Sixth Edition

1. 4/2/02 Lecture 17 Capital Budgeting: Cost of Capital Sixth Edition Principles of Corporate Finance BFIN 351 Sierra Nevada College Lake Tahoe Delivered by Mark R. Davidson, MBA

2. Lecture Outline Cost of Capital Revisiting Beta Example: Estimating Cost of Capital Summary and Conclusions

3. You need accurate numbers to make good NPV decisions • Cash Flows • Discount Rate (cost of capital) Note: discrepancy with book average vs. marginal • In the last lecture we focused on the appropriate size and timing of cash flows. • This chapter discusses the appropriate discount rate when cash flows are risky.

4. The Big Three Questions • What is Cost of Capital? The Weighted Average Cost of Capital (rWACC) indicates how much it costs a company (or “compensation to suppliers”) to use funds for capital projects or other investments • How is it used and why is it Important? rWACC is used to determine the present value of expected future cash flows from a firm’s investments; its used frequently and it quantifies assumptions about risk • How do we calculate rWACC? The cost of a firm’s debt and equity are weighted by the proportion of debt and equity in the firm’s capital structure.

5. The Weighted Average Cost of Capital Smooths Incremental Capital Inflow. • Firms get cash in “lumpy” amounts • E.g. Visa cash advance that only gives out $1,000 • rWACC helps us separate financing and investing decisions - by determining the average cost of funds across all possible projects and investments we do not make the mistake of associating specific funds with specific investment opportunities • The relative weights of debt and equity in the firm’s TARGET capital structure are used to avoid miscalculation due to temporary imbalances of debt and equity

6. rWACC Quantifies Several Important Assumptions • rWACC incorporates assumptions related to risk including interest rate risk, systematic risk, and company or default risk among others • When risk increases, we expect to be paid more to take that risk (example). The same is true for capital – when money is used for a risky venture, we must pay more to use it. • When given an rWACC you should always ask who calculated, using what method and what assumptions were incorporated.

7. Once We Have All the Components, Calculating rWACC is Very Straightforward rWACC = (% debt in firm) x ( after-tax cost of debt) + (% equity in firm) x (cost of equity) Example rWACC = (50%) x (10%) + (50%) x (16%) = 13% How do we determine all the components; % Debt? % Equity? Cost of Debt? Cost of Equity? Here’s where it gets fun.

8. Determine the Proportion (%) of Debt and Equity by looking at the Balance Sheet • Debt is listed under liabilities • Common Stock and Preferred Stock are typically listed under Stockholder’s Equity (sometimes preferred stock is listed as a liability) • Simply divide the number(s) on the balance sheet by the total assets Cumulative debtCommon StockPreferred Stock Total Assets Total Assets Total Assets

9. Pay cash dividend Invest in project The Cost of Equity Capital Shareholder invests in financial asset Firm withexcess cash A firm with excess cash can either pay a dividend or make a capital investment Shareholder’s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk.

10. To Determine Cost of Equity (rE) You Must Make an Assumption Your assumptions determine how you calculate cost of equity. • ASSUMPTION: returns to stockholders will remain the same forever USE: a variation of the perpetuity valuation formula to determine cost of equity • ASSUMPTION: returns to stockholders will grow at constant rate forever USE: The dividend valuation formula for perpetual growth 3.ASSUMPTION: returns will grow at a non-constant rate and then at a constant rate into the future USE: A combination of forecasted and discounted returns in combination with the dividend valuation formula for perpetual growth 4.ASSUMPTION: Someone has already figured this out – how can I be smart about using the brilliant work of others? USE: The Capital Asset Pricing Model (CAPM) to determine the cost of equity

11. CAPM Provides a Solution to Determine rE If we Know the Risk Premium of the Asset Recall from Chapter 5 that CAPM describes the return (or expected future payment) that investors require for any given level of risk We know that investors can get a risk free return from sort term govt. treasuries Return expected from a risky investment (e.g. common stock) is this risk free rate plus an additional premium to compensate for this additional risk rE = rf + risk premium

12. Historical Research Provides us With the Risk Premium for the Market • Over the long term (1926-1995), the risk premium for stocks in the the market (rm) has consistently held at 7% above the risk free rate (rm – rf = 7%) • CAPM provides us with an the equation: rE = rf + b(rm – rf) We can easily look up rf and we now know (rm – rf) Now all we need is a way to determine how similar our asset (our company stock) is to the market in terms of the risk characteristics. Guess What? Yep, that’s where b comes in .

13. Example • 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?

14. Estimation of Beta • Theoretically, the calculation of beta is straightforward: • Problems • Betas may vary over time. • The sample size may be inadequate. • Betas are influenced by changing financial leverage and business risk. • Solutions • Problems 1 and 2 (above) can be moderated by more sophisticated statistical techniques. • Problem 3 can be lessened by adjusting for changes in business and financial risk. • Look at average beta estimates of comparable firms in the industry.

15. Stability of Beta • Most analysts argue that betas are generally stable for firms remaining in the same industry. • That’s not to say that a firm’s beta can’t change. • Changes in product line • Changes in technology • Deregulation • Changes in financial leverage

16. Using an Industry Beta • It is frequently argued that one can better estimate a firm’s beta by involving the whole industry. • If you believe that the operations of the firm are similar 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 the rest of the industry, you should use the firm’s beta. • Don’t forget about adjustments for financial leverage.

17. Determinants of Beta • Business Risk • Cyclicity of Revenues • Operating Leverage • Financial Risk • Financial Leverage

18. Cyclicality of Revenues • Highly cyclical stocks have high betas. • Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle. • Transportation firms and utilities are less dependent upon the business cycle. • Note that cyclicality is not the same as variability—stocks with high standard deviations need not have high betas. • Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops”, but their revenues are not especially dependent upon the business cycle.

19. Total costs Fixed costs Total costs Fixed costs Volume Operating Leverage • The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs. • Operating leverage magnifies the effect of cyclicity on beta. • Operating leverage increases as fixed costs rise and variable costs fall.

20. Financial Leverage • Operating leverage refers to the sensitivity to the firm’s fixed costs of production. • Financial leverage is the sensitivity of a firm’s fixed costs of financing.

21. Determine Cost of Debt (rD)Using Current Market Data Cost of Debt (rD) = (current market yield) x (1-tax rate) Example: If current yield is 10% and tax rate is 40% then Cost of Debt (rD) = (7.5%) x (1 - 40%) = 4.5% Note on source of data: • Consider short term debt • Use company’s own most recent debt issue if possible • If not firm’s own debt then debt held by company in same industry with similar risk characteristics

22. The Cost of Capital with Debt • The Weighted Average Cost of Capital is given by: • It is because interest expense is tax-deductible that we multiply the last term by (1- TC)

23. The Firm versus the Project • Any project’s cost of capital depends on the use to which the capital is being put—not the source. • Therefore, it depends on the risk of the project and not the risk of the company. 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 firm’s beta is 1.3. 17% = 4% + 1.3 × [14% – 4%]

24. Capital Budgeting & Project Risk • This is a breakdown of the company’s investment projects: 1/3 Automotive retailer b = 2.0 1/3 Computer Hard Drive Mfr. 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? r = 4% + 0.6×(14% – 4% ) = 10% 10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project.

25. Estimating Cost of Capital • First, we estimate the cost of equity and the cost of debt. • We estimate an equity beta to estimate the cost of equity. • We can often estimate the cost of debt by observing the YTM of the firm’s debt. • Second, we determine the WACC by weighting these two costs appropriately.

26. Estimating Cost of Capital • The industry average beta for this particular company is 0.82; the risk free rate is 8% and the market risk premium is 9.2%. • Thus the cost of equity capital is

27. Estimating Cost of Capital • The yield on this company’s debt is 8% and the firm is in the 37% marginal tax rate. • The debt to value ratio is 32% 12.18% is this company’s cost of capital. It should be used to discount any project where one believes that the project’s 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.

28. Summary and Conclusions • The expected return on any capital budgeting project should be at least as great as the expected return on a financial asset of comparable risk. Otherwise the shareholders would prefer the firm to pay a dividend. • The expected return on any asset is dependent upon b. • A project’s required return depends on the project’sb. • A project’s b can be estimated by considering comparable industries or the cyclicality of project revenues and the project’s operating leverage. • If the firm uses debt, the discount rate to use is the rWACC. • In order to calculate rWACC, the cost of equity and the cost of debt applicable to a project must be estimated.

30. Continued General Design’s Diamond Film Project ($ millions)

31. General Design’s Diamond Film Project ($ millions) (Concluded)

32. Continued Representative Industry and Company Betas

33. Representative Industry and Company Betas (Concluded) * Numbers in parentheses are firms in sample. Source: Reprinted by permission of Vestek Systems, San Francisco, from Investment Data Book, November 1999.

34. Diversification Reduces Risk