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Capital Budgeting Under Uncertainty

The Cost of Capital and Capital Budgeting: Some Questions. Firms usually spend money on projects that are not risk free. How do we find the proper discount rate when projects are risky?Firms can raise funds for investment by retaining earnings, selling debt or selling equity. Does it make any difference how the firm obtains the money in determining the cost of capital?How can we determine the proper discount rate when the firm uses both debt and equity?How do we do capital budgeting when th33571

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Capital Budgeting Under Uncertainty

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    1. Capital Budgeting Under Uncertainty

    2. The Cost of Capital and Capital Budgeting: Some Questions Firms usually spend money on projects that are not risk free. How do we find the proper discount rate when projects are risky? Firms can raise funds for investment by retaining earnings, selling debt or selling equity. Does it make any difference how the firm obtains the money in determining the cost of capital? How can we determine the proper discount rate when the firm uses both debt and equity? How do we do capital budgeting when the project has different risk and/or a different capital structure than does the firm as a whole?

    3. Our analysis of risk and return, as summarized by the SML, can be extended to capital budgeting decisions. Remember what you are evaluating. If the firm uses no debt in its capital structure, the same is planned for the project, and the project has the same systematic risk (beta) as the firm’s existing assets, then the expected return required on the firm’s equity is the appropriate discount rate for the project. If the project’s systematic risk (beta) differs from the firm’s systematic risk then use a measure of the project’s beta to determine the discount rate. First we ask why then we ask how.

    4. Project vs. Firm Risk (All Equity Firm)

    5. Cost of Capital for a Project Ralph’s firm is an all equity financed firm in the fast food industry. Ralph is considering a project in the Bio-tech industry. The 10 year risk free rate is currently 4%. The historical average risk premium is 7%. The beta of Ralph’s firm = 1.1. The beta of Genzyme (an all equity firm) = 0.61. The cost of capital for the new investment is correctly calculated as: E(RP) = rs = 4% + 0.61 (7%) = 8.27% Not as: E(RP) = 4% + 1.1 (7%) = 11.7%. Why not? If it is, what mistake might the firm make?

    6. Project Beta: How do you estimate it? In evaluating a project, you want to know the risk of that “enterprise.” What would its beta be if it were a public firm on its own? It’s easy if the project falls neatly into an industry in which there are publicly traded firms. Find the enterprise or asset betas of a set of firms in the industry that closely resemble the project and take an average (why an average?). In the case of a new project that looks nothing like existing enterprises it gets squishy. Do a comparable firm analysis (when possible). Evaluate the cyclicality of its revenues and its operating leverage.

    7. Capital Budgeting Complexities If a project will be financed using both debt and equity, adjustments to the discount rate are required. Financial leverage increases the equity beta relative to the asset beta. Which of these would be estimated using the regression technique we discussed earlier? Interest is tax deductible. When you calculate NPV we must either allow for this in the estimated cash flows or alter the discount rate to reflect the presence of debt. We first consider adjusting the discount rate.

    9. WACC Fundamentally, the WACC is, just what its name suggests, an average of two costs of capital (the costs of debt and equity capital) weighted by the relative amounts of each security used. If I raise a dollar by selling 25˘ of debt and 75˘ of equity, and debt costs me 4% while equity costs me 8%, what is the total cost per dollar? Simple: (0.04)(0.25) = 0.01 for the debt and (0.08)(0.75) = 0.06 for the equity. The sum of these is 0.01 + 0.06 = 0.07 or 7˘ per dollar raised in this way.

    10. The Weights The two weights in the “weighted average” are just the relative amounts of borrowing represented by the different securities. Recall S+B is total value. S/(S+B) is the percent of value that is represented by equity. B/(S+B) is the percent of value that is represented by debt. Any time this calculation is done the current market values of these securities should be used in the calculation.

    12. Calculation of the Cost of Debt (rDebt) The before tax cost of debt can be calculated as the yield to maturity on the firm’s existing debt. Can also be found from bond ratings of companies with comparable financial structure in the same or related industries. Wall Street Journal Moody’s The after tax cost of debt is the before tax cost of debt multiplied by (1-Tc), where Tc is the firm’s effective marginal tax rate.

    13. Why Is There A Tax Adjustment For Debt? Consider a firm that has earnings before interest and taxes each period of $1000. Under scenario A, the firm is all equity financed. Under scenario B, the firm has issued debt with a face value of $1000 and a coupon rate of 10%. The firm has a 40% marginal tax rate.

    14. Why Is There A Tax Adjustment For Debt? Suppose ?NWC, Depr, and Cap Ex are zero in each scenario so net income is cash flow. In A, the firm can distribute a total of $600 to stakeholders. In B, the firm can distribute $100 (interest) + $540=$640. The tax shield from debt gives the firm $40 more to distribute to stakeholders. This tax shield lowers the effective interest payment on debt to $60=$100(1 - 0.4) or an “after tax” 6% coupon rate.

    15. WACC Example Gamma airlines is financed with 60% debt and 40% equity. Currently the YTM on Gamma bonds is 9%, and Gamma has estimated its cost of equity to be 14.5%. Gamma’s corporate tax rate is 40%. What is Gamma’s WACC? WACC = .40(14.5%) + .60(9%)(1-.40) = 9.04%. Issues: What if the risk of the project at hand differs from that of Gamma’s past projects? What if risk of this project is similar to that of Delta Airlines’ projects, and the 14.5% cost of equity figure was actually obtained for Delta (?S = 1.215). However, Delta’s capital structure differs from Gamma’s.

    16. Betas and Leverage We noted earlier that the beta of a portfolio is the average of the component betas. We can think of the firm’s assets as a portfolio of the debt and equity claims. From these insights it follows that: Where S is the market value of the stock (equity), B is the market value of debt (bonds), and Tc is the tax rate. Think of the “balance sheet” representation of the firm. The asset beta is the fundamental reflection of business risk.

    17. Beta Under Different Capital Structures In this analysis it is often assumed that the debt has a zero beta (sometimes a big simplification). Then:

    18. Beta Under Different Capital Structures

    19. Equity Betas and Leverage If the firm uses no debt (B=0) the equity beta and the asset beta are equal. If the firm uses debt, the equity beta is higher than the asset beta (since debt is first in line, levered equity is riskier than the firm’s underlying assets): The formula implies: (1) As we add more debt, equity holders will demand a higher rate of expected return. (2) When comparable firms are used to estimate beta, adjustments for differing capital structures may be needed.

    20. Why does beta increase with financial leverage? Leverage increases the volatility of the equity cash flow: Numerical Illustration: Outcome Good Bad % Ch. EBI 125 100 -20% Interest 50 50 0% Income 75 50 -33.3%

    21. How to use the set of tools developed here to select discount rates for capital budgeting. The cost of capital for each project should reflect the systematic risk of that project and the target capital structure of the firm (or division) taking the project. So, Select a publicly traded company that is comparable in terms of the risk of the underlying business/assets. Obtain the unlevered (asset) beta of the comparable company by transforming its equity beta. Obtain the corresponding project equity beta, reflecting the capital structure to be used by the project. Obtain the cost of equity and cost of debt for this project at your firm. Calculate the WACC for the project and perform NPV analysis.

    22. Example: “Un-levering” and “Re-levering” ? In the process of evaluating Gamma Airlines you find: Delta Airlines has an Equity beta of 1.215, Tc = 40%. Delta uses 70% equity and 30% debt financing. Find the asset beta of Delta: This will reflect the risk of the assets of Gamma Air’s project. Now find the equity beta of Gamma Air This will reflect the risk of the equity of Gamma Air’s project. If Delta’s and Gamma’s capital structures are different, their costs of equity will be different: 18.85% not 14.5%.

    23. Example: BK Industries

    24. Example: BK Industries Revisited BK Industries is a conglomerate company with operations in marine power, pleasure boating, defense, and fishing tackle. BK’s equity beta is 1.0. BK has and will maintain a debt/equity ratio of 1.0. Can we use the company cost of capital to value the text editing project? Latec Inc. is a firm that makes only text editing systems. Latec’s equity beta is 1.35. Latec has a debt to equity ratio of 0.75, and a marginal tax rate of 45% (as does BK).

    25. Levered Betas using debt/equity ratios The formulas for obtaining asset betas from equity betas and vice versa provided earlier required dollar values for debt (B) and equity (S). What if you are only given the leverage ratio, L = B/S? The formulas are easily restated as:

    26. “Unlever” Latec’s Beta to obtain the Beta of Text-Editing Assets: Latec has L = B/S = 0.75, TC = .45, and an equity beta of 1.35.

    27. “Relever” the asset Beta to reflect BK’s capital structure:

    28. BK Industries, Cont. Assume that the risk free rate is 8% and that BK’s cost of debt is also 8%. The market risk premium is 7%. Then the required equity return on BK’s project is:

    29. Finally, we can evaluate the NPV of the text editing venture using the WACC that reflects the risk associated with this particular business. Using the cash flow estimates obtained earlier:

    30. Questions BK Industries’ debt to equity ratio is 1.0 as it is for the project. BK’s equity beta prior to starting the text editing business was 1.0 (levered beta). What will happen to the beta of BK Industries after starting the text editing business? Suppose that BK uses its firm cost of capital to evaluate the text business? Would this favor undertaking the investment? Does BK diversifying into the text editor business help shareholders by providing them a more “diversified portfolio”?

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