Corporate Finance Thirteenth Edition

Stephen A. Ross / Randolph W. Westerfield / Jeffrey F. Jaffe / Bradford D. Jordan

Chapter 13

Risk, Cost of Capital, and Valuation

© McGraw Hill LLC. All rights reserved. No reproduction or distribution without the prior written consent of McGraw Hill LLC.
 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 the firm’s overall cost of capital.
• Understand the impact of flotation costs on capital
budgeting.

© McGraw Hill, LLC 2

 Chapter Outline
13.1 The Cost of 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 Flotation Costs

© McGraw Hill, LLC 3

 Where Do We Stand?
Earlier chapters on capital budgeting focused on the
appropriate size and timing of cash flows.
This chapter discusses the appropriate discount rate when
cash flows are risky.

© McGraw Hill, LLC 4

 13.1 The Cost of Equity Capital

Because stockholders can reinvest the dividend in risky

financial assets, the expected return on a capital budgeting
project should be at least as great as the expected return on
a financial asset of comparable risk.
© McGraw Hill, LLC 5
 The Cost of Equity Capital
From the firm’s perspective, the expected return is the cost of
equity capital:
RS = RF + b ( RM - RF )

To estimate a firm’s cost of equity capital, we need to know three

things:
1. The risk-free rate, RF
2. The market risk premium, R M - R F
Cov ( Ri , RM ) s i ,M
3. The company beta, bi = =
Var ( RM ) s M2

© McGraw Hill, LLC 6

 Example
Suppose the stock of Stansfield Enterprises, a publisher of
online presentations, has a beta of 1.5. The firm is 100
percent equity financed.
Assume a risk-free rate of 3 percent and a market risk
premium of 7 percent.
What is the appropriate discount rate for an expansion of this
firm?

RS = RF + b ( RM – RF )

RS = 3% + 1.5 ´ 7%

RS = 13.5%
© McGraw Hill, LLC 7
 The Risk-Free Rate
• Treasury securities are close proxies for the risk-free rate.
• 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 in the range
of 1-2 percent.

© McGraw Hill, LLC 8

 Market Risk Premium
Method 1: Use historical data
• the historical average difference between the returns on
the market portfolio and a risk-free security

Method 2: Use the Dividend Discount Model

D1
RS = +g
P0
• Using this equation to estimate total expected return
on the market.
• Market data and analyst forecasts can be used to
implement the DDM approach on a market-wide basis.

© McGraw Hill, LLC 9

 13.3 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.

To estimate beta, it is standard practice to use data on the stock's

monthly total returns for the past five years along with the monthly
total returns of the S&P 5.00 Index as a proxy for the return of the
market portfolio.
Ø compute the covariance of the stock return with market returns
Ø regress the stock return on the returns of market portfolio

© McGraw Hill, LLC 10

 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.

© McGraw Hill, LLC 11

 Using an Industry Beta
It is frequently argued that one can better estimate a firm’s
beta by involving the whole industry.
If you believe that the operations of the firm are similar to the
operations of the rest of the industry, you should use the
industry beta.
If you believe that the operations of the firm are
fundamentally different from the operations of the rest of the
industry, you should use the firm’s beta.
Do not forget about adjustments for financial leverage.

© McGraw Hill, LLC 12

 13.4 Determinants of Beta
Business Risk
• Cyclicality of Revenues.
• Operating Leverage.

Financial Risk
• Financial Leverage.

© McGraw Hill, LLC 13

 Cyclicality of Revenues
Highly cyclical stocks have higher betas.
• Empirical evidence suggests that high-tech firms, retailers
and automotive firms fluctuate with the business cycle.
• Transportation firms and utilities are less dependent on the
business cycle.

Note that cyclicality is not the same as variability—stocks

with high standard deviations need not have high betas.
• Movie studios have revenues that are variable, depending
upon whether they produce “hits” or “flops,” but their
revenues may not be especially dependent upon the
business cycle.

© McGraw Hill, LLC 14

 Operating Leverage
The degree of operating leverage measures how sensitive a
firm (or project) is to its fixed costs.
Firms with high fixed costs and low variable costs are
generally said to have high operating leverage.
Operating leverage increases as fixed costs rise and variable
costs fall.
Operating leverage magnifies the effect of cyclicality on beta.

© McGraw Hill, LLC 15

 Financial Leverage and Beta
B: market value of the firm’s debt
S: market value of the firm’s equity
⇒ The relationship between the betas of the firm’s debt,
equity, and assets is given by:
S B
b Asset = ´ b Equity + ´ b Debt
B+S B+S
1. Asset’s beta is the weighted average of equity and debt
2. For an all-equity firm ⇒ B =0 ∴ βAsset = βEquity
3. In general, βDebt → 0
S æ Bö
Þ b Asset = ´ b Equity \ b Equity = ç1 + ÷ ´ b Asset
B+S è Sø
→ the equity beta of a levered firm will always be greater than
the equity beta of an otherwise identical all-equity firm.

© McGraw Hill, LLC 16

 Financial Leverage and Beta
In a world with corporate taxes

Financial leverage always increases the equity beta relative

to the asset beta.

© McGraw Hill, LLC 17

 Example
Consider Grand Sport, Inc., which is currently all-equity
financed and has a beta of .90.
The firm has decided to lever up to a capital structure of 1
part debt to 1 part equity.
Since the firm will remain in the same industry, its asset beta
should remain .90.
However, assuming a zero beta for its debt, its equity beta
would become twice as large:

1
b Asset = .90 = ´ b Equity b Equity = 2 ´ .90 = 1.80
1+1

© McGraw Hill, LLC 18

 13.5 Dividend Discount Model
D1
RS = +g
P0

The DDM is an alternative to the CAPM for calculating a

firm’s cost of equity.
The DDM and CAPM are internally consistent, but
academics generally favor the CAPM and companies seem
to use the CAPM more consistently.
• The CAPM explicitly adjusts for risk.
• It can be used on companies that do not pay dividends.

© McGraw Hill, LLC 19

 13.6 Capital Budgeting & Project Risk

A firm that uses one discount rate for all projects may over
time increase the risk of the firm while decreasing its value.

Access the text alternative for slide images

© McGraw Hill, LLC 20
 Cost of Capital for Projects
DDR, a conglomerate firm that is considering a new project in computer software.
Since DDR is not a pure play specializing in computer software, it decides to use
firms in the computer software industry as comparables for the project.
Compute equity beta and asset beta (assume the corporate tax rate is 21% and
debt betas are zero)

Apply the CAPM. Assuming a risk-free rate of 1% and a market risk premium of
6%, it might estimate its cost of capital for the project as:

Access the text alternative for slide images

© McGraw Hill, LLC 21
 13.7 Cost of Fixed Income Securities
In this section, we examine the cost of two types of fixed
income securities: debt and preferred stock.

Cost of Debt
Interest rate required on new debt issuance (i.e., yield to
maturity on outstanding debt)
Adjust for the tax deductibility of interest expense
After-tax cost of debt = (1 – tax rate) * Borrowing rate

© McGraw Hill, LLC 22

 Cost of Preferred Stock
Preferred stock is a perpetuity, so its price is equal to the
coupon paid divided by the current required return.
Rearranging, the cost of preferred stock is:
D
Rp =
PV

© McGraw Hill, LLC 23

 13.8 The Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is given by:

Equity Debt
RWACC = ´ REquity + ´ RDebt ´ (1 - TC )
Equity + Debt Equity + Debt

S B
RWACC = ´ RS + ´ RB ´ (1 - TC )
S+B S+B

Because interest expense is tax deductible, we multiply the

last term by (1 - TC ) .

© McGraw Hill, LLC 24

 Example
Consider a firm whose debt has a market value of $40m and whose stock
has a market value of $60m. The firm pays a 15% rate of interest on its
new debt and has a beta of 1.41. The corporate tax rate is 34%, the risk
premium on the market is 9.5%, and the current T-bill rate is 11%.
⇒ What is the firm’s RWACC?
Sol:
1. The aftertax cost of debt RB × (1 – tC) = 15% × (1 – 34%) = 9.9%
2. The cost of equity
RS = RF + β× (RM – RF) = 11% +1.41 × 9.5% = 24.40%
3. The proportion of equity and debt: 60% vs. 40%
4. WACC:
S B
RWACC = ´ RS + ´ RB ´ (1 - tc )
S+B S+B
=60% ´ 24.40% + 40% ´ 9.9% = 18.60%

© McGraw Hill, LLC 25

 Firm Valuation
The value of the firm is the present value of expected future
(distributable) cash flow discounted at the WACC.
To find equity value, subtract the value of the debt from the
firm value.

© McGraw Hill, LLC 26

 Example
Consider a firm whose debt has a market value of $40m and
whose stock has a market value of $60m. The firm pays a 15%
rate of interest on its new debt and has a beta of 1.41. The
corporate tax rate is 34%, the risk premium on the market is 9.5%,
and the current T-bill rate is 11%.
=> WACC = 18.6%
Suppose the firm is considering taking on a warehouse renovation
costing $50m that is expected to yield cost savings of $12m a year
for 6 years.

=> NPV = -8.67 => reject the project.

© McGraw Hill, LLC 27

 13.9 Flotation Costs
Flotation costs represent the expenses incurred upon the
issue, or float, of new bonds or stocks.
These are incremental cash flows of the project, which
typically reduce the NPV since they increase the initial
project cost (that is, CF0 ).
Amount raised = Necessary proceeds / (1–% Flotation cost )

The % flotation cost is a weighted average based on the

average cost of issuance for each funding source and the
firm’s target capital structure:

æS ö æBö
fA = ç ÷ ´ fS + ç ÷ ´ f B
èV ø èV ø

© McGraw Hill, LLC 28

 Example
Suppose an all-equity firm has a cost of equity of 20%, i.e. RWACC
= RE = 20%. The firm is considering a $100m expansion of its
existing operation, which will be funded by selling new stocks. If
the flotation costs is 10% of the amount sold. What is the cost of
the expansion?

Sol: The firm has to sell enough equity to raise $100m after
covering the flotation costs
⇒ (1 – 10%) × Amount raised = $100m
⇒ Amount raised = $100m / 90% = $111.11m
*Note:
1. The true cost including the flotation costs = $111.11m
2. The flotation costs = $111.11m – $100 = $11.11m

© McGraw Hill, LLC 29

 Example
Q. What if the firm uses both debt and equity ??
→ Suppose the firm’s target capital structure is 60% equity vs. 40%
debt. Assume the flotation costs of issuing equity fE = 10% and the
flotation costs of issuing bond fD = 5%:
⇒ We can compute the weighted average of flotation costs:
fA = (E/V) × fE + (D/V) × fD = 60% × 10% + 40% × 5% = 8%
When the project cost is $100m, the true cost including the
flotation costs = $100m / (1 – fA) = $100m / 92% = $108.7m

© McGraw Hill, LLC 30

 Quick Quiz
How do we determine the cost of equity capital?
How can we estimate a firm or project beta?
How does leverage affect beta?
How do we determine the weighted average cost of capital?
How do flotation costs affect the capital budgeting process?

© McGraw Hill, LLC 31

 Suggested exercises
Questions and Problems
3, 5, 7, 9, 10, 11, 12, 13, 17, 19, 20

© McGraw Hill, LLC 32