Risk and the cost of capital

Slides:



Advertisements
Similar presentations
Models and methods to estimate the appropriate r
Advertisements

McGraw-Hill/Irwin Copyright © 2014 by the McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
1 Risk, Return, and Capital Budgeting Chapter 12.
Chapter Outline The Cost of Capital: Introduction The Cost of Equity
© Prentice Hall, Chapter 10 Establishing Required Rates of Return Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to.
McGraw-Hill © 2004 The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Cost of Capital Chapter 12.
Chapter Outline The Cost of Capital: Introduction The Cost of Equity
Last Study Topics Company and Project Costs of Capital Beta As a Proxy.
Hurdle Rates for Firms 04/15/08 Ch. 4.
Corporate Finance Lecture 6.
QDai for FEUNL Finanças Nov 30. QDai for FEUNL Topics covered  Capital budgeting with debt Adjusted Present Value Approach Flows to Equity Approach Weighted.
Hurdle rates for projects
Estimating Hurdle Rates. Cost of Capital To evaluate project, need estimates of cashflows, and also estimate of an appropriate hurdle rate (r). Hurdle.
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Cost of Capital Chapter Fourteen.
 Capital Budgeting and Risk Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will Chapter 9 © The McGraw-Hill Companies,
15-0 Chapter 15: Outline The Cost of Capital: Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of.
J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk and Investment Decisions April 23, 2007 (LA), or April 12, 2007 (OCC)
QDai for FEUNL Finanças November 7. QDai for FEUNL Topics covered  CAPM for cost of capital  Estimation of beta.
Chapter 9 Principles of Corporate Finance Eighth Edition Capital Budgeting and Risk Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies,
Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 15 Cost of Capital.
Key Concepts and Skills
Estimating the Discount Rate
DOES DEBT POLICY MATTER?
CORPORATE FINANCIAL THEORY Lecture 2. Risk /Return Return = r = Discount rate = Cost of Capital (COC) r is determined by risk Two Extremes Treasury Notes.
Weighted Average Cost of Capital
Weighted Average Cost of Capital (WACC) Module 6.2 Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin.
FIN 614: Financial Management Larry Schrenk, Instructor.
Cost of Capital and Efficient Capital Markets. Why Cost of Capital Is Important Cost of capital provides us with an indication of how the market views.
WSU EMBA Corporate Finance12-1 Chapter 12: Risk, Cost of Capital, and Capital Budgeting Weighted Average Cost of Capital (WACC) Estimating cost of capital.
Capital budgeting and the capital asset pricing model “Less is more.” – Mies can der Rohe, Architect.
Financing and Valuation
Chapter 9 Principles of Corporate Finance Tenth Edition Risk and the Cost of Capital Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill.
© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Cost of Capital Chapter Fourteen Prepared by Anne Inglis, Ryerson University.
Cost of Capital Chapter 14. Key Concepts and Skills Know how to determine a firm’s cost of equity capital Know how to determine a firm’s cost of debt.
VALUATION AND FINANCING
FIN 614: Financial Management Larry Schrenk, Instructor.
 Introduction to Risk, Return, and the Opportunity Cost of Capital Principles of Corporate Finance Brealey and Myers Sixth Edition Slides by Matthew Will.
McGraw-Hill/Irwin Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved Corporate Finance Ross  Westerfield  Jaffe Sixth Edition.
Chapter 06 Risk and Return. Value = FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business.
COST OF CAPITAL Chapter 7. Chapter Outline The Cost of Capital: Introduction The Cost of Equity (CAPM and DDM) The Costs of Debt and Preferred Stock The.
Exercises in Capital Structure and Cost of Capital
TOPIC: WEIGHTED AVERAGE COST OF CAPITAL (WACC) Firm Value should be Maximized when WACC is Minimized Factors that impact on WACC include operating profitability,
Financial Management FIN300 Cost of Capital. Objectives Upon completion of this lesson, you will be able to: –Determine a firm’s cost of equity capital.
Risk and the cost of capital
Portfolio theory and the capital asset pricing model
Risk and the cost of capital
Chapter 9 The Cost of Capital. Copyright ©2014 Pearson Education, Inc. All rights reserved.9-1 Learning Objectives 1.Understand the concepts underlying.
Chapter McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved. 15 Cost of Capital.
McGraw-Hill/Irwin ©2001 The McGraw-Hill Companies All Rights Reserved 12.0 Chapter 12 Cost of Capital.
1 Global Cost of Capital and Financial Structure International Financial Management Dr. A. DeMaskey.
Chapter 14 Cost of Capital McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 12 Estimating the Cost of Capital. Copyright ©2014 Pearson Education, Inc. All rights reserved The Equity Cost of Capital The Capital.
Lecture 9 Capital Budgeting and Risk Managerial Finance FINA 6335 Ronald F. Singer.
3- 1 Outline 3: Risk, Return, and Cost of Capital 3.1 Rates of Return 3.2 Measuring Risk 3.3 Risk & Diversification 3.4 Measuring Market Risk 3.5 Portfolio.
Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.
© The McGraw-Hill Companies, Inc., 2000 Irwin/McGraw Hill 7- 1 B Class #3  BM6 chapters 7, 8, 9  Based on slides created by Matthew Will  Modified.
Copyright © 2003 McGraw Hill Ryerson Limited 10-1 prepared by: Carol Edwards BA, MBA, CFA Instructor, Finance British Columbia Institute of Technology.
1 CHAPTER 10 The Cost of Capital. 2 Topics in Chapter 10 Individual sources of capital and their cost WACC.
1 Ch 7: Project Analysis Under Risk Incorporating Risk Into Project Analysis Through Adjustments To The Discount Rate, and By The Certainty Equivalent.
F9 Financial Management. 2 Designed to give you the knowledge and application of: Section F: Estimating the cost of equity F1. Sources of finance and.
12-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin IMPORTANT: In order to view the correct calculator key.
Corporate Finance MLI28C060 Lecture 6 Monday 19 October 2015.
Chapter 9 Principles of Corporate Finance Eighth Edition Capital Budgeting and Risk Slides by Matthew Will, adopted by Craig Mayberry Copyright © 2006.
RISK, COST OF CAPITAL, AND CAPITAL BUDGETING This topic applies the concept of NPV to risky cash flows. NPV = C o + Σ C t ¯ /(1+r) t r = discount rate.
Cost of Capital Chapter Fourteen. Prof. Oh, KUMBA 2010Ch14-1 Corporate Finance Key Concepts and Skills  Know how to determine a firm’s cost of equity.
Risk and the Cost of Capital
The McGraw-Hill Companies, Inc., 2000
Corporate Finance, Concise Risk and the Cost of Capital
Case 1- Marriott Corporation:
Presentation transcript:

Risk and the cost of capital 9 Risk and the cost of capital McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

9-1 company and project costs of capital Firm Value Sum of value of assets Each asset is valued by discounting its forecasted future cash flows at a rate reflecting the risk of that asset. Value additive property is an important concept that has many applications. A firm’s value is the sum of the value of its various assets.

Figure 9.1 company cost of capital The company cost of capital is not the appropriate discount rate for all its projects. If you consider each project as a mini-firm, the value of that mini-firm depends on its beta. What happens if the firm uses the same cost of capital to value different projects? Required return Project beta 0.5 Company cost of capital 5.5 0.2 SML The company cost of capital is not the appropriate discount rate for all its projects. If you consider each project as a mini-firm, the value of that mini-firm depends on its beta. The discount rate depends on the project’s discount rate. The required rate of return depends on the project and not on the company that is undertaking it.

9-1 company and project costs of capital Company Cost of Capital This is possibly the most important slide in the chapter. Take time to explain the difference between accounting terminology and finance terminology. While we use the same format for firm value, the meanings are distinctly different. Instead of asset we use value. And in place of debt and equity we use market values, not book values. Note the cost of capital for debt and equity is different. Each variable in the COC equation must be explained in detail or students will not follow the rest of the material.

9-1 company and project costs of capital Weighted Average Cost of Capital Traditional measure of capital structure, risk and return There is much less to cover here, other than to show the WACC formula as the result of the prior exercise.

9-2 measuring the cost of equity Generally CAPM is used to estimate the cost of equity: r = rf + β(rm − rf) requity = rf + β(rm − rf) Generally the CAPM is used to estimate the cost of equity. But other methods like DCF (Gordon’s model) or APT (arbitrage pricing theory) can also be used for these estimations. These models require different data. Capital structure is the mix of debt and equity that finances the firm.

9-2 measuring the cost of equity Estimating Beta SML shows relationship between return and risk CAPM uses beta as proxy for risk Other methods can also determine slope of SML and beta Regression analysis can be used to find beta The SML can be used to determine the required rate of return on a project. Regression analysis is used for estimating beta. Generally, monthly returns (60 months) for the firm and the market are used for the estimation.

Figure 9.2a citigroup Return Weekly Data 2010-2011   beta = 1.83 alpha = -0.31 R-squared = 0.64 Correlation = 0.80 Annualized std dev of market = 19.52 Annualized std dev of stock = 44.55 Variance of stock = 1984.83 Std error of beta 0.14 Regression analysis can be used to estimate the beta of a firm. Total return data for the firm is used. A broadly based value-weighted index is used for market return. Generally 5-year (60 months) monthly data is used. Market return is plotted on the x-axis and the company returns on the y-axis. Slope of the fitted line is the beta estimate. A financial calculator can be used to estimate beta. The graph shows the beta estimate for Citigroup. The following five slides repeat the same exercise for three different stocks.

Figure 9.2B citigroup Return Wkly Data 2008-2009   beta = 3.32 alpha = 0.24 R-squared = 0.49 Correlation = 0.70 Annualized std dev of market = 30.11 Annualized std dev of stock = 142.95 Variance of stock = 20436.08 Std error of beta 0.34 Citigroup beta, part two.

Figure 9.2c disney Return Wkly Data 2010-2011 beta = 0.33 alpha = 0.02   beta = 0.33 alpha = 0.02 R-squared = 0.22 Correlation = 0.47 Annualized std dev of market = 19.52 Annualized std dev of stock = 13.68 Variance of stock = 187.13 Std error of beta 0.06 Disney beta

Figure 9.2D disney Return Wkly Data 2008-2009 beta = 0.41 alpha = 0.17   beta = 0.41 alpha = 0.17 R-squared = 0.19 Correlation = 0.44 Annualized std dev of market = 30.11 Annualized std dev of stock = 28.08 Variance of stock = 788.62 Std error of beta 0.08 Disney beta, part two.

Figure 9.2e campbell’s Return Wkly Data 2010-2011   beta = 0.33 alpha = 0.02 R-squared = 0.22 Correlation = 0.47 Annualized std dev of market = 13.68 Annualized std dev of stock = 19.52 Variance of stock = 381.22 Std error of beta 0.06 Campbell’s beta.

Figure 9.2f campbell’s Return, % Wkly Data 2008-2009   beta = 0.41 alpha = 0.17 R-squared = 0.19 Correlation = 0.44 Annualized std dev of market = 28.08 Annualized std dev of stock = 30.11 Variance of stock = 906.55 Std error of beta 0.08 Campbell’s beta, part two.

Table 9.1 estimates of betas Standard Error Canadian Pacific 1.27 .10 CSX 1.41 .08 Kansas City Southern 1.68 .12 Genesee & Wyoming 1.25 Norfolk Southern 1.42 .09 Rail America 1.15 .14 Union Pacific 1.21 .07 Industry portfolio 1.34 .06 Beta estimates have standard errors. Standard error can be used to construct a range of values for beta within which true beta lies.

9-2 measuring the cost of equity Beta Stability % IN SAME % WITHIN ONE RISK CLASS CLASS CLASS 5 YEARS LATER 5 YEARS LATER 10 (High betas) 35 69 9 18 54 8 16 45 7 13 41 6 14 39 5 14 42 4 13 40 3 16 45 2 21 61 1 (Low betas) 40 62 Source: Sharpe and Cooper (1972) The beta values are not stable over time. This frame shows what percentage of firms have same (same risk class) beta after five years.

Division’s required return on equity: re = rRF + (rM – rRF)B . Find the division’s market risk and cost of capital based on the CAPM and the pure play approach, given these inputs: Target debt ratio = 10%. rd = 12%. rRF = 7%. Tax rate = 40%. Pure play company beta = 1.7. Market risk premium = 6%. Division’s required return on equity: re = rRF + (rM – rRF)B . = 7% + (6%)1.7 = 17.2%. WACCDiv. = wdrd(1 – T) + were = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%.

How does the division’s WACC compare with the firm’s overall WACC? Division WACC = 16.2% versus company WACC = 11.1%. “Typical” projects within this division would be accepted if their returns are above 16.2%.

measuring the cost of equity Extension: Financial Leverage and Beta The betas used in the CAPM are estimated from returns on stocks. Thus, they are the firm’s stock or equity beta. Imagine an individual who owns all the firm’s debt and all its equity. In other words, this individual owns the entire firm. What is the beta of her portfolio of the firm’s debt and equity?

9-2 measuring the cost of equity Company cost of capital (COC) is based on the average beta of the assets The average beta of the assets is based on the % of funds in each asset Assets = debt + equity Bequity = Basset (1+ D/E) This equation is handy when we can not calculate Be for the Project. Betas are also calculated for specific assets. Explain how a firm is the weighted sum of its parts.

Financial Leverage and Beta Basset = D/(D+E) x Bd + E/(D+E) x Be Bd is very low in practice, we can assume Bd = 0 Basset = E/(D+E) x Be For a levered firm, E/(D+E) < 1, hence Basset < Be Let us rewrite it: Be = Ba x (D+E)/ E Be = Ba (1 + D/E)

How to determine the risk-adjusted cost of capital for a particular division? Estimate the cost of capital that the division would have if it were a stand-alone firm. This requires estimating the division’s beta, cost of debt, and capital structure. One method for Estimating Beta for a Division is the pure play approach. Find several publicly traded companies exclusively in division’s business. Use average of their betas as proxy for division’s beta.

Ex.: Financial Leverage and Beta Previously, we calculated a divisional WACC, where Bdivision = 1,7. Assume that the pure play firms, on the average, have D/V = 40% instead of D/V = 10% as targeted by the firm. How should we adjust the previous calculation to reflect the difference in financial leverage? The process is called “unlever – relever”.

Unlever - relever Unlever first: Be = Ba (1 + D/E) WACCdiv = 0,1(12%)(0,6) + 0,9(13,8%) WACCdiv = 13,14% instead of 16,2%

9-4 certainty equivalents—another way to adjust for risk Example Project A expects CF = $100 mil for each of three years. What is PV of project given 6% risk-free rate, 8% market premium, and .75 beta? A numerical example of a risky cash flow is given. Use CAPM to calculate the risk-adjusted discount rate for risky cash flows. Using a single discount rate may not be appropriate for all situations.

9-4 certainty equivalents—another way to adjust for risk Example, continued Project A expects CF = $100 mil for each of three years. What is PV of project given 6% risk-free rate, 8% market premium, and .75 beta? This slide shows the calculation for the PV of the risky cash flows using the risk-adjusted discount rate.

9-4 certainty equivalents—another way to adjust for risk Example, continued Now let us calculate the certainty equivalent cash flows. Certainty equivalent cash flows, when discounted at the risk-free rate, should provide the same PV. Project B cash flows change, but are risk-free. What is new PV? Now let us calculate the certainty equivalent cash flows. Certainty equivalent cash flows, when discounted at the risk-free rate, should provide the same PV. The table provides the example of certainty equivalent cash flows. Note that these are different from risky cash flows. Year 1 CEQ = [100/1.12](1.06) = $94.6; Year 2 CEQ = [100/(1.12^2)](1.06^2) = $89.6; Year 3 CEQ = [100/(1.12^3)](1.06^3) = $84.8.

9-4 certainty equivalents—another way to adjust for risk Example, continued 94.6 is risk-free, is certainty equivalent of 100 Present value is obtained by discounting risky cash flows using risk-adjusted discount rate. The certainty equivalent cash flows are discounted at the risk-free rate to get the same PV. Present value is obtained by discounting risky cash flows using risk-adjusted discount rate. The certainty equivalent cash flows are discounted at the risk-free rate to get the same PV. Here the relationship between risky cash flows and equivalent risk-free cash flows is explored.

9-4 certainty equivalents—another way to adjust for risk Example, continued Project A expects CF = $100 mil for each of three years. What is PV of project given 6% risk-free rate, 8% market premium, and .75 beta? The table provides a comparison of risky cash flows and certainty equivalent cash flows.

9-4 certainty equivalents—another way to adjust for risk Example, continued Project A expects CF = $100 mil for each of three years. What is PV of project given 6% risk-free rate, 8% market premium, and .75 beta? Assume cash flows change, but are risk-free. What is new PV? Difference between 100 and certainty equivalent (94.6) is 5.66% This % can be considered annual premium on risky cash flow $94.6 [94.6 = (100/1.12)(1.06)] is the certainty equivalent cash flow of $100 for year 1. This provides another way to look at project cash flows. Similarly, $89.6 and $84.8 are certainty equivalent cash flows for year 2 and year 3 respectively. Since certainty equivalent cash flows are risk-free, these are discounted using the risk-free rate. The present value is the same as before. 1.12/1.06 = 1.0566 100/1.0566 = $94.6 100/(1.0566^2) = $89.6 100/(1.0566^3) = $84.8

9-4 certainty equivalents—another way to adjust for risk Example, continued Project A expects CF = $100 mil for each of three years. What is PV of project given 6% risk-free rate, 8% market premium, and .75 beta? Assume cash flows change, but are risk-free. What is new PV? If you can calculate the certainty equivalent cash flows for a project directly, then calculating the present value is very easy. All you have to do is to discount them at the risk-free rate. You do not need to estimate the cost of capital. CEQ is conceptually appealing, but very difficult to estimate in practice.