Risk, Return, and Capital Budgeting (Chapter 12) Financial Policy and Planning (MB 29)

Outline The concept of required rate of return for a project The concept of weighted average cost of capital Cost of Capital for all equity firm Significance of Beta How to measure Beta? Stability of Beta over time Determinants of Beta Cost of capital with Debt

The Concept of Required Rate of Return for a Project Given an unbiased estimate of cash flows of a project, at what rate should we discount the cash flows of the project? Cash flows should be discounted at the required rate of return— the rate of return that similar risk class investments are providing in the market or the minimum rate of return that a project must earn to justify investment of resources Required rate chosen to discount the cash flows and to compute the NPV must be appropriate to the risk of the project.

What if we choose a required rate of return that is too high for the project given its riskiness? We will end up rejecting some good projects, because with a high discount rate the NPV will either be very low or sometimes even negative, because we are unnecessarily using a very conservative discount rate. By rejecting good projects, the firm will compromise its competitiveness and market value

What if we choose a required rate of return that is too low for the project given its riskiness? We will end up accepting some bad projects, because with a low discount rate the NPV will either be high and positive, because we are unnecessarily using a very low discount rate. By accepting bad projects, the firm will increase the risk of its cash flows. This will compromise its competitiveness and market value

Weighted Average Cost of Capital Choosing the right discount rate also know as required rate of return for a project is critical for its success Use a weighted-average cost of capital A weighted-average of the cost of each component of capital used to fund the project, where weights represent the proportion of each component in the total capital for the project An optimal cost of capital is the cost at which value of the firm is maximum

For an all equity firm Whenever a firm has excess cash, it can take one of the two actions. On the one hand, it can pay out the cash immediately as dividend or it can invest extra cash in a project, paying out the future cash flows of the project as dividends A firm should invest money in the project only if the project provides a return higher than the required rate of stockholders.

Stockholders’ required rate is the opportunity cost of not receiving dividend or the return they would forgo by not receiving the dividend, which will be the rate which similar risk class investments are providing in the market

Required Rate of Return = r f + (r market – r f )  Market rate of return minus the risk free rate equals market risk premium If we multiply market risk premium by the beta of the security, it is known as the security risk premium Required rate of return equals risk free rate of return plus security risk premium How do we compute beta?  = (  i,m )/  2 m Beta equals covariance between the security and the market divided by the variance of the market

Computation of Beta Look at the spreadsheet Beta is defined as the sensitivity of a security to the market. How sensitive a security’s price is to the changes in the market? Beta of the market always equals 1 Beta of a risk free security equals 0 Beta books are compiled by various investment services companies such as Value Line, Merrill Lynch

Use historical beta carefully, beta keeps changing over time Beta is affected by cyclical revenues, operating leverage, and financial leverage

Cost of Capital with Debt If a firm uses both debt and equity to finance its investments, we need to use overall cost of capital as the discount rate r wacc = (S/V  r s ) + (D/V  r D  (1-T c )) Where r wacc = the weighted average cost of capital S = market value of equity D = market value of debt V = total market value of the firm (D+S) r s = cost of equity r D = cost of debt T c = corporate tax rate

Example of WACC Debt to equity ratio = 0.25 Beta of common equity = 1.15 Beta of debt = 0.3 Market risk premium = 10% Risk free rate = 6% Corporate Tax Rate = 35% What is the overall cost of capital? Rs = 6 + (10)  1.15 = 17.5% rD = 6 + (10)  0.3 = 9% Rwacc = (0.8  17.5) + (0.2  9  (1 – 0.35)) = 15.17%