Transcript Finance I - Universidade Nova de Lisboa

Finanças
November 7
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Topics covered
CAPM for cost of capital
 Estimation of beta

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Risk and cost of capital
Previously: Determine the timing and the
size of cash flows
 Now: determine the discount rate for risky
cash flows
 The discount rate can be computed from
the CAPM

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Choices of a firm with extra cash
Firm with
excess cash
Pay cash dividend
Shareholder
invests in
financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment
Invest in project
Shareholder’s
Terminal
Value
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Capital budgeting rule

The discount rate of a project

The expected return
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Cost of capital

Example



Suppose the stock of a company has a beta of 2.5. The firm
is 100-percent equity financed.
Assume a risk-free rate of 5-percent and a market risk
premium of 10-percent.
What is the appropriate discount rate for an expansion of
this firm?
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Example (continued)
Suppose the company is evaluating the following non-mutually
exclusive projects. Each costs $100 and lasts one year.
Project
Project b
Project’s
Estimated Cash
Flows Next Year
IRR
NPV at
30%
A
2.5
$150
50%
$15.38
B
2.5
$130
30%
$0
C
2.5
$110
10%
-$15.38
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SML
IRR
Project
Using the SML to Estimate the Risk-Adjusted
Discount Rate for Projects
5%
Firm’s risk (beta)
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Estimation of beta
Beta: Sensitivity of a stock’s return to
the return on the market portfolio.
 Market Portfolio: Portfolio of all assets in
the economy. In practice a broad stock
market index, such as the S&P
Composite, is used to represent the
market.

 β  Cov( Ri , RM )  σ i , M
2
Var ( RM )
σM
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Stability of Beta
Many analysts argue that betas are generally
stable for firms remaining in the same
industry.
 That’s not to say that a firm’s beta can’t
change.

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Using an Industry Beta


It is frequently argued that one can better estimate
a firm’s beta by involving the whole industry.
If you believe that the operations of the firm are
similar to the operations of the rest of the industry,

If you believe that the operations of the firm are
fundamentally different from the operations of the
rest of the industry

Adjustments
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Determinants of beta

Cylicality of revenues
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Determinants of beta

Operating leverage

how sensitive a firm is to its fixed costs.
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Operating Leverage
 EBIT
$
 Volume
Volume
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Determinants of beta

Financial leverage

Operating leverage

Financial leverage

The relationship between the betas of the firm’s
debt, equity, and assets is given by:

The beta of debt
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Financial Leverage and Beta: Example
Consider a company which is currently all-equity and
has a beta of 0.90. The firm has decided to lever up
to a capital structure of 1 part debt to 1 part equity.
Since the firm will remain in the same industry, its
asset beta should remain 0.90. However, assuming a
zero beta for its debt, its equity beta would become:
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Financial leverage and beta

Conclusion
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Extension of the basic model

The firm vs the project

The risk of a project

The project should be discounted with
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Project IRR
The firm vs the project
SML
RF  βFIRM ( R M  RF )
Hurdle
rate
rf
bFIRM
Firm’s risk (beta)
A firm that uses one discount rate for all projects may over time
increase the risk of the firm
while decreasing its value.
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The firm vs the project
Suppose the Conglomerate Company has a cost of capital, based
on the CAPM, of 17%. The risk-free rate is 4%; the market
risk premium is 10% and the firm’s beta is 1.3.
17% = 4% + 1.3 × [14% – 4%]
This is a breakdown of the company’s investment projects:
1/3 Automotive retailer b = 2.0
1/3 Computer Hard Drive Mfr. b = 1.3
1/3 Electric Utility b = 0.6
average b of assets = 1.3
When evaluating a new electrical generation investment,
which cost of capital should be used?
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Capital Budgeting & Project Risk
SML
Project IRR
24%
Investments in hard
drives or auto retailing
should have higher
discount rates.
17%
10%
Project’s risk (b)
0.6
1.3
2.0
r = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment in
electrical generation, given the unique risk of the project.
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Extention of the basic model

The Weighted Average Cost of Capital

It is because interest expense is taxdeductible that we multiply the last term by
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WACC
Example: a firms with a debt-equity ratio
of 0.6, a cost of debt of 15.15%, and a
cost of equity of 20%. The corporate tax
rate is 34%.
 Debt to value ratio=6/(10+6)=0.375
 Equity to value ratio=1-0.375=0.625
 rwacc=0.625*20%+0.375*15.15%*(1-0.34)
=16.25%

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Steps to calculate WACC
Cost of equity
Cost of debt
Calculate WACC
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