Chapter 13 Risk, Cost of Capital, and Valuation 13-0 Key Concepts - PowerPoint PPT Presentation

Chapter 13 Risk, Cost of Capital, and Valuation 13-0

Key Concepts and Skills • Know how to determine a firm’s cost of equity capital • Understand the impact of beta in determining the firm’s cost of equity capital • Know how to determine a firm’s cost of debt • Know how to determine the firm’s overall cost of capital • Understand how to find the appropriate cost of capital for any given capital project • Understand the impact of flotation costs on capital budgeting 13-1

Chapter Outline 13.1 The Cost of Equity Capital 13.2 Estimating the Cost of Equity Capital with the CAPM 13.3 Estimation of Beta 13.4 Determinants of Beta 13.5 The Dividend Discount Model Approach 13.6 Cost of Capital for Divisions and Projects 13.7 Cost of Fixed Income Securities 13.8 The Weighted Average Cost of Capital 13.9 Valuation with R WACC 13.10 Estimating Eastman Chemical’s Cost of Capital 13.11 Flotation Costs and the Weighted Average Cost of Capital 13-2

Where Do We Stand? • Earlier chapters on capital budgeting focused on the identification of relevant (incremental) cash flows and their timing, evaluating, say, NPV using a given discount rate. • This chapter discusses how to find the appropriate discount rate or required rate of return or the cost of capital when cash flows are risky. 13-3

13.1 The Cost of Equity Capital Shareholder invests in Firm with Pay cash dividend financial excess cash asset A firm with excess cash can either pay a dividend or make a capital investment Shareholder’s Terminal Invest in project Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as 4 great as the expected return on a financial asset of comparable risk. 13-4

Cost of Equity Capital • Implication: Discount rate needs to be appropriate for project’s risk (not necessarily the same as the firm’s overall risk) • Let’s begin by considering how to estimate a firm’s cost of equity capital. • Two approaches for finding a firm’s equity cost of capital: – From last time, CAPM – Dividend Discount Model (DDM) 5 13-5

The Cost of Equity Capital • The cost of equity capital is the required return on the stockholders’ investment in the firm. CAPM can be used to estimate the required return. From the firm’s perspective, the expected return is the Cost of Equity    β Capital: ( ) R R R R i M F i F • To estimate a firm’s cost of equity capital, we need to know three things: 1. The risk-free rate, R F  2. The market risk premium, R R M F σ ( , ) Cov R R   β i , M i M 3. The company beta, i σ 2 ( ) Var R M M 13-6

Example • Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 1.5. The firm is 100% equity financed. • Assume a risk-free rate of 3% and a market risk premium of 7%. • What is the appropriate discount rate for an expansion of this firm?    β ( ) R R R R s M F F    3 % 1 . 5 7 % R s  13 . 5 % R s 13-7

Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project b Project’s Project IRR NPV at Estimated Cash 13.5% Flows Next Year 1.5 $125 25% $10.13 A 1.5 $113.5 13.5% $0 B 1.5 $105 5% -$7.49 C 13-8

Using the SML SML Project IRR Good A project 30% B Bad project C 5% Firm’s risk (beta) 2.5 An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. 13-9

The Risk-free Rate • Treasury securities are close proxies for the risk-free rate. • Although the T-Bill rate is theoretically risk free, it is frequently distorted by Fed Policy. • The CAPM is a period model. However, projects are long-lived. So, average period (short-term) rates need to be used. • The historic premium of long-term (20-year) rates over short-term rates for government securities is 2%. • So, the risk-free rate to be used in the CAPM could be estimated as 2% below the prevailing rate on 20-year treasury securities. • Or use short term T-Note rates instead, say, 10 years. • http://finance.yahoo.com/q?s=^TNX 13-10

The Market Risk Premium • Method 1: Use historical data. • Method 2: Use the Dividend Discount Model D   1 R g P – Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis. – Will not be stable. Also subject to growth assumption • Method 3. Use forecasts 13-11

Historical Market Risk Premium • From SBBI Data:1926-2010 – Small Stocks: 12.22% – S&P 500: 9.85% – US LT Gov Bonds: 5.45% – US 30 Day T Bills: 3.62% – US Inflation: 3.04% • Risk Premium: – SP500-LT Bonds = 9.85%-5.45%= 4.4% – SP500-T Bills = 9.85%-3.62%= 6.23% 13-12

Implied Risk Premium using the S&P 500 • http://pages.stern.nyu.edu/~adamodar/ • D 1 /P is the dividend yield. Because firms also buyback shares, we can use in its place the dividend yield plus the buyback yield. – 1.81%+2.08% = 3.88% • g is the growth rate of dividends. For simplicity use the historic growth rate. – Dividend in 2001 = 15.74, in 2010 = 22.73. g=(22.73/15.74) (1/9) -1 = 4.2% D   1 R g P   3 . 88 % 4 . 2 % R  8 . 08 % R   R RF ERP      8 . 08 % 2 % 6 . 08 % ERP R RF 13-13

Survey data on the risk premium • Most survey data is of academics and industry professionals. – Average is about 5.5%. – Has fallen in recent years from above 6%. 13-14

Estimation of Beta Market Portfolio - Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P 500, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio. 13-15

Estimation of Beta ( , ) Cov R R β  i M ( ) Var R M • Problems 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk. (see Rolling Beta for TGT.xlsx) 13-16

Stability of Beta • Most analysts argue that betas are generally stable for firms remaining in the same industry. • That is not to say that a firm’s beta cannot change. – Changes in product line – Changes in technology – Deregulation – Changes in financial leverage 13-17

Determinants of Beta • Business Risk – Cyclicality of Revenues – Operating Leverage • Financial Risk – Financial Leverage • Highly cyclical stocks have higher betas. – Retailers, auto makers • Less cyclical – Utilities. 13-18

Example • Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100% equity financed. • Assume a risk-free rate of 5% and a market risk premium of 10%. • What is the appropriate discount rate for an expansion of this firm? 13-19

Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project b Project’s Project IRR NPV at Estimated Cash 30% Flows Next Year 2.5 $150 50% $15.38 A B 2.5 $130 30% $0 C 2.5 $110 10% -$15.38 13-20

Using the SML SML Project IRR Good A project 30% B Bad project C 5% Firm’s risk (beta) 2.5 An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. 13-21

What if project betas vary? • If the firm has a single cost of capital, but considers projects of varying risk, adjustments should be made. – Different risk adjusted costs of capital should be used for each project. • Otherwise the firm will over invest in risky projects. – Why? - See the following example. 13-22

Capital Budgeting & Project Risk 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 × 10% This is a breakdown of the company’s investment projects: 1/3 Automotive Retailer b = 2.0 1/3 Computer Hard Drive Manufacturer 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? 13-23

Capital Budgeting & Project Risk SML 24% Project IRR Investments in hard drives or auto 17% retailing should have 10% higher discount rates. Project’s risk ( b ) 0.6 1.3 2.0 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. 13-24

Capital Budgeting & Project Risk Project IRR SML The SML can tell us why: Incorrectly accepted negative NPV projects   Hurdle β ( ) R R R M F FIRM F rate Incorrectly rejected r f positive NPV projects Firm’s risk (beta) b FIRM A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value. 13-25