Risk, Return, and Capital Budgeting

1. Risk, Return, and Capital Budgeting Chapter 12

2. In evaluating projects, all future cash flows are discounted using a discount rate called cost of capital • When the cash flow is risk-less, we use the risk-less discount rate • When the cash flow is risky, we have to use the discount rate that takes into account of risk. • The appropriate discount rate can be computed from the CAPM Model and the Constant Growth Dividend Model. • We will first calculate the cost of capital based on two assumptions: (1) The firm is all equity financed. (2) Risk of the project = risk of the whole firm. • We will relax the assumptions later on.

3. The Cost of Equity • Based on the previous two assumptions, the cost of capital is the cost of equity. • Equity Beta: bS = sSm / sm2 • The Cost of Equity (CAPM): E(rs) = rf + bs [E(rm) – rf ] Example: The following are BCE stocks and TSX300 index returns for the 1994-1997 period: YearBCETSX300 1994 4.00% -0.18% 1995 30.00 14.53 1996 42.00 28.35 1997 34.00 14.98

4. Step 1: Calculating the Equity Beta • Calculating average returns: • Calculating the covariance: • Calculating the market variance: • Calculating beta of BCE:

5. Step 2: Calculating the Cost of Equity • Cost of Equity (CAPM): Given the current T-bill rate is 5.09% and expected market return is 14.42%. Expected market risk premium = 9.33%. Based on the CAPM, the cost of BCE’s equity is given by: E(rs) = rf + bBCE [E(rm) - rf]

6. An alternative Method for Calculating the Cost of Equity • In the Chapter 5, we reviewed the constant dividend growth model. • Where rsis the required rate of return of shareholders or the firm’s cost of equity. g is the growth rate of dividends. • The above model can be refomulated as

7. Example: The stock price of BCE Inc. is $19.70 per share today. The dividend is paid annually. The next dividend is $2.50 one year from now. The expected dividend growth rate is 5% per year indefinitely. Calculate the cost of equity for BCE.

8. The Investment Decision • Suppose that BCE is an all equity firm. The following are the expected cash flows for a new project. YearCFs (’000) 0 (40,000) 1 5,000 IRR = 13.41% 2 17,000 3 15,000 Calculate NPV and take decision 4 20,000 Assume: • The BCE Inc. is an all equity firm • The new project’s beta is the same as BCE’s beta (1.35) Decision: • =>. Or: • Since by the CAPM (SML) the required return for beta of 1.35 is _____, and IRR=13.41< or > => reject or accept (which one) the new project

9. The SML and the Investment Decision Expected Return (%) SML Whole firm 17.69 New Project IRR = 13.41 5.09 Beta 1.35

10. Determinants of Beta Factors affecting Equity Beta: • Business Risk • Cyclicity of Revenues: • Typically there are years of good return followed by poor returns. • Operating Leverage: • The use of fixed costs in operations may result in magnification of operating incomes and losses with changes in sales. • Operating leverage increases as fixed costs rise and as variable costs decline. • Financial Risk • Financial Leverage • The use of fixed costs in financing (e.g. Once the firm accumulated debt, the firm must make interest payments regardless of the firm’s sale)

11. Asset Beta and Equity Beta • The asset beta is the beta of the assets of the firm. • When the firm is financed with equityonly • When the firm is financed with debt and equity • Typically:

12. The Cost of Capital When debt is used • Assume: Cost of debt = rB Cost of equity = rS • In principal, the cost of capital is the weighted average of rB and rS . Since the interest payment is a tax deductible expense, the actual after tax interest cost to the firm is rB (1-Tc) • The Weighted Average Cost of Capital(WACC):

13. Example: BCE has a debt/equity ratio of 0.4. Assume s = 0.8; the T- bill rate =4.4%; the market risk premium = 12%; pre-tax borrowing rate = 10%; the corporate tax rate is 37%. Calculate the WACC for BCE.

14. When the Firm’s beta Differs from the Project’s Beta • The project and the firm may have different betas • When the project and the firm are not from the same line of business • Use industry beta (not always available) • When the project’s risk is inherently different (even if same industry) • Estimate the individual project’s beta • If the project’s risk is higher than the firm’s risk, the project beta should be used. The higher betahigher rs higher rwacc lower project NPV • If the project’s risk is lower than the firm’s risk, the project beta should be used • Otherwise 2 errors may occur: • Accept too many high-risk projects • Reject too many low-risk projects