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Last Study Topics

Last Study Topics. Company and Project Costs of Capital Beta As a Proxy. Today’s Study Topics. Capital structure and COC Measuring the Cost of Equity. The Expected Return on Union Pacific Corporation’s Common Stock.

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Last Study Topics

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  1. Last Study Topics • Company and Project Costs of Capital • Beta As a Proxy

  2. Today’s Study Topics • Capital structure and COC • Measuring the Cost of Equity

  3. The Expected Return on Union Pacific Corporation’s Common Stock • Suppose that in mid-2001 you had been asked to estimate the company cost of capital of Union Pacific Corporation. • Table 1 provides two clues about the true beta of Union Pacific’s stock: • The direct estimate of .40 and the average estimate for the industry of .50. • Use the industry average of .50

  4. Continue • In mid-2001 the risk-free rate of interest rfwas about 3.5%. • 8% for the risk premium on the market, • You would have concluded that the expected return on Union Pacific’s stock was about 7.5%. • Expected stock return= rf +Beta(rm – rf) = 3.5 + .5(8.0) = 7.5%

  5. CAPITAL STRUCTURE AND THE COMPANY COST OF CAPITAL • we need to look at the relationship between the cost of capital and the mix of debt and equity used to finance the company. • Think again of what the company cost of capital is and what it is used for. • We define it as the opportunity cost of capital for the firm’s existing assets; • we use it to value new assets that have the same risk as the old ones.

  6. Company Cost of Capitalsimple approach • Company Cost of Capital (COC) is based on the average beta of the assets. • The average Beta of the assets is based on the % of funds in each assets. • Example • 1/3 New Ventures B=2.0 • 1/3 Expand existing business B=1.3 • 1/3 Plant efficiency B=0.6 • AVG Beta of assets = 1.3

  7. Capital Structure • Capital Structure - The mix of debt & equity within a company • Expand CAPM to include Capital Structure R = rf + B ( rm - rf ) Becomes; Requity = rf + B ( rm - rf )

  8. Union Pacific Corp. Example

  9. Understanding • If the firm is contemplating investment in a project that has the same risk as the firm’s existing business, the opportunity cost of capital for this project is the same as the firm’s cost of capital; in other words, it is 12.75%. • What would happen if the firm issued an additional 10 of debt and used the cash to repurchase 10 of its equity?

  10. Union Pacific Corp. Example

  11. Understanding • The change in financial structure does not affect the amount or risk of the cash flows on the total package of debt and equity. • Therefore, if investors required a return of 12.75% on the total package before the refinancing, they must require a 12.75% return on the firm’s assets afterward.

  12. Solve for Equity • Since the company has more debt than before, the debt holders are likely to demand a higher interest rate. • We will suppose that the expected return on the debt rises to 7.875%. • Now you can write down the basic equation for the return on assets and solve for return on Equity. i.e.

  13. Continue • Return on equity = 16% • Increasing the amount of debt increased debt holder risk and led to a rise in the return that debt holders required (rdebt rose from 7.5 to 7.875%). • The higher leverage also made the equity riskier and increased the return that shareholders required (requity rose from 15 to 16 %).

  14. Continue • The weighted average return on debt and equity remained at 12.75%. • What happen to cost of capital and return on equity, • If Co. has paid all of its debt and replace it with equity?

  15. How Changing Capital Structure Affects Beta • The stockholders and debtholders both receive a share of the firm’s cash flows, and both bear part of the risk. • For example, if the firm’s assets turn out to be worthless, there will be no cash to pay stockholders or debtholders. • But debtholders usually bear much less risk than stockholders. Debt betas of large blue-chip firms are typically in the range of .1 to .3.

  16. Continue • The firm’s asset beta is equal to the beta of a portfolio of all the firm’s debt and its equity. • The beta of this hypothetical portfolio is just a weighted average of the debt and equity betas:

  17. Continue • If the debt before the refinancing has a beta of .1 and the equity has a beta of 1.1, then; • Beta assets = .8

  18. Continue • What happens after the refinancing? The risk of the total package is unaffected, but both the debt and the equity are now more risky. • Suppose that the debt beta increases to 0.2. • Beta Equity = 1.2

  19. Understanding • Financial leverage does not affect the risk or the expected return on the firm’s assets, but it does push up the risk of the common stock. • Shareholders demand a correspondingly higher return because of this financial risk. • Figure on the next slide shows the expected return and beta of the firm’s assets. • It also shows how expected return and risk are shared between the debtholders and equity holders before the refinancing.

  20. Capital Structure & COC Expected Returns and Betas prior to refinancing Expected return (%) Requity=15 Rassets=12.75 Rrdebt=7.5 Bdebt Bassets Bequity

  21. Understanding • After the refinancing. • Both debt and equity are now more risky, and therefore investors demand a higher return. • But equity accounts for a smaller proportion of firm value than before. • As a result, the weighted average of both the expected return and beta on the two components is unchanged.

  22. Capital Structure & COC Expected Returns and Betas prior to refinancing Expected return (%) Requity=16 Rassets=12.75 Rrdebt=7.875 Bdebt Bassets Bequity

  23. Capital Structure and Discount Rates • The company cost of capital is the opportunity cost of capital for the firm’s assets. • That’s why we write it as rassets. • If a firm encounters a project that has the same beta as the firm’s overall assets, then rassetsis the right discount rate for the project cash flows.

  24. Continue • When the firm uses debt financing, the company cost of capital is not the same as requitythe expected rate of return on the firm’s stock; requity is higher because of financial risk. • When the firm changes its mix of debt and equity securities, the risk and expected returns of these securities change; however, the asset beta and the company cost of capital do not change.

  25. Continue • When companies discount an average-risk project, they do not use the company cost of capital as we have computed it. • They use the after-tax cost of debt to compute the after-tax weighted-average cost of capital or WACC.

  26. Summary • Capital structure and COC • Measuring the Cost of Equity

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