Estimating Hurdle Rates
Cost of Capital
CFN
CF1
CF2
NPV  InitialInvestment


2
1  r  1  r 
1  r N
• To evaluate project, need estimates of cashflows, and also
estimate of an appropriate hurdle rate (r).
• Hurdle rate must reflect risk
• riskier project = higher hurdle rate
• consider a scale enhancing project
• potential project which is similar to the existing
assets of the firm
• risk of project should be similar to risk of firm
• the cost of capital of the firm is an appropriate hurdle rate
• cost of capital is based on riskiness of firm’s assets
• Cost of capital = average cost of raising money for the firm
• If use cost of capital as hurdle rate and:
• IRR > hurdle rate (NPV >0)
Take project since expected to earn more than
it will cost to finance
• IRR < hurdle rate (NPV < 0)
Reject project as expected to earn less than it
would cost to finance
Estimating Cost of Capital
Three sources of capital:
Internal
Funds
Debt
New Issues
of equity
Equity
Firm
Preferred
equity
• cost of capital is based on the cost of each source of capital
and how much the firm uses each one
Cost of Capital =
(% of firm financed with debt) x (cost of debt)
+ (% of firm financed with equity) x (cost of equity)
+ (% of firm financed with preferred equity) x (cost of preferred)
Important Note: only an appropriate hurdle rate if the project is
of same risk as overall firm.
What if the project is a new business line for the firm?
• Have to estimate the project’s cost of capital
• We will look at how to do that later.
Issues in Estimating Cost of Capital
• The weights on each type of capital should be based on
market values
• If firm has target D/E ratio, should use that to
calculate weights
• Problem: debt is often not traded or very thinly traded
• No market price available to calculate weight
• Sometimes use book value as a proxy
– Only good estimate of interest rates have not
changed much
• Also, no yield to maturity available for cost of debt
• Could use average yield on firms with same bond
rating
Issues in Estimating Cost of Capital
• The actual manner in which a project is financed is
irrelevant
• Weights should be based upon how project affects
debt capacity of the firm
• For a project that is in the firm’s regular line of
business (scale enhancing), assumed that project
has same debt capacity as the firm overall
» May not be true for project’s that involve
expanding into new businesses (see
“Project Cost of Capital” later)
Issues in Estimating Cost of Capital
• Cost of equity:
– Different methods to estimate
• CAPM, Dividend Growth Model, others
– Problem: results are very sensitive to estimates used
on the models
• Sometimes, a group of comparable firms is used
• firms in similar business (“comps”)
• E.g. you are worried that estimate of beta for
CAPM is wrong…calculate beta for several other
similar firms and use average as beta for your
company
» By averaging across firms, reduces errors in
estimate
» Problem: assumes that the comps are truly
the same as your firm
Another Issue: Convertible Debt
• Have looked at weighting debt/equity/preferred to get
WACC
• What about convertible debt?
• Hybrid security
• In between debt and equity
• How to take account of it in cost of capital?
• Part of the market value of the convertible debt must be
assigned to debt and part assigned to equity
Convertible Debt
Process:
– use the yield on firm’s regular debt to calculate what
the market value of convertible debt would be if it
were straight debt (i.e. not convertible)
– Add this amount to market of value of debt for
firm in WACC calculation
– Remainder of market value of convertible is added to
market value of equity for firm
Convertible Debt
Example:
• You have already determined that a firm has a cost of
equity of 12%, a cost of debt before-tax of 6% and a tax
rate of 35%
• Firm also has:
– Common shares with market value = $500 million
– Bonds outstanding with market value = $300 million
– Convertible bonds outstanding with market value =
$100 million
• The firm’s convertible bonds mature in 10 years, carry a
5% coupon (paid semi-annually), and have a book value
of $75 million
• What is firm’s cost of capital?
Project Cost of Capital
• What of a project is not scale enhancing?
• Not same as normal business of firm
• Inappropriate to use firm’s WACC as discount rate
• Have to estimate the project’s cost of capital that takes
into account the project’s level of risk (which is different
from the firm’s)
Project Cost of Capital
Three main issues in coming up with the project cost of
capital:
1. How to get cost of equity?
2. How to get cost of debt?
3. What weights to use for debt and equity?
(Note: we are ignoring preferred here for simplicity)
Project Cost of Equity
• Common to use “pure play” approach (a.k.a. using
“comparables”)
• Find other firms that operate in the same business as the
project you are evaluating
• They should be “pure play” firms: operate only in
that business
• These firms are your “comparables”
• Assume using CAPM:
• Get beta for each comparable firm
• Use these to estimate beta for the project
Project Cost of Equity
• However, know beta is affected by amount of leverage a
firm has (e.g. debt increases risk) and comparable firms
may have different leverage than the project in your firm
will have
• Must control for this using the formula:
D

 L   U 1  (1  T) 
E

• βL= levered beta = beta including effect of leverage
• βU = unlevered beta = “asset beta” = beta if the firm had
no leverage
• D, E, T are market value of debt and equity, and tax rate,
respectively
Project Cost of Equity
• Comparable firm betas are “delevered” using their D/E
ratio to get underlying unlevered beta
• Average unlevered beta across comparable firms =
estimate of unlevered beta of project
• “re-lever” the beta by applying formula again, this time
with the D/E appropriate for the project
• (see notes later on appropriate D and E values of
project)
• The resulting beta represents the same business risk as
comparable firms but with D/E of project
• Use in CAPM to get project cost of equity
Project Cost of Debt
• Depends on how project will affect default risk of overall
firm
• If project is relatively small and will not affect default risk
of firm → use firm’s cost of debt
• If project is big and may affect overall firm risk → need to
estimate cost of debt for project itself
• Typical to use average cost of debt for comparable
firms
Weights on Debt and Equity for
Project
• Based on how the project would affect the debt capacity
of the firm
• Not the same as how the project is actually
financed
• If the project is relatively small, often assumed that it will
not meaningfully affect debt capacity
– Use firm’s D and E weights
• If the project is large enough to affect firm’s debt
capacity, need to estimate how those types of assets
could be financed
– Use D and E weights from comparable firms
– Note: in this case, you would use the
comparable firms’ D/E ratios to “re-lever” the
beta for cost of equity purposes
Project Cost of Capital Example
• A firm is currently in the grocery business
• It has already calculated the following information:
• Cost of debt = 6.5% before tax
• Beta of stock = 0.75 (i.e. levered beta)
• D/E ratio using market values = 0.6
• Tax rate = 35%
• Also know that the yield on long term Gov’t of Canada
bonds is 5%, and risk premium on the market is 4.5%
• To finance the project, the firm will borrow all of the
required capital.
• Firm is considering entering a new line of business,
selling electronics in its stores
• Three electronic retailing companies have the following
information:
Comparable
Firm
Beta of
stock
D/E using
market
values
Cost of
Debt
Tax rate
A
1.2
0.4
7.5%
30%
B
1.35
0.3
8%
30%
C
1.15
0.37
7.75%
30%
•
What is the project's cost of capital if:
1. The project is very small relative to the
firm and will not affect its debt capacity or
default risk?
2. The project is quite large and could have
a significant effect on the firm’s risk and
debt capacity?