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Chapter Outline
CHAPTER 12.1 The Cost of Equity Capital

12 12.2 Estimation of Beta


12.3 Determinants of Beta
12.4 Extensions of the Basic Model
Risk, Cost of Capital, 12.5 Estimating International Paper’s Cost of
and Capital Budgeting Capital
12.6 Reducing the Cost of Capital
12.7 Summary and Conclusions
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What’s the Big Idea? 12.1 The Cost of Equity Capital


Shareholder
invests in
Earlier chapters on capital budgeting Firm with
Pay cash dividend financial
excess cash
focused on the appropriate size and timing asset
of cash flows. A firm with excess cash can either pay a
dividend or make a capital investment
This chapter discusses the appropriate
Shareholder’s
discount rate when cash flows are risky. Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
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The Cost of Equity 12.3 Determinants of Beta


From the firm’s perspective, the expected return
is the Cost of Equity Capital: Business Risk
Ri = RF + βi ( RM − RF ) Cyclicity of Revenues
To estimate a firm’s cost of equity capital, we Operating Leverage
need to know three things: Financial Risk
1. The risk-free rate, RF Financial Leverage
2. The market risk premium, RM − RF
3. The company beta, β = Cov( Ri , RM ) = σi , M
i
Var ( RM )2
σM
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Cyclicality of Revenues Operating Leverage


Highly cyclical stocks have high betas.
Empirical evidence suggests that retailers and automotive The degree of operating leverage measures how
firms fluctuate with the business cycle. sensitive a firm (or project) is to its fixed costs.
Transportation firms and utilities are less dependent upon the Operating leverage increases as fixed costs rise and
business cycle. variable costs fall.
Note that cyclicality is not the same as Operating leverage magnifies the effect of cyclicity on
variability—stocks with high standard deviations beta.
need not have high betas. The degree of operating leverage is given by:
Movie studios have revenues that are variable, depending upon
DOL = ∆ EBIT × Sales
whether they produce “hits” or “flops”, but their revenues are EBIT ∆ Sales
not especially dependent upon the business cycle.
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Operating Leverage Financial Leverage and Beta


Operating leverage refers to the sensitivity to the firm’s fixed
∆ EBIT costs of production.
Total
$ costs Financial leverage is the sensitivity of a firm’s fixed costs of
financing.
Fixed costs
∆ Volume The relationship between the betas of the firm’s debt, equity, and
assets is given by:
Fixed costs
Volume βAsset = Debt × βDebt + Equity × βEquity
Debt + Equity Debt + Equity
Operating leverage increases as fixed costs rise Financial leverage always increases the equity beta relative to the
and variable costs fall. asset beta.

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12.4 Extensions of the Basic Model The Firm versus the Project
The Firm versus the Project Any project’s cost of capital depends on the
The Cost of Capital with Debt use to which the capital is being put—not
the source.
Therefore, it depends on the risk of the
project and not the risk of the company.

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Capital Budgeting & Project Risk Capital Budgeting & Project Risk
Project IRR

Suppose the Conglomerate Company has a cost of capital, based on


SML the CAPM, of 17%. The risk-free rate is 4%; the market risk
The SML can tell us why: premium is 10% and the firm’s beta is 1.3.
Incorrectly accepted
negative NPV projects 17% = 4% + 1.3 × [14% – 4%]
This is a breakdown of the company’s investment projects:
Hurdle RF + βFIRM ( R M − RF )
rate 1/3 Automotive retailer β = 2.0
Incorrectly rejected
rf 1/3 Computer Hard Drive Mfr. β = 1.3
positive NPV projects
Firm’s risk (beta) 1/3 Electric Utility β = 0.6
βFIRM average β of assets = 1.3
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value. When evaluating a new electrical generation investment,
which cost of capital should be used?
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The Cost of Capital with Debt 12.5 Estimating International Paper’s


Cost of Capital
The Weighted Average Cost of Capital is given First, we estimate the cost of equity and the
by: cost of debt.
Equity Debt
rWACC = × rEquity + × rDebt ×(1 – TC) We estimate an equity beta to estimate the cost
Equity + Debt Equity + Debt
of equity.
S B We can often estimate the cost of debt by
rWACC = × rS + × rB ×(1 – TC)
S+B S+B observing the YTM of the firm’s debt.
It is because interest expense is tax-deductible Second, we determine the WACC by
that we multiply the last term by (1 – TC) weighting these two costs appropriately.
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12.5 Estimating IP’s Cost of Capital 12.5 Estimating IP’s Cost of Capital
The yield on the company’s debt is 8% and the firm is in
The industry average beta is 0.82; the risk the 37% marginal tax rate.
free rate is 8% and the market risk premium The debt to value ratio is 32%
is 8.4%. r = R + β × ( R – R ) S B
rWACC = × rS + × rB ×(1 – TC)
S F i M F S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
Thus the cost of equity capital is = 8.34%
= 3% + 0.82×8.4% 8.34 percent is International’s cost of capital. It should be used to
discount any project where one believes that the project’s risk is
= 9.89% equal to the risk of the firm as a whole, and the project has the same
leverage as the firm as a whole.
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12.7 Summary and Conclusions


The expected return on any capital budgeting project should be at
least as great as the expected return on a financial asset of
comparable risk. Otherwise the shareholders would prefer the firm
to pay a dividend.
The expected return on any asset is dependent upon β.
A project’s required return depends on the project’s β.
A project’s β can be estimated by considering comparable
industries or the cyclicality of project revenues and the project’s
operating leverage.
If the firm uses debt, the discount rate to use is the rWACC.
In order to calculate rWACC, the cost of equity and the cost of debt
applicable to a project must be estimated.
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