Cost of Capital B

1
Cost of Capital (B)

• Risk Adjustments

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Timberland Revisited

• Timberlands Cost of Capital (WACC1)
• The cost of equity here is the cost of retained
  earnings
• What if Timberland had to issue new equity?
• Lets assume a floatation adjustment of 2.5
• ke ks 2.5 15 2.5 17.5

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• Timberlands Cost of Capital (WACC2)
• We have two WACCs what does this mean
• Our cost of capital is WACC1 13.4
• As long as we have retained earnings available
• Our cost of Capital is WACC2 15.5 after that

4

• When do we run out of retained earnings?
• Timberland 1993
• Depreciation Expense (93) 8.3
• Addition to RE (93) 22.4
• Retained Earnings Break-Point
• we 85.1 wd 14.9

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• If Timberland raises 26.3 at the current capital
  structure it would look like this

• To raise more capital Timberland would have to
  issue new equity.
• We can raise 26.3 million at WACC1 13.4

6

• What about depreciation?
• Depreciation provides a cash flow of 8.3 million
  in 93
• This represents a return of investment
• What do we do with this cash flow
• Return to investors
• Pay off debt
• Buy back shares of common stock

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• What is the opportunity cost if we keep
• Cost of debt
• Cost of Retained earnings
• WACC WACC1 13.4
• We have an additional 8.3 million available at
  WACC1 13.4

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Putting It Together

• WACC1 13.4
• 26.3 available from RE
• 8.3 available from depreciation
• 34.6 total
• WACC2 15.5 above that
• Any capital raised above 34.6 million

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Marginal Cost of Capital
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Other Issues

• Different Project Risk
• To recognize that project risk differs
• Companies may utilize multiple hurdle rates
• Hypothetical for Timberland

11

• This recognizes that project risk differs
• But still ad hoc
• We need a way of incorporating risk in capital
  budgeting

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Divisional Hurdle Rates

• Suppose we have two distinct divisions with
  distinct levels of risk
• High Risk Division WACC 20 (50 of assets)
• Low Risk Division WACC 10 (50 of assets)
• Corporate WACC 15

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• And we are analyzing the following project

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• How would you rate this investment?
• NPV _at_ 20 -26,151
• NPV _at_ 10 22,891
• NPV _at_ 15 -9,625
• Without divisional hurdle rates
• Reject this project
• If it is a low-risk division project we miss a
  good opportunity

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CAPM Revisited

• Risk
• Total Risk Diversifiable Risk
• Non Diversifiable Risk
• Total risk
• Measured as standard deviation, variance,
  coefficient of variation

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• Diversifiable risk (Non Systematic)
• Industry or firm specific risk
• Law suits
• New discoveries
• Events that impact one or few companies
• This risk should be eliminated or reduced when we
  combine securities in a portfolio
• Eggs in One Basket philosophy

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• Non Diversifiable Risk
• Market Risk (Systematic Risk)
• Beta (?) is CAPM measure of market risk
• Measures the sensitivity of stock j to market
  shocks
• How do we measure?

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• CAPM

• We are going to explore all of the inputs

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• The risk free investment
• Short-term Treasury Bill
• Closest thing to a risk free investment
• More consistent with theory
• Long-term Treasury Bond
• Some like to match the maturity of the the risk
  free investment to the maturity of the project
• Yield curve is fairly flat after 10 years so use
  the 10 year T-Bond rate
• Higgans method

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• Best Practices
• 70 of practitioners use T-Bonds
• 30 of Text books advocate T-Bonds

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• Market Risk Premium (km krf)
• Measure using historical premium
• Do we use T-Bills or T-Bonds?
• How far back in history do we go
• Especially important if you think the
  relationship may have changed
• Do we use past arithmetic or geometric returns?

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• Arithmetic vs. Geometric Returns
• Arithmetic average

• (100 (-50))/2 25
• Does this seem reasonable

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• Geometric Return
• ((1100)(1-50))½ - 1 0
• This more accurately measures your change in
  wealth.
• May be a better estimate if you believe that
  investors are buy and hold investors

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• How do assumptions impact the risk premium
• Measured using Ibbotson data (1926-1995)

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• Best Practices
• Most practitioners and text books report the use
  of arithmetic returns
• Practitioners tend to use lower risk premiums
• It is clear that the assumptions we use have an
  important impact on ke.

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• Beta Estimates
• Theory calls for a forward looking beta
• In practice this is impossible
• Varied methods of measuring the relationship
• Beta measures the sensitivity of returns to the
  market.
• What is the Market? (SP500, NYSE, other)
• Over what period do you measure the relationship
• 60 days of daily returns, 5 years of monthly
  returns, 2 years of weekly returns

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Example of Disparity

• Quaker Oats
• Beta estimates range from
• High 1.38
• Low .67
• Market risk premiums range from
• High 8.5 (T-Bills)
• Low 5.4 (T-Bonds)

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• Current Govt. Bond Rates
• T-Bills 5
• T-Bonds 6.5
• Calculate a range
• A Low estimate
• Using a Treasury bond market risk premium of 5.4
• Using a low beta estimate of .67
• Ks 6.5 .67(5.4) 10.11

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• A High estimate
• Using a Treasury Bill market risk premium of 8.5
• Using a high beta estimate of 1.38
• Ks 5 1.38(8.5) 16.73
• What would I use
• Arithmetic T-Bond market risk premium of 7
• Current 10 year T-Bond rate of 6.5
• An average beta from the best practices Case
• Dropping the lowest outlier estimate
• The average is 1.18
• ks 6.5 1.18(7) 14.76

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Conclusions on CAPM Estimates

• My preference is for arithmetic averages in
  calculating the market risk premium
• I use 10 year T-bonds for the risk free
  investment
• Beta estimates should be chosen carefully
• If your business structure has changed recently
• Look for betas calculated over shorter horizons
• If not
• Longer calculations might eliminate noise found
  in shorter observations.

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Divisional Hurdle Rates Revisited

• How do we measure divisional WACCs?
• Techniques for measuring market risk
• ?f(business risk, financial risk)
• Beta is influenced by the business environment
• Public utility vs. Internet start up
• Beta is also influenced by the financial risk
  created by debt usage.
• Leverage can magnify returns but also increases
  risk

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• A company is a portfolio of divisions or

• Overall beta is a function of the asset beta and
  the amount of leverage a firm employs.

33

• Calculating the beta of assets
• unlevered firm

• This is the beta of the firm if it were all
  equity financed.
• We call it the unlevered beta

34

• We can also adjust an unlevered asset beta for
  different levels of debt.

• This allows us to scale the business risk of a
  firm (asset beta) for differing debt levels.

35
The Pure Play Approach

• A company tries to find one or more
  single-product companies in the same line of
  business as a prospective project.

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• Example 
• Williams Company has a target capital structure
  of 40 debt and 60 equity, and will apply this
  capital structure to new projects under
  consideration. The firms beta is 1.50.
  Williams is evaluating a new project which is
  totally unrelated to its existing line of
  business. However it has identified two proxy
  firms engaged in the new business. They have a
  average beta of 1.2 and a debt ratio of 50.
  Williams new project has an IRR of 13.5. The
  risk-free rate is 10 and the market risk premium
  is 5. All three firms have a marginal tax rate
  of 34. Williams pre-tax cost of debt is 14.

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• What is the projects unlevered beta?

• We start with this because the competitors use
  more debt then us
• Next we have to scale this asset beta up for the
  leverage we will use.

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• What is the beta of the project to Williams?

• This is lower than competitors
• Because Williams uses less debt

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• Should the firm accept the Project?
• kS(project) krf bP(kM Krf)
• 10 1.04(5) 15.2
• WACC wdkd(1-T) weke
• (.40)(.14)(1-.34)(.60)(15.2)12.8
• IRR 13.5 gt WACC 12.8 (ACCEPT)

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Risk Adjustments in Practice

• 1st Step
• Adjustments are made for divisional risk
  differences
• Pure Play approach
• Ad Hoc
• Divisional WACC is used for evaluating average
  risk projects

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• 2nd Step
• Adjust for different project risks
• Replacement decisions vs. New projects
• Ad hoc usually
• Some Companies adjust cash flows for risk
• Why? Does this doesnt make sense

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Inflation

• How do we handle inflation in capital budgeting?
• Be consistent
• Most of our WACC calculations have been nominal
• kd incorporates an inflation premium
• ks incorporates an inflation premium
• If the WACC incorporates inflation then our cash
  flows should be inflated as well
• We ignored this in the Vesuvio case didnt we.
• A common pitfall is to use a nominal cost of
  capital but real operating cash flows.

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Economic Value Added (EVA)

• The Model
• EVA EBIT?(1-T) WACC?(Capital Employed)
• Measures whether a company returns enough in
  operating profits to cover the cost of capital.
• The advantage over NI analysis (ROE) is that we
  incorporate the cost of equity in the model
• Closely related to NPV
• We will see that the present value of a projects
  EVA is the projects NPV.

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Example

• Chapter 8 Question 7
• Analyze the following investment

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NPV analysis (First 4 Years)
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(No Transcript)
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EVA analysis (First 4 Years)
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(No Transcript)
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• EVA and NPV yield the same result
• Notice the importance of inflation in the outcome

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Conclusions

• Appeal of EVA
• Links NPV, performance appraisal and Compensation
• More closely linked to Value than ROE and EPS
• Weakness
• Still myopic (look at the EVA in year 1)
• Would you be concerned as a manager taking on a
  project like this?
• Most EVA comes late
• Doesnt really add to NPV analysis

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Summary

• The three main goals of this section are
• Train you to estimate the cost of capital and the
  components that make up the WACC
• Illustrate the relationship between WACC and
  value creation
• Illustrate the pitfalls and uncertainty that
  arise in estimating the WACC

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The End