Corporate Value
and the Cost of Capital
Prof. Ian Giddy
New York University
How to Create Shareholder Value

Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.




Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.


The hurdle rate should be higher for riskier projects and reflect
the financing mix used - owners’ funds (equity) or borrowed
money (debt)
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics.
Manage financial risk
Copyright ©1998 Ian H. Giddy
Corporate Finance 4
Create Value When Return on
Investments Exceeds Cost of Capital
Assets
Liabilities
Debt
Cost of debt
Return
on
Investments
Equity
Cost of Equity
Copyright ©1998 Ian H. Giddy
Corporate Finance 5
The Cost of Capital
The cost of capital is a composite cost
to the firm of raising financing to fund its
projects.
 It is the discount rate that will be applied
to capital investment projects within the
firm.

Copyright ©1998 Ian H. Giddy
Corporate Finance 6
People Expect Higher Returns for
Higher Risk
$1 Investment in
Different Types of
Portfolios: 1926-1996
Index ($)
10000
Small Company
Stocks
$4,495.99
$1,370.95
1000
100
10
Long-Term
Government
Bonds
Large
Company
Stocks
$33.73
$13.54
$8.85
1
Treasury Bills
Year-End
Inflation
0.1
1925 1935 1945 1955 1965 1975 1985 1995
Copyright ©1998 Ian H. Giddy
Corporate Finance 7
Risk Types


The risk (variance) on any individual investment can be broken down
into two sources. Some of the risk is specific to the firm, and is called
firm-specific, whereas the rest of the risk is market wide and affects all
investments.
The risk faced by a firm can be fall into the following categories –





(1) Project-specific; an individual project may have higher or lower cash
flows than expected.
(2) Competitive Risk, which is that the earnings and cash flows on a project
can be affected by the actions of competitors.
(3) Industry-specific Risk, which covers factors that primarily impact the
earnings and cash flows of a specific industry.
(4) International Risk, arising from having some cash flows in currencies
other than the one in which the earnings are measured and stock is priced
(5) Market risk, which reflects the effect on earnings and cash flows of
macro economic factors that essentially affect all companies
Copyright ©1998 Ian H. Giddy
Corporate Finance 8
People Can Diversify:
Portfolio Return...
To compute the return of a portfolio: use the
weighted average of the returns of all
assets in the portfolio, with the weight given
each asset calculated as
(value of asset)/(value of portfolio).
The portfolio return E(Rp) is:
E(Rp) = (w1k1)+(w2k2)+ ... (wnkn) =

wj kj
where wj = weight of asset j, kj = return on asset j
Copyright ©1998 Ian H. Giddy
Corporate Finance 9
People can Diversify:
Portfolio Risk
The variance of a 2-asset portfolio is:

2
P
= w 2A 2A + w 2B 2B + 2w Aw B  AB A B
where wA and wB are the weights of A and B in the
portfolio.
Copyright ©1998 Ian H. Giddy
Corporate Finance 10
Case Study: A Portfolio
GPU
Teledyne
Kodak
Thai Fund
Merck
ATT
TOTAL
Copyright ©1998 Ian H. Giddy
Weight E(R)
Std Dev
0 0.1267
0.1715
0.25 0.1396
0.2893
0.25 0.1402
0.3082
0 0.2075
0.3278
0 0.1781
0.341
0.5 0.1126
0.1606
1
Corporate Finance 11
Portfolio Return Computation
ASSET
RETURN WEIGHT PRODUCT
1 GPU
12.67%
0.00% 0.0000
2 Teledyne
13.96% 25.00% 0.0349
3 Kodak
14.02% 25.00% 0.0351
4 Thai Fund
20.75%
0.00% 0.0000
5 Merck
17.81%
0.00% 0.0000
6 ATT
11.26% 50.00% 0.0563
TOTAL
100%
Portfolio return
12.63%
Copyright ©1998 Ian H. Giddy
Corporate Finance 12
Portfolio Risk Computation
CT
STD DEV
0.1715
GPU
0.2893
Teledyne
0.3082
Kodak
0.3278
Thai Fund
0.341
Merck
0.1606
ATT
CORRELATION MATRIX
ATT
Merck
Kodak Thai Fund
GPU Teledyne
1
1
0.44
1
0.17 0.65
1
0.22 0.44 0.24
1
0.35 0.15 0.13 0.03
0.68 0.4 0.43 0.23 0.6327
Portfolio Variance
Portfolio Std Deviation
Copyright ©1998 Ian H. Giddy
1
3.48%
18.66%
Corporate Finance 13
The Minimum-Variance Frontier of
Risky Assets
E(r)
“Efficient frontier”
Individual
assets
Global minimumvariance portfolio

Copyright ©1998 Ian H. Giddy
Corporate Finance 14
Given Return, Find Lowest-Risk
Compositions
OPTIMAL PORTFOLIOS
Given
Best
Composition
Return
Std. Dev. GPU
Teledyne Kodak
Thai Fund Merck
ATT
ALL ATT
0.1126
0.1606
0%
0%
0%
0%
0%
100%
0.115
0.1548
17%
0%
0%
0%
0%
83%
0.12
0.1494
33%
0%
5%
2%
0%
60%
0.125
0.1475
36%
0%
6%
6%
0%
52%
MIN RISK
0.1283
0.1471
38%
0%
6%
9%
0%
47%
0.13
0.1472
39%
0%
7%
11%
0%
44%
0.14
0.1509
44%
0%
9%
16%
5%
25%
0.15
0.1572
50%
0%
12%
20%
11%
7%
0.16
0.168
43%
0%
11%
28%
18%
0%
0.17
0.184
30%
0%
9%
37%
24%
0%
0.18
0.2045
17%
0%
7%
46%
30%
0%
0.19
0.2282
4%
0%
5%
55%
36%
0%
MAX RETURN 0.2075
0.3278
0%
0%
0%
100%
0%
0%
ORIGINAL
12.63%
18.66%
0%
25%
25%
0%
0%
50%
Copyright ©1998 Ian H. Giddy
Corporate Finance 15
Plotting the Efficient Frontier
0.25
THAI FUND
0.2
0.15
ORIGINAL
0.1
ATT
0.05
0
0
Copyright ©1998 Ian H. Giddy
0.05
0.1
0.15
0.2
0.25
0.3
0.35
Corporate Finance 16
The Efficient Frontier of Risky Assets
with the Optimal CAL
E(r)
CAL(P)
Efficient frontier
rf

Copyright ©1998 Ian H. Giddy
Corporate Finance 17
Finding the Optimal Portfolio:
Computations
Given the Risk-Free rate is:
5.00%
OPTIMAL PORTFOLIOS
Risk
Ratio
Return
Std. Dev. Premium RP/SD
GPU
11.26%
0.1606
6.26%
0.390
11.50%
0.1548
6.50%
0.420
12.00%
0.1494
7.00%
0.469
12.50%
0.1475
7.50%
0.508
MIN RISK
12.83%
0.1471
7.83%
0.532
13.00%
0.1472
8.00%
0.543
14.00%
0.1509
9.00%
0.596
15.00%
0.1572
10.00%
0.636
0.655
16.00%
0.168
11.00%
17.00%
0.184
12.00%
0.652
18.00%
0.2045
13.00%
0.636
19.00%
0.2282
14.00%
0.613
THAI
20.75%
0.3278
15.75%
0.480
Copyright ©1998 Ian H. Giddy
0.25
That's the one!
0.2
0.15
0.1
0.05
0
0
0.05
0.1
0.15
0.2
0.25
0.3
0.35
Corporate Finance 18
The Capital Asset Pricing Model
CAPM Says:
All
investors will choose
to hold the market
portfolio, ie all assets, in
proportion to their
market values
This market portfolio is rf
the optimal risky portfolio
The part of a stock’s risk
that is diversifiable does
not matter to investors.
Copyright ©1998 Ian H. Giddy
E(r)
CAL(P)

Corporate Finance 19
The Capital Asset Pricing Model
CAPM Says:
The
E(r)
total risk of a financial
asset is made up of two
components.
A. Diversifiable
(unsystematic) risk
r
f
B. Nondiversifiable
(systematic) risk
The only relevant risk is
nondiversifiable risk.
Copyright ©1998 Ian H. Giddy
CAL(P)

Corporate Finance 20
The Equation for the CAPM
rj = RF + j (rm - RF)
where:
rj
=
RF =
j
rm
=
=
Required return on asset j;
Risk-free rate of return
Beta Coefficient for asset j;
Market return
The term [j(rm - RF)] is called the risk premium and
(rm-RF) is called the market risk premium
Copyright ©1998 Ian H. Giddy
Corporate Finance 21
The Capital Asset Pricing Model
Uses variance as a measure of risk
 Specifies that only that portion of variance
that is not diversifiable is rewarded.
 Measures the non-diversifiable risk with beta,
which is standardized around one.
 Translates beta into expected return Expected Return = Riskfree rate + Beta * Risk
Premium
 Works as well as the next best alternative in
most cases.

Copyright ©1998 Ian H. Giddy
Corporate Finance 22
Limitations of the CAPM


1. The model makes unrealistic assumptions
2. The parameters of the model cannot be estimated
precisely



- Definition of a market index
- Firm may have changed during the 'estimation' period'
3. The model does not work well

- If the model is right, there should be



a linear relationship between returns and betas
the only variable that should explain returns is betas
- The reality is that


Copyright ©1998 Ian H. Giddy
the relationship between betas and returns is weak
Other variables (size, price/book value) seem to explain
differences in returns better.
Corporate Finance 23
Interpreting Beta

Market Beta = 1.0 = average level of
risk
A Beta
of .5 is half as risky as average
A Beta of 2.0 is twice as risky as average
A negative Beta asset moves in opposite
direction to market
Copyright ©1998 Ian H. Giddy
Corporate Finance 24
Beta Coefficients for Selected Companies
Exxon
0.65
AT&T
0.90
IBM
0.95
Wal-Mart
1.10
General Motors1.15
Microsoft
1.30
Harley-Davidson1.65
America Online2.40
Source: From Value Line Investment Survey, April 19, 1996.
Copyright ©1998 Ian H. Giddy
Corporate Finance 25
Estimating Beta

The standard procedure for estimating
betas is to regress stock returns (Rj)
against market returns (Rm) Rj = a + b R m
where
a is the intercept and b is the slope
of the regression.

The slope of the regression
corresponds to the beta of the stock,
and measures the riskiness of the stock.
Copyright ©1998 Ian H. Giddy
Corporate Finance 26
Disney’s Historical Beta
Disney versus S & P 500: January 1992 - 1996
15 .00%
10 .00%
Disney
5.00%
0.00%
-6.00%
-4.00%
-2.00%
0.00%
2.00%
4.00%
6.00%
8.00%
-5.00%
-10 .00%
-15 .00%
S & P 500
Copyright ©1998 Ian H. Giddy
Corporate Finance 27
The Regression Output
 ReturnsDisney
= -0.01% + 1.40 ReturnsS & P 500
R squared=32.41%
Standard error of Beta=0.27
 Intercept
= -0.01%
 Slope = 1.40
Copyright ©1998 Ian H. Giddy
Corporate Finance 28
Beta Estimation in Practice:
Bloomberg
Copyright ©1998 Ian H. Giddy
Corporate Finance 29
Beta Differences: A Look Behind Betas
BETA AS A MEASURE OF RISK
High Risk
America Online:
Beta = 2.10: Operates in Risky Business
Beta > 1
Above-average Risk
Time Warner:
Beta = 1.45: High leverage is the reason
General Electric:
Beta = 1.15: Multiple Business Lines
Beta = 1
Average Stock
Beta < 1
Below-average Risk
Philip Morris:
Beta = 1.05: Risk from Lawsuits ????
Microsoft:
Beta = 0.95: Size has its advantages
Exxon:
Beta=0.65: Oil price Risk may not be market risk
Oracle:
Beta = 0.45: Betas are just estimates
Government bonds:
Beta = 0
Low Risk
Copyright ©1998 Ian H. Giddy
Corporate Finance 30
Determinant 1: Product Type

Industry Effects: The beta value for a
firm depends upon the sensitivity of the
demand for its products and services
and of its costs to macroeconomic
factors that affect the overall market.
Cyclical
companies have higher betas than
non-cyclical firms
Firms which sell more discretionary
products will have higher betas than firms
that sell less discretionary products
Copyright ©1998 Ian H. Giddy
Corporate Finance 31
Determinant 2: Operating Leverage
Effects
Operating leverage refers to the
proportion of the total costs of the firm
that are fixed.
 Other things remaining equal, higher
operating leverage results in greater
earnings variability which in turn results
in higher betas.

Copyright ©1998 Ian H. Giddy
Corporate Finance 32
Measures of Operating Leverage
Fixed Costs Measure = Fixed Costs / Variable
Costs
 This measures the relationship between fixed
and variable costs. The higher the proportion,
the higher the operating leverage.
EBIT Variability Measure = % Change in EBIT /
% Change in Revenues
 This measures how quickly the earnings
before interest and taxes changes as revenue
changes. The higher this number, the greater
the operating leverage.
Copyright ©1998 Ian H. Giddy
Corporate Finance 33
Determinant 3: Financial Leverage
As firms borrow, they create fixed costs
(interest payments) that make their
earnings to equity investors more
volatile.
 This increased earnings volatility which
increases the equity beta

Copyright ©1998 Ian H. Giddy
Corporate Finance 34
Betas are Weighted Averages


The beta of a portfolio is always the marketvalue weighted average of the betas of the
individual investments in that portfolio.
Thus,
 the
beta of a mutual fund is the weighted average
of the betas of the stocks and other investment in
that portfolio
 the beta of a firm after a merger is the marketvalue weighted average of the betas of the
companies involved in the merger.
Copyright ©1998 Ian H. Giddy
Corporate Finance 35
Firm Betas versus Divisional Betas
Firm Betas as weighted averages: The
beta of a firm is the weighted average of
the betas of its individual projects.
 At a broader level of aggregation, the
beta of a firm is the weighted average of
the betas of its individual division.

Copyright ©1998 Ian H. Giddy
Corporate Finance 36
Bottom-up versus Top-down Beta


The top-down beta for a firm comes from a regression
The bottom up beta can be estimated by doing the
following:

Find out the businesses that a firm operates in
 Find the unlevered betas of other firms in these businesses
 Take a weighted (by sales or operating income) average of these
unlevered betas
 Lever up using the firm’s debt/equity ratio

The bottom up beta will give you a better estimate of
the true beta when

the standard error of the beta from the regression is high (and) the
beta for a firm is very different from the average for the business
 the firm has reorganized or restructured itself substantially during the
period of the regression
 when a firm is not traded
Copyright ©1998 Ian H. Giddy
Corporate Finance 37
Decomposing Disney’s Beta
Business
Creative Content
Retailing
Broadcasting
Theme Parks
Real Estate
Disney
Business
Creative Content
Retailing
Broadcasting
Theme Parks
Real Estate
Firm
Copyright ©1998 Ian H. Giddy
Unlevered
Beta
1.25
1.50
0.90
1.10
0.70
1.09
D/E Ratio Levered
Beta
20.92%
1.42
20.92%
1.70
20.92%
1.02
20.92%
1.26
50.00%
0.92
21.97%
1.25
Riskfree
Rate
7.00%
7.00%
7.00%
7.00%
7.00%
7.00%
Estimated Value
Comparable Firms
$ 22,167
Motion Picture and TV program producers
$ 2,217
High End Specialty Retailers
$ 18,842
TV Broadcasting companies
$ 16,625
Theme Park and Entertainment Complexes
$ 2,217
REITs specializing in hotel and vacation propertiers
$ 62,068
Risk
Premium
5.50%
5.50%
5.50%
5.50%
5.50%
5.50%
Cost of
Equity
14.80%
16.35%
12.61%
13.91%
12.08%
13.85%
Unlevered Beta
Division Weight
1.25
35.71%
1.5
3.57%
0.9
30.36%
1.1
26.79%
0.7
3.57%
100.00%
Corporate Finance 38
From Cost of Equity to Cost of Capital
The cost of capital is a composite cost
to the firm of raising financing to fund its
projects.
 It is the discount rate that will be applied
to capital budgeting projects within the
firm

Copyright ©1998 Ian H. Giddy
Corporate Finance 39
The Cost of Capital
Choice
Cost
1. Equity
- Retained earnings
- New stock issues
- Warrants
Cost of equity
- depends upon riskiness of the stock
- will be affected by level of interest rates
Cost of equity = riskless rate + beta * risk premium
2. Debt
- Bank borrowing
- Bond issues
Cost of debt
- depends upon default risk of the firm
- will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity =
Capital
Cost of capital = Weighted average of cost of equity and
cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©1998 Ian H. Giddy
Corporate Finance 40
Estimating Cost of Capital: Disney

Equity




Debt




Cost of Equity = 13.85%
Market Value of Equity = $50.88 Billion
Equity/(Debt+Equity ) = 82%
After-tax Cost of debt = 7.50% (1-.36) = 4.80%
Market Value of Debt = $ 11.18 Billion
Debt/(Debt +Equity) = 18%
Cost of Capital = 13.85%(.82)+4.80%(.18) = 12.22%
Copyright ©1998 Ian H. Giddy
Corporate Finance 41
Choosing a Hurdle Rate



Either the cost of equity or the cost of capital
can be used as a hurdle rate, depending
upon whether the returns measured are to
equity investors or to all claimholders on the
firm (capital)
If returns are measured to equity investors,
the appropriate hurdle rate is the cost of
equity.
If returns are measured to capital (or the
firm), the appropriate hurdle rate is the cost of
capital.
Copyright ©1998 Ian H. Giddy
Corporate Finance 42
Back to First Principles

Invest in projects that yield a return greater than the minimum
acceptable hurdle rate.




Choose a financing mix that minimizes the hurdle rate and
matches the assets being financed.
If there are not enough investments that earn the hurdle rate,
return the cash to stockholders.


The hurdle rate should be higher for riskier projects and reflect
the financing mix used - owners’ funds (equity) or borrowed
money (debt)
Returns on projects should be measured based on cash flows
generated and the timing of these cash flows; they should also
consider both positive and negative side effects of these projects.
The form of returns - dividends and stock buybacks - will depend
upon the stockholders’ characteristics.
Manage financial risk
Copyright ©1998 Ian H. Giddy
Corporate Finance 43
www.giddy.org
Ian Giddy
NYU Stern School of Business
Tel 212-998-0332; Fax 212-995-4233
ian.giddy@nyu.edu
http://www.giddy.org
Copyright ©1998 Ian H. Giddy
Corporate Finance 47