Chapter 12: Risk, Cost of Capital, and Capital Budgeting

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Chapter 12 Risk, Cost of Capital, and Capital
Budgeting

• Weighted Average Cost of Capital (WACC)
• Estimating cost of capital for
• Existing corporation
• New projects
• Beta estimation
• Economic Value Added (EVA)

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Three types of risk facing a firm

• (1) Stand-alone or total risk
• The risk or variability of a single projects
  cash flows, ignoring everything else.
• (2) Corporate risk the firm is a portfolio of
  projects
• The risk or variability of the firms cash flows.
• How will a new project affect the total risk of
  the firms cash flows?
• How are the projects cash flows correlated with
  the firms existing cash flows?

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Three types of risk facing a firm, continued

• (3) Market or Beta risk (CAPM)
• How does the firms new project affect the
  overall risk faced by a well-diversified investor
  that owns stocks of many firms?
• Stand-alone and corporate (firm-specific) risks
  would not be relevant to a well-diversified
  shareholder.
• Diversified investors are largely concerned about
  the market or CAPM Beta (systematic or
  macroeconomic) risk.
• However, some parties are likely concerned about
  total and corporate risks.
• Managers usually cannot diversify their careers.
• Employees and undiversified investors may have
  concerns.

4
Diversification at the corporate level

• Firms often may attempt to diversify or
  manage/reduce their corporate risk by
• Hedging or risk management
• Expanding into new businesses, usually by
  acquisitions. Commonly, they pay too much for a
  business they have no experience in managing.
• Such actions, especially acquisitions, may not be
  in the best interests of shareholders.
• Shareholders can diversify far more easily and
  cheaply.
• Corporate diversification only makes sense if it
  creates value that shareholders cannot create on
  their own.

5
What constitutes the value and relevant risk of a
firm

• All of a firms value comes from the cash flows
  that the firms assets are expected to produce.
  The firms risk originates from the risk of the
  assets/operations.
• A firm can be viewed as a portfolio of various
  types of assets or projects, or a portfolio of
  divisions.
• Each project and division that comprises the firm
  may have a different level of market or Beta
  risk.
• Same analogy as a stockholder holding a portfolio
  of different stocks, each having its own Beta.

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Example of corporate and project cost of capital,
the all equity case

• The asset Beta is the true measure of a firms
  risk. Stocks and bonds are risky because the
  assets are risky. A firms assets, equity, and
  debt each have a Beta.
• The required return on the market portfolio is
  rM10 and the risk free rate is rF5.
• ABCs assets are 100 equity financed (no debt is
  used). The Beta of ABC common stock is ß1.2.
• Since ABC is all equity, the stockholders have a
  100 claim on the firms assets. For an all
  equity firm, the Asset and Equity Betas are
  equal, i.e., ßequityßassets.

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Example of corporate and project cost of capital,
the all equity case

• We use the CAPM model to estimate the cost of
  equity or required return on ABC stock.
• rE 0.05 1.20.10 0.05 0.11 or 11
• Since ABC is 100 financed by equity, then its
  weighted average cost of capital or WACC is also
  equal to 11.
• Asset Betas are only a function of the firms
  systematic or market risk. Asset Betas only
  change with the Beta risk of the firms assets
  change.
• Changes in the mix of debt and equity financing
  will change the debt and equity Betas however,
  the firms asset Beta remains unchanged.

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Example of corporate and project cost of capital,
the all equity case

• ABC has a new proposed project. If the new
  project were a separate mini-firm, it would have
  an Asset Beta of ßassets0.8.
• This proposed project is less risky than ABCs
  existing asset Beta of 1.2. This projects cost
  of capital is thus
• rproject 0.05 0.80.10 0.05 0.09 or 9
• The project has the following expected cash flows.

9
Example of corporate and project cost of capital,
the all equity case

• The projects NPV, using the correct project cost
  of capital of rproject9 is calculated below
• NPV0 -950 300/(10.09) 300/(10.09)2
  300/(10.09)3 300/(10.09)4 21.915
• The projects IRR10.0466, which is greater than
  this projects 9 cost of capital.
• This project should be accepted.
• If the project has been evaluated at the firms
  existing WACC of 11, the project would have been
  wrongly rejected since the NPV would have been
  negative.

10
WACC and Financial Leverage

• Note the following terms
• D market value of Debt (not the accounting book
  value)
• E market value of Equity (not the accounting
  book value)
• rD cost of debt (before taxes)
• rE cost of equity, where rE rF ?ErM rF
• A market value of assets D E
• ?A Beta of assets (fixed and independent of
  capital structure)
• ?U Beta of unlevered equity (?U ?A, since
  these are equivalent)
• ?E Beta of equity (see equation below for
  explanation)
• ?D Beta of debt (often assumed to be zero in
  this chapter)
• TC Corporate tax rate

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WACC and Financial Leverage

• The following all important equation relates the
  Asset and Equity Betas, assuming that the Debt
  Beta ?D0.
• ?E ?A1 (1 TC)D/E
• The all important equation for cost of capital
  is
• D/(DE)(1 TC)rD E/(DE)rE
• When the above equation is solved for the entire
  firm, division, or project, then the result will
  be the entire firms WACC, divisional WACC, or
  project cost of capital, respectively.

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WACC and Financial Leverage

• XYZ Corp. is financed with 100 million of equity
  and 50 million of debt, at current market
  values.
• The Asset Beta is ?asset1.3 and the debt Beta is
  assumed to be zero in this example.
• Let TC40, rM12, and rF6.
• Given the above information, what is this firms
  existing WACC?
• Here, the WACC calculation consists of three
  steps, as shown on the following slide.

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WACC and Financial Leverage

• ?E ?A1 (1 TC)D/E
• ?E 1.31 (1 0.4)(50/100) 1.69
• rE rF ?ErM rF
• rE 0.06 1.690.12 0.06 16.14
• rD rF ?DrM rF 0.06 00.12 0.06
  6
• WACC D/(DE)(1 TC)rD E/(DE)rE
• WACC 50/(50100)(1 0.4)(0.06)
  100/(50100)(0.1614) 11.96

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WACC and Financial Leverage

• The diagram below illustrates XYZs assets, debt,
  and equity.

Asset risk is passed on to the firms equity
Asset risk is the source of the firms risk
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WACC and Financial Leverage

• XYZ has a new proposed project. The proposed
  project has an asset Beta of ßassets1.0. Assume
  the following
• The project should be financed in the same
  proportions as XYZ 1/3 debt and 2/3 equity.
  Therefore, both the firms and projects D/E
  ratio is 0.5.
• The Beta of any new debt is ßdebt0
• The project has the following expected cash
  flows. The Internal Rate of Return of these cash
  flows is IRR14.33.

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WACC and Financial Leverage, finding the project
cost of capital

• ?E ?A1 (1 TC)D/E
• ?E 1.01 (1 0.4)(0.5) 1.30
• rE rF ?ErM rF
• rE 0.06 1.30.12 0.06 13.8
• rD rF ?DrM rF 0.06 00.12 0.06
  6
• rproject D/(DE)(1 TC)rD E/(DE)rE
• rproject 1/3(1 0.4)(0.06) 2/3(0.138)
  10.40
• This projects IRR of 14.33 is higher than this
  projects rproject10.40 cost of capital, and
  therefore the project should be accepted.

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Adjustments to existing WACC for actual firms

• Here is a risk adjustment method that some firms
  use. Say that a firm has a WACC11. It may do
  the following to estimate project cost of
  capital. Average risk projects are evaluated
  using the firms existing WACC.

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Capital budgeting at a major firm the case of
Hershey Foods

• Excerpts from a 1998 interview with Samuel
  Weaver, Ph.D., the former Director of Financial
  Planning and Analysis.
• Managers appear to have trouble in interpreting
  the meaning of NPV. They understand IRR more
  easily. When Hershey must choose between
  mutually exclusive projects, they always use NPV,
  since IRR lead to mistakes with these projects.
• Hershey does calculate its own WACC, using their
  market values of debt and equity and not the book
  values.
• Hershey does not use the CAPM, they use the
  dividend discount model to estimate their cost of
  equity. Most other firms in the industry use the
  CAPM.
• Hershey does adjust the project cost of capital
  in order to reflect the unique risk of the
  project.

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Estimating Equity Betas, An Example Using GE Stock

• A common and easy (often not the best) method,
  for publicly traded firms, is to regress the
  firms past stock returns on the returns of a
  market index such as the SP 500.
• Our example uses three years of monthly stock
  returns from Jan. 1997 to Dec. 1999 to estimate
  the equity Beta of General Electric.
• The following regression is estimated
• rGE,t rF,t ?GE ?GErM,t rF,t eGE,t
• The Beta obtained from this regression is
  ?GE1.0473.

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Scatter Plot of GE versus Market Index Returns
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Economic Value Added (EVA)

• Items such as net income or even cash flow items
  such as FCF or FCFE, by themselves, cannot answer
  such questions as did the firms operations
  generate an acceptable return to its investors?.
• In order to generate positive EVA, a firm has to
  more than just cover its operating costs. It
  must also provide an above normal return to those
  who have provided the firm with capital.
• EVA takes into account the total cost of capital
  provided by both debtholders and stockholders.

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Economic Value Added (EVA)

• EVA equals after-tax operating income after-tax
  capital costs. Using numbers
• EVA EBIT(1-TC) (Total capital)(WACC)
• Let D40,000, E100,000, EBIT30,000, TC40,
  rD5, and rE12.
• WACC 40,000/(40,000100,000)(1-0.4)(0.05)
  100,000/(40,000100,000)(0.12) 0.0943 or
  9.43
• EVA (30,000)(1-0.4) (140,000)(0.0943)
• EVA 18,000 13,202 4798

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Economic Value Added (EVA)

• The firms investors expected the firm to
  generate at least 13,202 based on its risk. The
  firm was able to actually generate 18,000, and
  thus the EVA is 4798.
• The EVA method can be used to evaluate financial
  performance of non-traded firms, various plants,
  or non-traded divisions of publicly traded firms,
  etc.
• Managerial compensation is typically linked to
  changes in annual EVA, rather than the absolute
  EVA.
• In a perfect world, the ideal measure of value
  are market prices of stocks and debt however,
  most firms (and divisions of firms) are not
  publicly traded.