity + Debt

Debt RDebt(1tC)

RWACC =S+B

S RS+

S+B

B RB (1tC)


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12-30

Example (7) International Paper First, we estimate the cost of equity and

the cost of debt.

We estimate an equity beta to estimate thecost 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.


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12-31

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:

RS=RF+ bi (RMRF)

= 3% + 0.828.4%

= 9.89%


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12-32

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%

8.34 percent 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.

= 0.68 9.89% + 0.32 8% (10.37)

= 8.34%

RWACC= S+B

S RS+ S+B

B RB (1tC)


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12-33

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 initialproject cost (i.e., CF0).

Amount Raised = Necessary Proceeds / (1-% flotation cost)

The % flotation cost is a weighted average based on the

average cost of issuance for each funding source and thefirms target capital structure:

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


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Reading Assignment

Cost of capital, gearing and CAPM By Ken Garrett (2009)

Assessable at

http://www.accaglobal.com/pubs/students/publications/student_accou

ntant/archive/sa_oct09_garrett2.pdf

12-34


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12-35

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 cost of capital with

debt? What are the two factors affecting cost of

equity? (ref: Ken Garrett 2009)

Documents

Topic 6 Supplement (Cost of Capital, Capital Structure and Risk)