Risk, Return, & Capital Budgeting

ACTSC 372: Corporate Finance

Winter 2021
Pengyu Wei
Review
§ Capital budgeting considers the value of a project given a discount rate
§ A project is a stream of cash flows
§ When discounted by 𝑟! , cash flows are assumed risk-free
§ What if the cash flows are risky (e.g., capital gain of a stock)?

§ CAPM & APT are ways to compute the “fair” risky returns
§ “fair” return ⇔ “appropriate” discount rate
§ Discount rate reflects the risk of an investment
§ Systematic risk of an investment is indicated by its 𝛽’s

§ Now we combines the two:

§ Find the appropriate discount rate
§ Capital budgeting for risky projects
Recall CAPM & APT
§ CAPM Formula
𝐶𝑜𝑣 𝑅" , 𝑅# 𝜎"#
𝜇" = 𝑟! + 𝛽" 𝜇# − 𝑟! , 𝛽" = = $
𝑉𝑎𝑟 𝑅# 𝜎#

§ 𝛽" measures the sensitivity of asset 𝑖 to the systematic factor

§ Market portfolio is the only systematic factor

§ APT Formula
𝜇" = 𝑟! + 𝛽"% 𝛾% + ⋯ + 𝛽"& 𝛾&
§ Linear model for expected return w.r.t. risk factors
§ Allows capturing risks from different systematic factors
Value of a Project
§ Company Z is considering a project. The company has two options:
1. Invest in the project directly
2. Pay dividends to the shareholders (S/H) & let S/H invest

Company Project

Shareholders

§ What’s the project’s value under these two options?

§ Does it matter which option is taken?
Value of a Project
§ Project value depends on its cash flow pattern, not investor identity
§ Company & S/H should use the same discount rate for valuation

Capital Budgeting Rule

The discount rate of a project should be
the expected return on a financial asset of comparable risk

§ Investor risk preference/appetite is irrelevant

§ The discount rate for a project is driven primarily by the project beta
Project Beta
§ How to compute the beta of a project?

§ If the project “looks like” an extension of the company, use the

company’s beta
§ e.g., Rogers is planning to offer a new cellphone plan
§ Called “scale enhancing” projects

§ If the project looks very different from the company, typically an

industry beta is used
§ e.g., Rogers is planning to build a condo
§ Use an average of betas of condo developers

§ If Project P is a combination of 𝑛 projects with known 𝛽% , … , 𝛽' , then

§ 𝛽( = ∑' ")% 𝑤" 𝛽" , where the weights sum to 1
Example
§ Tim Horton is opening a new location. Suppose CAPM holds, and
§ Company’s beta = 2
§ market premium = 7%
§ risk free rate = 2%.

§ What discount rate should we use to value the new location?

𝑟* = 𝑟! + 𝛽* 𝜇# − 𝑟! = 2% + 2×7% = 16%

§ The question is, what factors affect/determine 𝛽* ?

Determinants of beta
§ Why do different companies/projects have different betas?

§ Business Risk
§ Cyclicality of Revenues
§ Operating Leverage

§ Financial Risk
§ Financial Leverage
Cyclicality of Revenues
§ Highly cyclical stocks have high betas
§ High-tech firms & retailers fluctuate with the business cycle
§ Utilities & funeral homes are less dependent upon the business cycle

§ Cyclicality ≠ Variability
§ Stocks with high volatilities need not have high betas
§ Movie studios have revenues that are highly variable but low beta
§ Depends on movie quality but not the business cycle

§ This is more a qualitative idea than quantitative calculation

Operating Leverage: basic ideas
§ Definition:
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐸𝐵𝐼𝑇
𝑂𝐿 =
% 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑆𝑎𝑙𝑒𝑠

§ It can be shown that

§ High proportion of fixed cost è high OLè high risk
§ Both qualitative and quantitative

§ high OL
⇒ profits are more sensitive to sales
⇒ magnifies the effect of cyclicality
⇒ cyclicality is a determinant of beta
⇒ high beta
Operating Leverage: Example 1
§ Project A generates $250 revenue and costs $50 annually, in perpetuity.
§ 𝛽+ = 0.6, 𝑟! = 5%, 𝜇# = 10%
§ Assume CAPM holds

§ If the costs are 100% variable costs, what is the NPV of this project?
𝑟+ = 𝑟! + 𝛽+ 𝜇# − 𝑟! = 8%
$250 − $50
𝑁𝑃𝑉 = = $2,500
8%

§ If the costs are 100% fixed costs, what is the NPV of this project?
§ Fixed costs are “risk-free” (you have to pay no matter what), so
$250 $50
𝑁𝑃𝑉 = − = $2,125
8% 5%
Example 1 continued
§ If the costs are 100% fixed costs, what is the new project beta?
§ Revenue’s beta remains 𝛽,-. = 0.6
§ Fixed costs’ beta is 𝛽/0 = 0
§ Project A is a combination of revenue and costs, weighted by NPVs
$250 −$50
𝑁𝑃𝑉,-. = = $3,125, 𝑁𝑃𝑉/0 = = −$1,000
8% 5%
$3,125 −$1,000
𝑤,-. = = 1.47, 𝑤/0 = = −0.47
$3,125 − $1,000 $3,125 − $1,000

§ The project’s new beta has become:

𝛽+ = 𝑤,-. 𝛽,-. + 𝑤/0 𝛽/0 = 1.47 ∗ 0.6 = 0.88

§ Bottom line: high fixed cost è high beta è high risk

Financial Leverage
§ Definition (Debt-to-Equity ratio):
𝐷𝑒𝑏𝑡
𝐷𝐸 𝑟𝑎𝑡𝑖𝑜 =
𝐸𝑞𝑢𝑖𝑡𝑦

§ Asset is a portfolio of Debt & Equity, based on the balance sheet equation
𝐷 𝐸
𝐴 = 𝐷 + 𝐸 ⇒ 𝛽+ = 𝛽1 + 𝛽2
𝐴 𝐴

§ Usually 𝛽234"56 ≫ 𝛽1 ≈ 0, so
𝐷
𝛽2 ≈ 𝛽+ 1+
𝐸
§ Value of stock ≈ Value of equity
§ As DE ratio increases, 𝛽2 increases, stock has higher risk
beta computation in practice
§ Run a regression of stock returns against the market returns
§ Stock = equity, so 𝛽2 is obtained from regression

§ CAPM & APT computed the equity beta, not the asset beta

§ Most companies/projects are financed by the company’s asset

§ Asset is a mix of debt and equity
§ Need a “blended” discount rate

§ Need to calculate discount rate for asset. How?

Weighted Average Cost of Capital (WACC)
§ Weighted average cost of capital (WACC)
𝐸 𝐷
𝑟7+00 = 𝑟2 + 𝑟1 (1 − 𝑇0 )
𝐴 𝐴
§ 𝑟2 : cost of equity, calculated by CAPM or APT
§ 𝑟8 : cost of debt, promised interest rate on company’s debt
§ 𝑇0 : corporate tax rate

§ Cost of debt: interest paid by a corporation is tax-deductible

§ Suppose $𝑋𝑟1 interest is paid on principal $𝑋, tax-deductible
§ Tax bill is reduced by $𝑋𝑟1 𝑇0
§ After-tax interest paid is $𝑋𝑟1 − $𝑋𝑟1 𝑇0 = $𝑋𝑟1 1 − 𝑇0
§ After-tax interest rate is
$𝑋𝑟1 1 − 𝑇0
= 𝑟1 1 − 𝑇0
$𝑋
Usages of WACC
§ Investment rules, capital budgeting, CAPM/APT can all be connected
𝐸 𝐷
𝑟7+00 = 𝑟2 + 𝑟1 (1 − 𝑇0 )
𝐴 𝐴
§ WACC can be viewed as the company’s overall return on assets

§ IRR rule: accept investment projects with IRR > WACC

§ Some problems still exist: e.g., financing & mixed projects?
§ NPV/Capital budgeting: use WACC to discount EBIAT (Earnings before
interest after taxes)
§ CAPM/APT: 𝑟2 = 𝑟! + 𝛽" 𝜇# − 𝑟!
§ Formula is simple, putting right number in the right place is difficult
Example revisited
§ Recall Tim’s beta=2, market risk premium=7%, 𝑟! = 2%. In addition,
§ Tim Horton’s has a D/E ratio of 2
§ It pays 25% corporate tax
§ It’s cost of debt is 3%

§ Compute WACC for the expansion project

𝐸 𝐷
𝑟7+00 = 𝑟2 + 𝑟1 (1 − 𝑇0 )
𝐴 𝐴
1 2
𝑟7+00 = 16% + 3% 1 − 25% = 6.83%
3 3
§ We would use this cost of capital to discount cash flows of projects that
1. Have the same risk as the overall firm and
2. Are financed at the same mixed of debt/equity as the overall firm
Reducing the cost of capital
Suppose the OCF remains constant in perpetuity
𝑂𝐶𝐹
𝐴𝑠𝑠𝑒𝑡 𝑉𝑎𝑙𝑢𝑒 = 𝑂𝐶𝐹×𝑎 ∞, 𝑟7+00 =
𝑟7+00

§ Lower WACC è lower cost of capital è higher asset values

§ Therefore, managers wish to have a low WACC

§ Important task in risk management

§ Two factors that affect cost of capital

§ Risk
§ Liquidity
Liquidity
§ The ease and cost with which investors can trade a security.

§ Investors think of their final returns, net of all costs

§ transaction costs, management fees, etc.
§ All else equal, stocks with high liquidity usually have a lower WACC

§ Transaction costs include:

§ Brokerage fees: price paid to brokers to complete trades
§ Bid-ask spread: price difference for purchasing and selling a stock
§ Market impact cost: price fluctuation due to large-volume trades
Adverse Selection
§ In real life, we do not have access to all relevant information
§ Information asymmetry

§ If I believe you know more than I do, I am reluctant to trade with you
§ Knowing more è more likely to take advantage

§ If you are willing to trade with me, I suspect you know more

§ In compensation, I sell you at a higher price than I would buy from you
§ This leads to wider bid-ask spreads and less trades
§ Then causes lower liquidity
Reducing the cost of capital
§ What can companies do to reduce cost of capital?

§ Disclose more information, thus reduce information asymmetry

§ Legal compliance
§ Voluntary disclosure

§ Try to make their stock easier to trade

§ Stock split, lower unit price
§ List on more exchanges
§ Online trading