Cost of Capital & Risk Analysis

Cost of Capital & Risk Analysis MBA Fellows Corporate Finance Learning Module Part II

Class Topics • Incorporating risk in Capital Budgeting • Cost of Capital Components: cost of debt, preferred stock, common equity. • Calculating the Weighted Average Cost of Capital (WACC) • Capital Structure Decisions • EVA

Capital Budgeting and Risk • Prior discussion of alternative projects assumed that the level of risk associated with each project was the same. • How do you evaluate projects when they have different levels of risk?

Project Risk • Reflects the the potential variability of returns. • Portfolio effect - if a project’s proposed returns are not perfectly correlated with the returns from the firm’s other projects. • Diversification - influences risk. The total risk of the firm may be reduced by accepting the proposed project, if its returns are not perfectly correlated with the returns from the firm’s other investments.

Types of Project Risk • Stand-alone Risk • Corporate/Within Firm Risk • Market/Beta Risk • All Risk is not equal - some risk can be diversified away, and some cannot.

Stand-Alone Risk • The risk associated with a particular project, ignoring the firm’s other projects/assets and firm/shareholder diversification. • Measured by the  (standard deviation) or CV (coefficient of variation) of NPV, IRR, or MIRR. • Methods for estimating stand-alone risk: Sensitivity Analysis, Scenario Analysis, Monte Carlo Simulation

Stand-alone risk • Stand-alone risk is easiest to measure, more intuitive. • Core projects are highly correlated with other assets, so stand-alone risk generally reflects corporate risk. • If the project is highly correlated with the economy, stand-alone risk also reflects market risk.

Coefficient of Variation (COV) • COV is a relative measure of stand-alone risk used. It used to compare the risk of 2 or more assets because it enables us to choose between 2 investments when one has a higher expected rate of return, but the other has a lower standard deviation. • It measures the the risk per unit of return. COV = Standard Deviation Expected Return

Measuring Stand-Alone Risk • Entails determining: • the uncertainty inherent in the project’s cash flows. • the nature of the individual cash flow distributions and their correlations with each other to determine the nature of the NPV probability distribution.

Probability Density Flatter distribution, larger , larger stand-alone risk. NPV 0 E(NPV)

Corporate Risk • The risk that the project contributes to the firm as a whole (the effect of the project on the earnings and cash flow variability of the firm). • Corporate risk considers the fact that some of the project's risk will be “diversified away” when the project is combined with the firm’s other projects. • However, corporate risk ignores shareholder diversification. • Depends on the project’s , and its correlation with returns on the firm’s other projects. • Measured by the project’s beta.

Profitability Project X Total Firm Rest of Firm 0 Years 1. Project X is negatively correlated to firm’s other assets. 2. If r < 1.0, some diversification benefits. 3. If r = 1.0, no diversification effects.

Market Risk • The effect (risk) of the project on a well diversified stock portfolio. • It takes in consideration the stockholders’ other assets (investments). • Depends on project’s  and its correlation with the stock market. • Measured by the project’s market beta.

Variables that Influence a Project’s NPV and IRR • Market Size • Selling Price • Market Growth Rate • Market Share (unit volume sales) • Residual Value of Investment • Operating/Fixed Costs • Investment required

Sensitivity Analysis • Answers the question “what if” • Shows how changes in one variable affects NPV or IRR. • The value of one variable is changed while holding all other variables constant. • Provides some idea of stand-alone risk. • Provides breakeven information.

Why is sensitivity analysis useful? • Provides some idea of stand-alone risk. • Identifies dangerous variables. • Provides breakeven information.

Sensitivity Analysis • Each variable is changed by several percentage points above and below its expected value (while holding the other variables constant). • Then a new NPV is calculated using each of these values. • Finally the set of NPV’s is plotted against the variable that was changed.

Example

NPV (000s) Unit Sales Salvage 82 k -30 -20 -10 Base 10 20 30 Value

Sensitivity Analysis • Slope of the lines in the graphs show how sensitive NPV is to changes in each of the inputs. • The steeper the slope, the more sensitive the NPV is to a change in the variable. • Comparison of 2 projects - the one with the steeper slope (sensitivity lines) would be riskier, because for that project a relatively small error in estimating a variable would produce a large change in the project’s expected NPV.

Results of Sensitivity Analysis • Steeper sensitivity lines show greater risk. Small changes result in large declines in NPV. • Unit sales line is steeper than salvage value or k, so for this project, should worry most about accuracy of sales forecast.

Weaknesses ofSensitivity analysis • Does not reflect diversification. • Says nothing about the likelihood of change in a variable, i.e. a steep sales line is not a problem if sales aren’t expected to fall. • Ignores the relationships among variables.

Scenario Analysis • Considers both the sensitivity of NPV to changes in key variables and identifies the range of possible outcomes under the worst, best, and most likely case. • It considers the impact of simultaneous changes in key variables on the project. • It provides a range of possible outcomes.

Scenario Analysis • Standard Deviation of NPV: • Coefficient of Variation: CVNPV =

Scenario Analysis • The project’s COV can be compared with the COV of the company’s average project to get an idea of the relative riskiness of the project under consideration. • Although scenario analyze can provide useful information about a project’s stand alone risk, it is limited because it only considers a few discrete outcomes (NPVs), even though there can be an infinite amount of possibilities.

Assume: all variables are known with certainty except unit sales, which could range from 900 to 1,600. E(NPV) = $ 82 (NPV) = 47 CV(NPV) = (NPV)/E(NPV) = 0.57

If the firm’s average project has a CV of 0.2 to 0.4, is this a high-risk project? What type of risk is being measured? • Since CV = 0.57 > 0.4, this project has high risk. • CV measures a project’s stand-alone risk. It does not reflect firm or stockholder diversification.

Would a project in a firm’s core business likely be highly correlated with the firm’s other assets? • Yes. Economy and customer demand would affect all core products. • But each product would be more or less successful, so correlation < +1.0. • Core projects probably have correlations within a range of +0.5 to +0.9.

How do correlation and  affect a project’s contribution to corporate risk? • If P is relatively high, then project’s corporate risk will be high unless diversification benefits are significant. • If project cash flows are highly correlated with the firm’s aggregate cash flows, then the project’s corporate risk will be high if P is high.

Would correlation with the economy affect market risk? • Yes. • High correlation increases market risk (beta). • Low correlation lowers it.

Subjective risk factors should also be considered • A numerical analysis may not capture all of the risk factors inherent in the project. • For example, if the project has the potential for bringing on harmful lawsuits, then it might be riskier than a standard analysis would indicate.

Weaknesses of Scenario Analysis • Only considers a few possible out-comes. • Assumes that inputs are perfectly correlated--all “bad” values occur together and all “good” values occur together. • Focuses on stand-alone risk, although subjective adjustments can be made.

Monte Carlo Simulation • A computerized version of scenario analysis. • Computer randomly selects a value for each variable and combines these values to determine the NPV/IRR of the project. • The process is repeated many times (1,000 or more) until a probability distribution of the project’s NPVs/IRRs is developed with its own expected value and standard deviation.

Monte Carlo Simulation • The inputs to a simulation include all of the principal factors affecting the project’s profitability, and the simulation output is a probability distribution of NPVs or IRRs for the project. • The project is accepted if the decision maker feels that enough of the distribution lies above the normal cutoff criteria (NPV >0) or (IRR> Required Rate of Return).

Simulation Results (1000 trials) UnitsPriceNPV Mean 1260 $202 $95,914 St. Dev. 201 $18 $59,875 CV 0.62 Max 1883 $248 $353,238 Min 685 $163 ($45,713) Prob NPV>0 97%

Interpreting the Results • Inputs are consistent with specified distributions. • Units: Mean = 1260, St. Dev. = 201. • Price: Min = $163, Mean = $202, Max = $248. • Mean NPV = $95,914. Low probability of negative NPV (100% - 97% = 3%).

Histogram of Results

Probability Density x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x x 0 E(NPV) NPV Also gives NPV, CVNPV, probability of NPV > 0.

Advantages of Monte Carlo Simulation • Reflects the probability distributions of each input. • Shows range of NPVs, the expected NPV, NPV, and CVNPV. • Gives an intuitive graph of the risk situation.

Weaknesses of simulation • Difficult to specify probability distributions and correlations. • If inputs are bad, output will be bad:“Garbage in, garbage out.”

Project Risk Analysis • Sensitivity, scenario, and simulation analyses do not provide a decision rule. They do not indicate whether a project’s expected return is sufficient to compensate for its risk. • Sensitivity, scenario, and simulation analyses also ignore diversification. As a result, they measure only stand-alone risk, which may not be the most relevant risk in capital budgeting.

Risk Adjusted Discount Rate • Calculate the NPV of a project, using a discount rate that has been adjusted for the riskiness of the project. • Risk premiums applied to individual projects are chosen in a subjective manner. • Projects assigned to risk classes and then the same discount rate is assigned to all projects in each class.

Cost of Capital • Capital : amount of money raised by a corporation from creditors and investors through the issuance of bonds (debt), preferred stock, and/or common stock. • Cost: the rate of return required by investors and creditors who supply capital to the firm, or • The cost to the corporation of raising funds from investors and/or creditors, or • The minimum rate of return required on new investments undertaken by the firm.

Capital Structure • The proportion of a firm’s total assets financed by debt, preferred stock, and common stock. • Component cost - the required rate of return on each source of capital (debt, preferred stock, common stock) • Target Capital Structure - percentages are set for different financing sources.

Weighted Average Cost of Capital (WACC) • The average (after-tax) cost of the sources of capital weighted by the proportion of each component in the firm’s capital structure. • EVA - firms create value if their income exceeds the cost of capital used to finance their operations. • For a project to be accepted, it must generate a return greater than its WACC.

WACC • The WACC is based on the weighted costs of the individual components of capital. The weights are equal to the proportion of each of the components in the target capital structure. • The appropriate component costs to use are the marginal costs or the costs associated with the next dollar of capital to be raised. These may differ from the historical costs of capital raised in the past.

Marginal Cost of Capital • The primary objective of managers is to maximize shareholder value. To do this managers must select projects that are expected to earn more than the firm’s cost of capital. • To evaluate a project that requires raising and investing new capital, managers must compare the marginal cost of capital to the project’s expected return.

Cost of Debt • The after-tax cost of debt is used in the calculation of WACC because of the tax savings that result from the deductibility of interest. kd = ( 1- Tax rate)

Component Cost of Debt • Interest is tax deductible, so the after tax (AT) cost of debt is: rd AT = rd BT(1 - T) = 10%(1 - 0.40) = 6%. • Use the nominal rate.

Cost of Preferred Stock • The rate of return investors require on the firm’s preferred stock adjusted for flotation costs. • kps = Dps/Pn • Because of the non-deductibility of preferred stock dividends, the cost of preferred stock is higher than that of debt. As a result, firms prefer to issue debt rather than from preferred stock.

Cost of Capital & Risk Analysis