FINANCE FOR
EXECUTIVES
Managing for Value Creation
Gabriel Hawawini
Claude Viallet
ESTIMATING THE COST OF CAPITAL
1
EXHIBIT 10.1:
Risk and Return
for the Sun Cream
and Umbrella
Investments.
2
EXHIBIT 10.2:
SMC Stock
Monthly Returns
versus the S&P
500 Monthly
Returns.
3
EXHIBIT 10.3:
Beta Coefficients of a Sample of U.S. Stocks.
Southwest Air
Texas Instrument
Compaq Computer
Whirlpool Corp.
AMR Corp.
Motorola, Inc.
Maytag Corp.
BancOne Corp.
Abbott Laboratories
Air Gas
Baxter International
General Electric
Viacom, Inc.
Turner Broadcasting
Ford Motor Company
General Motors
1.60
1.60
1.40
1.40
1.35
1.30
1.30
1.25
1.20
1.20
1.15
1.15
1.10
1.10
1.05
1.05
Source: Value Line Investment Survey, 1996.
4
Anheuser-Busch
McDonald’s
Walgreen Co.
Coca-Cola
Pepsi-Cola
AT&T
McGraw-Hill
GTE
Bell Atlantic
Quaker Oats
Ameritech
Continental Edison
Amoco Corp.
Energy Corp.
Texas Utilities
American Water Works
1.00
1.00
1.00
0.95
0.95
0.90
0.85
0.80
0.80
0.80
0.75
0.75
0.75
0.70
0.65
0.65
EXHIBIT 10.4:
Average Annual Rate of Return on Common Stocks,
Corporate Bonds, U.S. Government Bonds, and U.S.
Treasury Bills, 1926 to 1995.
TYPE OF
INVESTMENT
AVERAGE ANNUAL
RETURN
Common stocks (S&P 500)
AVERAGE RISK PREMIUM
DIFFERENCE BETWEEN RETURN
OF INVESTMENT AND RETURN OF
TREASURY
GOVERNMENT
BILLS
BONDS
12.2%
8.5%
7.0%
Corporate bonds
5.7%
2.0%
0.5%
Government bonds
5.2%
1.5%
—
Treasury bills
3.7%
—
—
Source: Ibbotson Associates, Inc., 1996 Yearbook.
5
EXHIBIT 10.5:
The Capital Asset Pricing Model.
6
EXHIBIT 10.6a:
Estimation of the Cost of Equity Based on the
Capital Asset Pricing Model (CAPM) for a Sample of
Companies Listed on the London Stock Exchange (1996).
GOVERNMENT
BOND RATE
MARKET RISK
PREMIUM
COMPANY
INDUSTRY
REUTERS
Agency
6%
7%
PEEK
Electronics
6%
7%
BRITISH AEROSPACE
Aerospace
6%
7%
INCHCAPE
Trading
6%
7%
GLAXO HOLDINGS
Health
6%
7%
LUCAS INDUSTRIES
Motor
6%
7%
MARKS & SPENCER
Stores
6%
7%
BRITISH TELECOM
Phone network
6%
7%
SAVOY HOTELS
Hotels
6%
7%
7
EXHIBIT 10.6b:
Estimation of the Cost of Equity Based on the
Capital Asset Pricing Model (CAPM) for a Sample of
Companies Listed on the London Stock Exchange (1996).
COMPANY
BETA
COEFFICIENT
ESTIMATED COST OF
EQUITY WITH THE CAPM
REUTERS
1.73
6% + (7%)(1.73) = 18.1%
PEEK
1.52
6% + (7%)(1.52) = 16.6%
BRITISH AEROSPACE
1.34
6% + (7%)(1.34) = 15.4%
INCHCAPE
1.30
6% + (7%)(1.30) = 15.1%
GLAXO HOLDINGS
1.27
6% + (7%)(1.27) = 14.9%
LUCAS INDUSTRIES
1.21
6% + (7%)(1.21) = 14.5%
MARKS & SPENCER
0.88
6% + (7%)(0.88) = 12.2%
BRITISH TELECOM
0.73
6% + (7%)(0.73) = 11.1%
SAVOY HOTELS
0.40
6% + (7%)(0.40) = 8.8%
8
EXHIBIT 10.7:
SMC’s Managerial Balance Sheet.
INVESTED CAPITAL OR NET ASSETS
CAPITAL EMPLOYED
Cash
Long-term debt
$10,000,000
1
$90,000,000
90,000 bonds
at par value $1,000
Working capital
$50,000,000
requirement
Owners’ equity
$90,000,000
2,500,000 shares
$25,000,000
at par value $10
Net fixed assets
$120,000,000
Total
$180,000,000
1 SMC
9
has no short-term debt.
Retained earnings
Total
$65,000,000
$180,000,000
EXHIBIT 10.8a:
The Estimation of a Firm’s Weighted Average Cost of
Capital (WACC), Including an Application to Sunlight
Manufacturing Company (SMC).
STEPS TO FOLLOW
Step 1:
Estimate the firm’s relative
proportions of debt (D) and
equity (E) financing:
D
E+D
E
and
E+D
HOW TO
• Use the firm’s market values of debt and
equity.
• The market value of debt is computed
from data on outstanding bonds using
the bond valuation formula (equation
10.1).
• The market value of equity is the share
price times the number of shares
outstanding.
• If the firm’s securities are not publicly
traded use the market value rations of
proxy firms.
10
EXHIBIT 10.8b:
The Estimation of a Firm’s Weighted Average Cost of
Capital (WACC), Including an Application to Sunlight
Manufacturing Company (SMC).
STEPS TO FOLLOW
Step 2:
Estimate the firm’s aftertax cost
of debt: k D(1 – Tc).
HOW TO
• If the firm has outstanding bonds that
are publicly traded, use equation 10.1 to
estimate k D.
• Otherwise, use the credit spread
equation (equation 10.2) or ask the bank.
• Use the marginal corporate tax rate
for Tc .
11
EXHIBIT 10.8c:
The Estimation of a Firm’s Weighted Average Cost of
Capital (WACC), Including an Application to Sunlight
Manufacturing Company (SMC).
STEPS TO FOLLOW
Step 3:
Estimate the firm’s
cost of equity: KE.
HOW TO
• Use the capital asset pricing model (equation
10.11).
• The risk-free rate is the rate on government
bonds.
• The market risk premium is 7% (historical
average) .
Step 4:
12
Calculate the firm’s
weighted average cost
of capital (WACC).
• Use the beta of the firm’s stock. If the firm’s
shares are not publicly traded, estimate beta from
proxies.
D
E
• WACC = k D(1 – Tc)
+ KE
E+D
E+D
EXHIBIT 10.9a:
Proxies for Buddy’s Restaurants.
EQUITY
BETA1
DEBT-TO-EQUITY RATIO1,2
D
E
At market value
ASSET
BETA3
McDonalds
1.01
0.17
0.92
Wendy’s International
0.92
0.23
0.81
CKE Restaurants
1.15
0.22
1.02
Average values
1.03
0.21
0.92
1 Data
from Alcar, June 1996.
= debt; E = equity.
3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.
2D
13
EXHIBIT 10.9b:
Proxies for Buddy’s Restaurants.
DEBT RATIO1,2
D
E+D
At market value
At book value
EQUITY RATIO1,2
E
E+D
At market value At book value
McDonalds
0.14
0.41
0.86
0.59
Wendy’s International
0.19
0.36
0.81
0.64
CKE Restaurants
0.18
0.47
0.82
0.53
Average values
0.17
0.41
0.83
0.59
1 Data
from Alcar, June 1996.
= debt; E = equity.
3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.
2D
14
EXHIBIT 10.10a:
The Estimation of a Project’s Cost of Capital when the
Project Risk Is Different from the Risk of the Firm,
Including an Application to the Buddy’s Restaurants
Project.
STEPS TO FOLLOW
Step 1:
Estimate the project’s relative
proportions of debt (D) and
equity (E) financing:
D
E+D
E
and
E+D
using proxy firms.
HOW TO
• Use the proxies’ market values of debt
and equity.
• The market value of debt is computed
from data on outstanding bonds using
the bond valuation formula (equation
10.1).
• The market value of equity is the share
price times the number of shares
outstanding.
• Take the mean of the proxies’ ratios.
15
EXHIBIT 10.10b:
The Estimation of a Project’s Cost of Capital when the
Project Risk Is Different from the Risk of the Firm,
Including an Application to the Buddy’s Restaurants
Project.
STEPS TO FOLLOW
Step 2:
Estimate the project’s aftertax
cost of debt: kD(1 – Tc).
HOW TO
• If the proxies have outstanding bonds
that are publicly traded, use equation
10.1 to estimate their cost of debt kD.
• Otherwise, use the credit spread
equation (equation 10.2) or ask the bank.
• Take the mean of the proxies’ cost of
debt.
• Use the marginal corporate tax rate
for Tc .
16
EXHIBIT 10.10c:
The Estimation of a Project’s Cost of Capital when the
Project Risk Is Different from the Risk of the Firm,
Including an Application to the Buddy’s Restaurants
Project.
STEPS TO FOLLOW
Step 3:
HOW TO
Estimate the project’s • Use the capital asset pricing model (equation 10.11).
cost of equity: k E.
• The risk-free rate is the rate on government bonds.
• The market risk premium is 7% (historical average).
• Un-lever the proxies’ equity betas using equation
10.7 to get their unlevered asset betas.
• Re-lever the mean of the proxies’ asset betas at the
project’s target debt-to-equity ratio using equation
10.6 to get the project’s equity beta.
• Apply the CAPM to the project’s equity beta to get
the project’s cost of equity kE.
17
EXHIBIT 10.10d:
The Estimation of a Project’s Cost of Capital when the
Project Risk Is Different from the Risk of the Firm,
Including an Application to the Buddy’s Restaurants
Project.
STEPS TO FOLLOW
Step 4:
18
Calculate the project’s
weighted average cost of
capital (WACC).
HOW TO
• WACC = k D(1 – Tc)
E
D
+ KE
E+D
E+D
EXHIBIT 10.11:
Company-Wide Cost of Capital and Projects’ Expected
Rates of Return.
19