Chapter 9: Cost of Capital and Project Risk

1. Chapter 9:Cost of Capital and Project Risk Corporate Finance, 3e Graham, Smart, and Megginson

2. Choosing the Right Discount Rate • Cost of equity • Weighted cost of capital (WACC) • The WACC and the CAPM • Asset betas and project discount rates • Equity risk premium 2

3. The numerator focuses on project cash flows, covered in Chapter 8: The denominator is the discount rate. Reflect the opportunity costs of the firm’s investors. The denominator should: Reflect the project’s risk. • Be derived from market data. Choosing the Right Discount Rate 3

4. Managers can estimate return shareholders require if they know: Their firm’s stock beta The risk-free rate The expected market risk premium Expected Risk Premium 4

5. Operating Leverage The extent to which a firm finances operations by borrowing Financial Leverage The fixed costs of repaying debt increase a firm’s beta in the same way that operating leverage does. Cost of Equity Beta plays a central role in determining whether a firm’s cost of equity is high or low. What factors influence a firm’s beta? The mix of fixed and variable costs; measures the tendency of the volatility of operating cash flows to increase with fixed operating costs 5

6. Cost of Equity 6 • Level of systematic risk varies from one industry to another • discount rate used in capital budgeting analysis should also. • Other factors affect betas, and thus project discount rates. • A firm’s cost structure: its mix of fixed and variable costs • The greater the importance of fixed costs in a firm’s overall cost structure, the more volatile will be its cash flows and the higher will be its stock beta.

7. Weighted Average Cost of Capital (WACC) 7 WACCis the simple weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of financing in the firm’s overall capital structure.

8. Finding WACC for Firms with Complex Capital Structures How do we calculate WACC if firm has long-term (D) debt as well as preferred (P) and common stock (E)? 8

9. The Link Between WACC and the CAPM WACC consistent with CAPM. Can use CAPM to compute WACC for levered firm. Calculate beta for bonds of a large corporation: • First find covariance between bonds and stock market. • Plug computed debt beta (d),Rfand Rm into CAPM to find rd. • Debt beta typically quite low for healthy, low-debt firms • Debt beta rises with leverage. Any asset that generates a cash flow has a beta, and that beta determines its required return as per CAPM. 9

10. The Link Between the CAPM and the WACC 10 • Any asset that generates cash flows has a beta that establishes the required return on the asset through the CAPM. • WACCrepresents the rate of return that a company must earn on its investments to satisfy both bondholders and stockholders. • The CAPM establishes a direct link between required rates of return on debt and equity and the betas of these securities.

11. The Link Between the CAPM and the WACC 11 If the firm has zero debt, the asset beta equals the equity beta. For firms that use debt, (1 + D/E) > 1.0, which in turn means that E > A. Holding the asset beta—the risk of the firm’s assets—constant, the more money the firm raises by issuing debt, the greater its financial leverage, and the higher its equity beta.

12. Asset Betas and Project Discount Rates 12 When a firm uses no leverage, its equity beta equals its asset beta. An unlevered beta simply tells us how risky the equity of a company might be if it used no leverage at all.

13. Discount Rate for Unique Projects What if a company has diversified investments in many industries? In this case, using firm’s WACC to evaluate an individual project would be inappropriate. Use project’s asset beta adjusted for desired leverage. 13

14. Finding the Right Discount Rate 14 When an all-equity firm invests in an asset similar to its existing assets, the cost of equity is the appropriate discount rate to use in NPVcalculations. When a firm with both debt and equity invests in an asset similar to its existing assets, the WACCis the appropriate discount rate to use in NPVcalculations.

15. Finding the Right Discount Rate 15 In conglomerates, the WACCreflects the return that the firm must earn on average across all its assets to satisfy investors, but using the WACCto discount cash flows of a particular investment leads to mistakes. When a firm invests in an asset that is different from its existing assets, it should look for pure-play firms to find the right discount rate.

16. Accounting for Taxes • Tax deductibility of interest payments favors use of debt. Accounting for interest tax shields yields the after-tax WACC. 16 The opportunity to deduct interest payments reduces the after-tax cost of debt and changes the relationship between asset betas and equity betas.

17. Measuring the Expected Risk Premium on the Market Portfolio 17 Earnings yield (E/P), or the reciprocal of the price-to-earnings ratios The dividend growth model Consensus of academic experts

18. Break-Even Analysis Managers often want to assess business’ value drivers: Useful to assessing operating risk is finding break-even point. Break-even point is level of output where all operating costs (fixed and variable) are covered. 18

19. Sensitivity Analysis 19 Firms establish a “base-case” set of assumptions for a particular project and calculate the NPVbased on those assumptions. Managers allow one variable to change while holding all others fixed, and they recalculate the NPVbased on that change. Repeating this process for all the uncertain variables in an NPVcalculation, allows managers to see how sensitive the NPVis to changes in baseline assumptions.

20. Scenario Analysis 20 A more complex variation on sensitivity analysis Rather than adjust one assumption up or down, analysts conduct scenario analysis by calculating the project NPVwhen a whole set of assumptions changes in a particular way.

21. Monte Carlo Simulation 21 A more sophisticated variation of the scenario analysis is Monte Carlo simulation. In a Monte Carlo simulation, analysts specify a range or a distribution of potential outcomes for each of the model’s assumptions.

22. Misuse of Simulation Analysis 22 • Most common misuse involves the calculation and misinterpretation of a distribution of project NPVs using the cost of capital • Plotting an entire distribution of NPVs and looking at the mean and variance of that distribution is, in a sense, double counting risk • Better approach is to calculate NPVs using the risk-free rate. • Interpreting a distribution of NPVs calculated using the risk-free rate has its own problems. • Although a useful tool, use NPV distributions from a simulation program with caution.

23. Decision Trees 23 Decision tree: a visual representation of the choices that managers face over time with regard to a particular investment.

24. Real Options 24 The NPV method may understate or overstate a project’s value by failing to account for real options embedded in the project. A real option is the right, but not the obligation, to take a future action that changes an investment’s value.

25. Real Options in Capital Budgeting Option pricing analysis helpful in examining multi-stage projects Embedded options arise naturally from investment; Called real options to distinguish from financial options. Value of a project equals value captured by NPV, plus option. Can transform negative NPV projects into positive NPV! 25

26. Types of Real Options 26 Expansion options Follow-on investment options Abandonment options Flexibility options

27. Link Between Risk and Real Option Values 27 • Generally, valuation problem covered in this text satisfies the following statement: • Holding other factors constant, an increase in an asset’s risk decreases its price. • This relationship does not hold for options.

28. Strategy and Capital Budgeting 28 In a perfectly competitive market, there are many buyers and sellers trading a homogeneous product or service. Everyone behaves as a price taker. Competition and the lack of entry or exit barriers for sellers ensures that the product’s market price equals the marginal cost of producing it, and no firm earns pure economic profit. In a market with zero economic profits, the NPVof any investment equals zero because every project earns just enough to recover the cost of capital: no more and no less.

29. Strategy and Capital Budgeting 29 If we want to know whether or not an investment proposal should have a positive NPV, we must identify ways in which the project deviates from the perfectly competitive ideal. Barrier to entry Competitive advantage

30. Strategic Thinking and Real Options 30 Managers must articulate strategy for a given investment Series of “if-then” statements has intangible value in that it forces managers to think through their strategic options before they invest. Identifying a real option is tantamount to identifying future points at which it may be possible for managers to create and sustain competitive advantages.