Chapter 12: Risk, Cost of Capital, and Capital Budgeting



Weighted Average Cost of Capital (WACC)



Estimating cost of capital for:

 Existing corporation  New projects 

Beta estimation



Economic Value Added (EVA)

WSU EMBA Corporate Finance 12-1

Three types of risk facing a firm

 (1) Stand-alone or total risk  The risk or variability of a single project’s cash flows, ignoring everything else.

 (2) Corporate risk – the firm is a

portfolio

of projects    The risk or variability of the firm’s cash flows.

How will a new project affect the total risk of the firm’s cash flows?

How are the project’s cash flows correlated with the firm’s existing cash flows?

WSU EMBA Corporate Finance 12-2

Three types of risk facing a firm, continued

  (3) Market or Beta risk (CAPM)  How does the firm’s new project affect the overall risk faced by a well-diversified investor that owns stocks of many firms?

  Stand-alone and corporate (

firm-specific

) risks would

not

relevant to a well-diversified shareholder.

be Diversified investors are largely concerned about the

market

or CAPM Beta (systematic or macroeconomic) risk.

However, some parties are likely concerned about total and corporate risks.

  Managers usually cannot diversify their careers.

Employees and undiversified investors may have concerns.

WSU EMBA Corporate Finance 12-3

Diversification at the corporate level

  Firms often may attempt to diversify or manage/reduce their corporate risk by:   Hedging or risk management Expanding into new businesses, usually by acquisitions. Commonly, they pay too much for a business they have no experience in managing.

Such actions, especially acquisitions, may not be in the best interests of shareholders.

  Shareholders can diversify far more easily and cheaply.

Corporate diversification only makes sense if it creates value that shareholders cannot create on their own.

WSU EMBA Corporate Finance 12-4

What constitutes the value and relevant risk of a firm

 All of a firm’s value comes from the cash flows that the firm’s

assets

are

expected

to produce. The firm’s risk originates from the risk of the assets/operations.

 A firm can be viewed as a portfolio of various types of assets or projects, or a portfolio of divisions.

 Each project and division that comprises the firm may have a different level of market or Beta risk.

 Same analogy as a stockholder holding a portfolio of different stocks, each having its own Beta.

WSU EMBA Corporate Finance 12-5

Example of corporate and project cost of capital, the

all equity

case

   The

asset

Beta is the true measure of a firm’s risk. Stocks and bonds are risky because the assets are risky. A firm’s assets, equity, and debt each have a Beta. The required return on the market portfolio is r M =10% and the risk free rate is r F =5%.

ABC’s assets are 100% equity financed (no debt is used). The Beta of ABC common stock is β=1.2.

 Since ABC is all equity, the stockholders have a 100% claim on the firm’s assets. For an

all equity

firm, the Asset and Equity Betas are equal, i.e.,

β equity =β assets

.

WSU EMBA Corporate Finance 12-6

Example of corporate and project cost of capital, the

all equity

case

   We use the

CAPM

model to estimate the cost of equity or required return on ABC stock.

 r E = 0.05 + 1.2[0.10 – 0.05] = 0.11 or

11%

Since ABC is 100% financed by equity, then its

weighted average cost of capital

or

WACC

is also equal to 11%.

Asset Betas are only a function of the firm’s systematic or market risk. Asset Betas only change with the Beta risk of the firm’s assets change.

 Changes in the mix of debt and equity financing will change the debt and equity Betas; however, the firm’s asset Beta remains unchanged.

WSU EMBA Corporate Finance 12-7

Example of corporate and project cost of capital, the

all equity

case

  ABC has a new proposed project. If the new project were a separate

mini-firm

, it would have an Asset Beta of β assets =0.8.

 This proposed project is

less risky

than ABC’s existing asset Beta of 1.2. This project’s cost of capital is thus:  r project = 0.05 + 0.8[0.10 – 0.05] = 0.09 or

9%

The project has the following expected cash flows.

CF 0 -950 CF 1 300 CF 2 300 CF 3 300 CF 4 300

WSU EMBA Corporate Finance 12-8

Example of corporate and project cost of capital, the

all equity

case

   The project’s NPV, using the

correct

project cost of capital of

r project =9%

 is calculated below:

NPV 0

= -950 + 300/(1+0.09) + 300/(1+0.09) 300/(1+0.09) 3 + 300/(1+0.09) 4 =

$21.915

2 +  The project’s

IRR=10.0466%

, which is greater than this project’s 9% cost of capital.

This project should be accepted.

If the project has been evaluated at the firm’s existing

WACC of 11%

, the project would have been wrongly rejected since the NPV would have been negative.

WSU EMBA Corporate Finance 12-9

WACC and Financial Leverage

 Note the following terms:   D ≡ market value of Debt (not the accounting

book

E ≡ market value of Equity (not the accounting

book

value) value)         r D ≡ cost of debt (before taxes) r E ≡ cost of equity, where r E = r F +  E [r M A ≡ market value of assets ≡ D + E  A  U  E  D ≡ Beta of assets (fixed and independent of capital structure) ≡ Beta of

unlevered

equity (  U – r F ] =  A , since these are equivalent) ≡ Beta of equity (see equation below for explanation) ≡ Beta of debt (often assumed to be zero in this chapter) T C = Corporate tax rate

WSU EMBA Corporate Finance 12-10

WACC and Financial Leverage

   The following all important equation relates the Asset and Equity Betas,

assuming

that the Debt Beta  D =0.

  E =  A [1 + (1 – T C )D/E] The all important equation for cost of capital is:  [D/(D+E)](1 – T C )r D + [E/(D+E)]r E When the above equation is solved for the entire firm, division, or project, then the result will be the entire firm’s WACC, divisional WACC, or project cost of capital, respectively.

WSU EMBA Corporate Finance 12-11

WACC and Financial Leverage

    XYZ Corp. is financed with $100 million of equity and $50 million of debt, at current

market

values. The Asset Beta is  asset =1.3 and the debt Beta is assumed to be zero in this example.

Let T C =40%, r M =12%, and r F =6%.

Given the above information, what is this firm’s existing WACC?

 Here, the WACC calculation consists of three steps, as shown on the following slide.

WSU EMBA Corporate Finance 12-12

WACC and Financial Leverage

   r  E  E E =  A [1 + (1 – T C )D/E] = 1.3[1 + (1 – 0.4)(50/100)] =

1.69

= r F +  E [r M – r F ] r E r D = 0.06 +

1.69

[0.12 – 0.06] =

16.14%

= r F +  D [r M – r F ] = 0.06 +

0

[0.12 – 0.06] =

6%

WACC = [D/(D+E)](1 – T C )r D + [E/(D+E)]r E WACC = [50/(50+100)](1 – 0.4)(

0.06

) + [100/(50+100)](

0.1614

) =

11.96% WSU EMBA Corporate Finance 12-13

WACC and Financial Leverage

 The diagram below illustrates XYZ’s assets, debt, and equity.

Asset risk is the source of the firm’s risk ASSETS Asset β = 1.30

Market value of firm equals $150 million DEBT Debt β = 0 Market value of debt equals $50 million EQUITY Equity β = 1.69

Market value of equity equals $100 million Asset risk is passed on to the firm’s equity

WSU EMBA Corporate Finance 12-14

WACC and Financial Leverage

  XYZ has a new proposed project. The proposed project has an asset Beta of β assets =1.0. Assume the following:  The project should be financed in the same proportions as XYZ; 1/3 debt and 2/3 equity. Therefore, both the firm’s and project’s D/E ratio is 0.5.

 The Beta of any new debt is β debt =0 The project has the following expected cash flows. The Internal Rate of Return of these cash flows is

IRR=14.33%

.

CF 0 -1000 CF 1 400 CF 2 500 CF 3 400

WSU EMBA Corporate Finance 12-15

WACC and Financial Leverage, finding the project cost of capital

    r r r  E  E E =  A [1 + (1 – T C )D/E] = 1.0[1 + (1 – 0.4)(0.5)] =

1.30

= r F +  E [r M – r F ] E D = 0.06 +

1.3

[0.12 – 0.06] =

13.8%

= r F +  D [r M – r F ] = 0.06 +

0

[0.12 – 0.06] =

6%

r project = [D/(D+E)](1 – T C )r D + [E/(D+E)]r E r project = [1/3](1 – 0.4)(

0.06

) + [2/3](

0.138

) =

10.40%

This project’s IRR of 14.33% is higher than this project’s r project =10.40% cost of capital, and therefore the project should be

accepted

.

WSU EMBA Corporate Finance 12-16

Adjustments to existing WACC for actual firms

 Here is a risk adjustment method that some firms use. Say that a firm has a WACC=11%. It may do the following to estimate project cost of capital. Average risk projects are evaluated using the firm’s existing WACC.

Type of Project Below average risk

Average risk

Above average risk Highest risk Cost of Capital 9%

11%

13% 15%

WSU EMBA Corporate Finance 12-17

Capital budgeting at a major firm: the case of Hershey Foods

     Excerpts from a 1998 interview with Samuel Weaver, Ph.D., the former Director of Financial Planning and Analysis.

Managers appear to have trouble in interpreting the meaning of NPV. They understand IRR more easily. When Hershey must choose between mutually exclusive projects, they always use NPV, since IRR lead to mistakes with these projects.

Hershey does calculate its own WACC, using their market values of debt and equity and not the book values.

Hershey does not use the CAPM, they use the dividend discount model to estimate their cost of equity. Most other firms in the industry use the CAPM.

Hershey does adjust the project cost of capital in order to reflect the unique risk of the project.

WSU EMBA Corporate Finance 12-18

Estimating Equity Betas, An Example Using GE Stock

   A common and easy (often not the best) method, for publicly traded firms, is to regress the firm’s past stock returns on the returns of a market index such as the S&P 500.

Our example uses three years of monthly stock returns from Jan. 1997 to Dec. 1999 to estimate the equity Beta of General Electric.

The following regression is estimated:   [r GE,t – r F,t ] =  GE +  GE [r M,t – r F,t ] + e GE,t The Beta obtained from this regression is 

GE =1.0473

.

WSU EMBA Corporate Finance 12-19

Scatter Plot of GE

versus

Market Index Returns

-0.10

GE returns regressed on CRSP Value Weighted Market Index for Jan. 1997 through Dec. 1999 (36 months)

0.25 0.20 0.15 -0.05

0.10 0.05 0.00 -0.05

0.00

-0.10 -0.15 0.15 -0.20 0.05

0.10

WSU EMBA Corporate Finance 12-20

Economic Value Added (EVA)

   Items such as net income or even cash flow items such as FCF or FCFE, by themselves, cannot answer such questions as “did the firm’s operations generate an acceptable return to its investors?” .

In order to generate

positive

EVA, a firm has to more than just cover its operating costs. It must also provide an

above normal

return to those who have provided the firm with capital.

EVA takes into account the total cost of capital provided by both debtholders and stockholders.

WSU EMBA Corporate Finance 12-21

Economic Value Added (EVA)

    EVA

equals

after-tax operating income – after-tax capital costs. Using numbers: 

EVA = EBIT(1-T C ) – (Total capital)(WACC)

Let D=$40,000, E=$100,000, EBIT=$30,000, T C =40%, r D =5%, and r E =12%.

WACC

= [40,000/(40,000+100,000)](1-0.4)(0.05) + [100,000/(40,000+100,000)](0.12) = 0.0943 or

9.43% EVA

= (30,000)(1-0.4) – (140,000)(0.0943)

EVA

= 18,000 – 13,202 =

$4798 WSU EMBA Corporate Finance 12-22

Economic Value Added (EVA)

    The firm’s investors expected the firm to generate at least $13,202 based on its risk. The firm was able to actually generate $18,000, and thus the EVA is $4798. The EVA method can be used to evaluate financial performance of non-traded firms, various plants, or non-traded divisions of publicly traded firms, etc.

Managerial compensation is typically linked to

changes

in annual EVA, rather than the absolute EVA.

In a perfect world, the ideal measure of value are market prices of stocks and debt; however, most firms (and divisions of firms) are not publicly traded.

WSU EMBA Corporate Finance 12-23