WSU EMBA Corporate Finance12-1 Chapter 12: Risk, Cost of Capital, and Capital Budgeting Weighted...

WSU EMBA Corporate Finance 12-1

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)


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?


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 be relevant to a well-diversified shareholder.

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.


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.


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.


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 rM=10% and the risk free rate is rF=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., βequity=βassets.



We use the CAPM model to estimate the cost of equity or required return on ABC stock. rE = 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.



ABC has a new proposed project. If the new project were a separate mini-firm, it would have an Asset Beta of βassets=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: rproject = 0.05 + 0.8[0.10 – 0.05] = 0.09 or 9%

The project has the following expected cash flows.

CF0 CF1 CF2 CF3 CF4

-950 300 300 300 300



The project’s NPV, using the correct project cost of capital of rproject=9% is calculated below: NPV0 = -950 + 300/(1+0.09) + 300/(1+0.09)2 +

300/(1+0.09)3 + 300/(1+0.09)4 = $21.915 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.


WACC and Financial Leverage Note the following terms:

D ≡ market value of Debt (not the accounting book value) E ≡ market value of Equity (not the accounting book value) rD ≡ cost of debt (before taxes) rE ≡ cost of equity, where rE = rF + E[rM – rF] A ≡ market value of assets ≡ D + E A ≡ Beta of assets (fixed and independent of capital structure) U ≡ Beta of unlevered equity (U = A, since these are equivalent) E ≡ Beta of equity (see equation below for explanation) D ≡ Beta of debt (often assumed to be zero in this chapter) TC = Corporate tax rate


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 – TC)D/E]

The all important equation for cost of capital is: [D/(D+E)](1 – TC)rD + [E/(D+E)]rE

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.


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 TC=40%, rM=12%, and rF=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.


WACC and Financial Leverage

E = A[1 + (1 – TC)D/E]

E = 1.3[1 + (1 – 0.4)(50/100)] = 1.69

rE = rF + E[rM – rF]

rE = 0.06 + 1.69[0.12 – 0.06] = 16.14%

rD = rF + D[rM – rF] = 0.06 + 0[0.12 – 0.06] = 6%

WACC = [D/(D+E)](1 – TC)rD + [E/(D+E)]rE

WACC = [50/(50+100)](1 – 0.4)(0.06) + [100/(50+100)](0.1614) = 11.96%


WACC and Financial Leverage

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

Asset risk is the source of the firm’s risk

Asset risk is passed on to the firm’s equity

ASSETS

EQUITY

DEBT

Asset β = 1.30

Debt β = 0

Equity β = 1.69 Market value of firm equals $150 million

Market value of equity equals $100 million

Market value of debt equals $50 million


WACC and Financial Leverage XYZ has a new proposed project. The proposed project has an

asset Beta of βassets=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 βdebt=0

The project has the following expected cash flows. The Internal Rate of Return of these cash flows is IRR=14.33%.

CF0 CF1 CF2 CF3

-1000 400 500 400


WACC and Financial Leverage, finding the project cost of capital

E = A[1 + (1 – TC)D/E] E = 1.0[1 + (1 – 0.4)(0.5)] = 1.30

rE = rF + E[rM – rF] rE = 0.06 + 1.3[0.12 – 0.06] = 13.8%rD = rF + D[rM – rF] = 0.06 + 0[0.12 – 0.06] = 6%

rproject = [D/(D+E)](1 – TC)rD + [E/(D+E)]rE

rproject = [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

rproject=10.40% cost of capital, and therefore the project should be accepted.


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 Cost of Capital

Below average risk 9%

Average risk 11%

Above average risk 13%

Highest risk 15%


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.


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: [rGE,t – rF,t] = GE + GE[rM,t – rF,t] + eGE,t

The Beta obtained from this regression is GE=1.0473.


Scatter Plot of GE versus Market Index Returns

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

-0.20

0.20

-0.15

0.15

-0.10

-0.05

0.00

0.05

0.10

0.15

0.20

0.25

-0.10 -0.05 0.00 0.05 0.10

GE - Rf

Rm

-- R

f


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.


Economic Value Added (EVA) EVA equals after-tax operating income – after-tax

capital costs. Using numbers: EVA = EBIT(1-TC) – (Total capital)(WACC)

Let D=$40,000, E=$100,000, EBIT=$30,000, TC=40%, rD=5%, and rE=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


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 Finance12-1 Chapter 12: Risk, Cost of Capital, and Capital Budgeting Weighted...

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