Title: Chapter 12: Risk, Cost of Capital, and Capital Budgeting
1Chapter 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)
2Three 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?
3Three 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.
4Diversification 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.
5What 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.
6Example 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.
7Example 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.
8Example 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.
9Example 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.
10WACC 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
11WACC 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.
12WACC 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.
13WACC 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
14WACC 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
15WACC 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.
16WACC 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.
17Adjustments 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.
18Capital 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.
19Estimating 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.
20Scatter Plot of GE versus Market Index Returns
21Economic 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.
22Economic 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
23Economic 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.