Chapter 12
Risk, Cost of Capital and Capital Budgeting
Copyright © 2016 McGraw-Hill Education. All rights reserved.
Chapter Overview
• The Cost of Equity Capital
• Estimation of Beta
• Determinants of Beta
• Extensions of the Basic Model
• Estimating Carrefour Group’s Cost of Capital
• Reducing the Cost of Capital
• Economic Value Added and the Measurement
of Financial Performance
The Cost of Equity Capital
Discount Rates and Projects
The Cost of Equity Capital
Choices of a Firm with Extra Cash
Return on
Project
Investor
Return
The Cost of Equity Capital
How to Estimate the Discount Rate of a Project
Return on
Project
Investor
Return
Discount
Rate
The discount rate of a project should be the expected return on a financial
asset of comparable risk.
RE = RF + b ( RM - RF )
Use CAPM or a Factor Model
Estimation of Beta
Practical Approaches
Estimation of Beta
Approaches
Theoretical Formula
Cov(Ri , RM ) s i ,M
Beta of security i =
= 2
Var(RM )
sM
Beta can be estimated as the slope coefficient
in a regression of Ri on RM
Estimation of Beta
Beta Estimation: Problems and Solutions
Problems
Solutions
• 1. Betas may vary over time
• 2. Sample size may be inadequate
• 3. Betas are influenced by
changing leverage and business
risk
• 1 and 2. Use better statistics
• 3. Adjust for changes in business
and financial risk
• 1, 2 and 3. Use average betas of
comparable firms
Estimation of Beta
Real World Betas: KPN and Unicredit
Estimation of Beta
Global Banking Betas, 2015
Determinants of Beta
Major Drivers
Determinants of Beta
Three major drivers
Cyclicity of
Revenues
Operating
Leverage
Financial
Leverage
Performance is
tied to
economic cycles
Fixed costs high
in relation to
total costs
High levels of
debt in capital
structure
Determinants of Beta
The Impact of Operating Leverage on Variability of Earnings
Determinants of Beta
Financial Leverage and Beta
Remember the Balance Sheet Equation
Assets
Equity
Debt
E
D
bAsset =
´ b Equity +
´ b Debt
D+ E
D+ E
Determinants of Beta
Financial Leverage and Beta: The Equity Beta
E
D
bAsset =
´ b Equity +
´ b Debt
D+ E
D+ E
The beta of debt is nearly zero – why?
E
bAsset =
´ b Equity
D+ E
æ Dæ
b Equity = bAsset æ1 + æ
æ Eæ
Extensions of the Basic Model
Firm versus Project Risk
Extensions of the Basic Model
Firm versus Project Risk
Project is in
the same
industry
•Use Firm
Discount
Rate
Project is in a •Use Project
different
Discount
industry
Rate
Extensions of the Basic Model
Dangers of Inappropriate Discount Rate
Extensions of the Basic Model
The Cost of Capital with Debt: Weighted Average Cost
of Capital (WACC)
Case 1: No Taxes
E
D
RA = RWACC =
´ RE +
´ RD
D+ E
D+ E
Case 2: With Taxes
E
D
RA = RWACC =
´ RE +
´ RD (1- TC )
D+ E
D+ E
Estimating Carrefour Group’s
Cost of Capital
Practical Case Study
Estimating Carrefour’s Cost of Capital
What do you need?
Three Variables
After-tax
Cost of
Debt
Cost of
Equity
Proportions
of Each in
Capital
Structure
Estimating Carrefour’s Cost of Capital
Carrefour’s Cost of Equity
Market Risk Premium: 7%; Risk-free Rate: 0.6%;
Company Beta: 1.22; Average Industry Beta: 0.75
Company Beta:
RE = 0.006 + 1.22(0.076) = 0.0987 or 9.87%
Industry Beta:
RE = 0.006 + .75(0.076) = 0.0630 or 6.30%
Estimating Carrefour’s Cost of Capital
Carrefour’s Cost of Debt
Estimate from data
Subjective estimate: 4%
Estimating Carrefour’s Cost of Capital
Carrefour’s Capital Structure Weights
Equity Market Value: €20,886 million
Debt Market Value: €37,483 million
Equity Weight
Equity/(Equity + Debt) = €20,886/(€20,886+€37,483) = 0.358
Debt Weight:
Debt/(Equity + Debt) = €37,483/(€20,886+€37,483) = 0.642
Estimating Carrefour’s Cost of Capital
Carrefour’s Weighted Average Cost of Capital
RE = 9.87%; RD = 4%; TC = 38.72%;
WE = 0.358; WD = 0.642
RWACC = 0.358 ´ 9.87% + 0.642 ´ 4.00% ´ (1 - 0.3872)
= 5.11%
Reducing the Cost of Capital
Considerations
Reducing the Cost of Capital
The Effect of Liquidity on Cost of Capital
Reducing the Cost of Capital
The Effect of Stock Exchange Location on Cost of Capital
Source: Partially reproduced from Oxera Consulting (2006).
Reducing the Cost of Capital
Cost of Equity and WACC across Europe by Industry
(Excerpt of Table 12.3)
How do Corporations Estimate
Cost of Capital in Practice?
Survey Evidence
How do Firms Estimate Cost of Capital?
Survey Evidence from Brounen et al. (2004, Table 2)
Economic Value Added and the
Measurement of Financial
Performance
How to Calculate EVA
Economic Value Added
EVA Formulae
EVA = (RoA – WACC) × Total Capital
EVA = Net Income – (WACC × Total Capital)
Economic Value Added
Criticisms of EVA
Criticisms
Shouldn’t be used
Encourages too great
for capital budgeting
a focus on current
because it doesn’t
earnings
use future cash flows
Concept Quiz
How much do you understand?
Quiz
Explain what is meant by the cost of equity capital. How is the
cost of equity capital linked to the risk of the assets of a firm? How
would you use cost of equity in a capital budget analysis?
What factors determine the beta of a security? Define and
describe each. How do you calculate beta and what are the pitfalls
you may face in its calculation? Can you foresee any problems
with using a historical beta for future capital budgeting projects?
Explain.
How would you estimate the cost of capital for a project if its risk
is different from the rest of the company? Similarly, how would
you estimate the cost of capital for a project when the company
has debt in its capital structure?