Risk, Cost of Capital, and Valuation

Course Name: Financial Management

Course Code: 20841109

Dr. Eliza Sharma

Assistant Professor
Symbiosis Institute of Business Management
Bengaluru, Karnataka (India)

2
13.1 The Cost of Capital
Firm with Shareholder
Pay cash dividend invests in
excess cash
financial asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
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.
13.2 The Cost of Equity Capital
• From the firm’s perspective, the expected return is
the Cost of Equity Capital:

R s  RF  β ( R M  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  RF
Cov ( Ri , RM ) σ i , M
3. The company beta, βi   2
Var ( RM ) σM
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?

R s  RF  β ( R M  RF )
R s  3 %  1 .5  7 %
R s  13 .5%
Example
Suppose Stansfield Enterprises is evaluating the
following independent projects. Each costs Rs.100
and lasts one year.
Project’s Estimated
Project Project b IRR NPV at 13.5%
Cash Flows Next Year
A 1.5 Rs.125 25% Rs.10.13
B 1.5 Rs.113.5 13.5% Rs. 0
C 1.5 Rs.105 5% -Rs.7.49

PV (inflows) = CF1/(1+ke)^1+CF2/(1+ke)^2+……………………………
NPV = PV of Inflow-outflow
Using the SML

Good SML

IRR
Project
A
project

13.5 B
%
C Bad project
3%
Firm’s risk (beta)
1.5
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.
The Risk-Free Rate
• Treasury securities are close proxies for the risk-free rate.
• Maturity matches to a particular project.
• Non –US valuations.

• Bl = Bu*(1+D/Eratio*(1-t))
Market Risk Premium

• Method 1: Use historical data

• Method 2: Use the Dividend Discount Model

Rs  D g1
P
• Market data and analyst forecasts can be used to implement the DDM approach
on a market-wide basis

P= DIV/(Ke-g) = Ke = Div/P +g
13.3 Estimation of Beta
• Market Portfolio - Portfolio of all assets in the
economy. In practice, a broad stock market index,
such as the BSE Sensex, is used to represent the
market.

• Beta - Sensitivity of a stock’s return to the return

on the market portfolio.
Estimation of Beta
Cov ( Ri , RM )
β
• Problems
Var ( RM )

1. Betas may vary over time.

2. The sample size may be inadequate.

3. Betas are influenced by changing financial

leverage and business risk.
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
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.
 13.4 Determinants of Beta

• Business Risk
• Cyclicality of Revenues
• Operating Leverage

• Financial Risk
• Financial Leverage
Cyclicality of Revenues
• Highly cyclical stocks have higher betas.
• Empirical evidence suggests that 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.
Operating Leverage

The degree of operating leverage measures how sensitive

a firm (or project) is to its fixed costs.
Operating leverage increases as fixed costs rise and
variable costs fall.
Operating leverage magnifies the effect of cyclicality on
beta.
The degree of operating leverage is given by:
D EBIT Sales
DOL = ×
EBIT D Sales
Operating Leverage

Total
Rs costs
.
Fixed costs

Fixed costs
Sales

Operating leverage increases as fixed costs rise

and variable costs fall.
Financial Leverage and Beta
• Operating leverage refers to the sensitivity to the firm’s
fixed costs of production.
• Financial leverage is the sensitivity to a firm’s fixed costs
of financing.
• The relationship between the betas of the firm’s debt,
equity, and assets is given by:

bAsset = Debt × bDebt + Equity × bEquity

Debt + Equity Debt + Equity
• Financial leverage always increases the equity beta
relative to the asset beta.
 Example
Consider Grand Sport, Inc., which is currently all-equity financed and has a
beta of 0.90.
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
0.90.
However, assuming a zero beta for its debt, its equity beta would become
twice as large:

bAsset = 0.90 1 ×b
1+1
Equity bEquity = 2 × 0.90 = 1.80
=
13.5 Dividend Discount Model

Rs  D 1
g
P
• 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 and it can be used
on companies that do not pay dividends.
Capital Budgeting & Project Risk

Project IRR
SML
The SML can tell us why:
Unprofitable high risk
projects
Hurdle R F  β F IR M ( R M  R F )
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.
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?
Capital Budgeting & Project Risk
SML

Project IRR 24% Investments in hard

drives or auto retailing
17%
should have higher
10% 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.
 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

 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:

RP = C / PV
13.8 The Weighted Average Cost of
Capital
• The Weighted Average Cost of Capital 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).
 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
 Example: International Paper
First, we estimate the cost of equity and the cost of
debt.
We estimate an equity beta to estimate the cost of equity.
We can often estimate the cost of debt by observing the
YTM of the firm’s debt.

Second, we determine the WACC by weighting these

two costs appropriately.
Example: International Paper

The industry average beta is 0.82, the risk free

rate is 3%, and the market risk premium is 8.4%.

Thus, the cost of equity capital is:

RS = RF + bi × ( RM – RF)

= 3% + 0.82×8.4%
= 9.89%
Example: International Paper
• The yield on the company’s debt is 8%, and the
firm has a 37% marginal tax rate.
• The debt to value ratio is 32%
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
8.34% is International’s cost of capital. It should be used to
discount any project where one believes that the project’s risk
is equal to the risk of the firm as a whole and the project has
the same leverage as the firm as a whole.
13.11 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 (i.e., 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:
fA = (E/V)* fE + (D/V)* fD
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?