Lectures in:

Corporate Finance (ØKA2008)

Plan for the lecture
Purpose
How to find the cost of capital

Objectives
1. Determine and measure CAPM elements:
• Risk-free rate
• Market risk premium
• Beta estimation
2. Determine and measure the firm’s Weighted Average Cost of Capital (WACC)
3. Understand the importance of information to reduce capital costs
4. Know financial performance measure and Economic Value Added (EVA)

End-state
The students understand and are able to indiviually estimate
• The factors in the CAPM model
• Weighted average cost of Capital for a firm
The Cost of Equity Capital
• When a firm has extra cash
it has two possibilities:
1. Pay dividends
2. Retain earnings
• Invest this cash in new
project only if the
expected return is greater
than another asset with
comparable risk.
 The Cost of Equity Capital
• The discount rate of a project IRR A SML
should be the expected return on a
financial asset with comparable
risk! Accept region B

• From the firms’ perspective expected

return on cost of equity capital may be
found by CAPM
• Alternatively: In the Internal Rate C
of Return Approach (IRR)
choose as benchmark the rate of
return of an asset with the same Rf Reject region
risk characteristics (that is the
same beta).
Firm’s Beta (risk)

4
The Capital Asset Pricing
Model (CAPM)
𝑅𝐸 = 𝑅𝑓 + 𝛽(𝑅ത𝑀 − 𝑅𝑓 )
Where
𝑅𝐸 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝒐𝒏 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦)
𝑅𝑓 = 𝑅𝑖𝑠𝑘 − 𝑓𝑟𝑒𝑒 𝑟𝑎𝑡𝑒
𝛽 = 𝐵𝑒𝑡𝑎 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑒𝑐𝑢𝑟𝑖𝑡𝑦
𝑅ത𝑀 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑚𝑎𝑟𝑘𝑒𝑡

𝑅ത𝑀 − 𝑅𝑓 = 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑒𝑥𝑐𝑒𝑠𝑠 𝑚𝑎𝑟𝑘𝑒𝑡 𝑟𝑒𝑡𝑢𝑟𝑛

or market risk premium
 The Capital Asset Pricing Model (CAPM)
𝑅𝐸 = 𝑅𝑓 + 𝛽(𝑅ത𝑀 − 𝑅𝑓 )

With CAPM we have the tool to estimate the firm’s cost of

equity capital. To use the model we need three inputs:
a. The current risk-free rate
b. The expected market risk premium, the premium expected
for investing in risky assets, i.e. the market portfolio over
the riskless asset
c. The beta of the asset being analyzed
 The Cost of Equity Capital - exercise
Assume a 100% equity financed company has a beta of 2.29.
The firm is about to expand and concider some new projects. These
projects are similar to the firms existing projects (the beta of firm and
project is the same).
Assume risk-free rate of 1.5% and market risk premium of 7.2%
(That is expected return on the market minus risk free rate)

What is the appropriate discount rate for the project?

5 minutes
The Cost of Equity Capital –
Example 2
Glencore, the natural resource company:

Assume all equity firm with a beta of 1.24

Market risk premium is 7.5% and risk free rate is 2%

The expected return for Glencore’s equity is?

E(R) = 2% + 1.24 X 7.5% = 11.3 %

 The Cost of Equity Capital –
Example 2 cont.
Glencore is evaluating three non-mutual exclusive projects:
Project Beta of Expected CF IRR of NPV of Project Accept or
Project next year project (%) (11.3%) Reject
A 1.24 140 40 25.79 Accept
B 1.24 120 20 7.82 Accept
C 1.24 110 10 -1.17 Reject

The initial cost for each project is 100, and they have the same risk as the
company.

As we can see:
• We accept the projects with positive NPV
• An all-equity firm should accept a project when IRR>cost of equity capital
In order to find the cost of equity capital
in practice you need estimates of:

I. Risk-free rate
II. Market risk premium
III. Company’s Beta
I. Risk-free rates
• On a risk-free asset the actual return is the expected
return, i.e variance and standar deviation are zero.
• Two criteria to be fulfilled:
1. No default risk
• In practice this implies that there should be a security issued by a
«safe» AAA-rated government
2. No uncertainty about the reinvestment rates
• It is a zero-coupon security with the same time horizon (maturity)
as the cash-flow analyzed
Source: Wikipedia
Choice of risk-free rate
• Time horizon
• On investment with long time-horizon use government bonds with
long maturity (e.g., 10 year or even 30 year dependent on the CF
analyzed). For short-term investment use short-term government
securities, e.g., 3 month T-Bill
• Note however, that only treasury bills are zero coupon - there can
be interest rate risk in long term bonds since they are coupon
bearing
• Currency
• The risk-free rate you choose should be in the same currency as the
risk-free rate. I.e. for Norwegian CFs use Norwegian risk-free rates,
for German CFs use German Euro government securities and so
on.
Risikopremien i det norske markedet 2018
(«Risk premium in the Norwegian Market 2018»)

“Respondents were asked what

should be used as risk-free interest
rate in the return of equity for
Norwegian companies. The
proportion of respondents
responding stating that 10-year
government bonds should be used
is 34% in this year's survey
compared to 35% in last year's
survey”.

Source: https://www.pwc.no/no/publikasjoner/risikopremien-2018.html
II. Market risk premium
• The (expected) premium the investors demand for investing
in the market portfolio (average risky asset) relative to the
risk-free rate
• The premium should be:
• Greater than zero
• Increase with increasing risk-aversion
• Increase with increased riskiness in the market
Choice of market risk premium in
practice
1. Surveys
• For example In Norway PWC publishes a survey on the market risk
premium in the Norwegian market.
2. Estimating historical premiums
• Determine a relatively long specific period, i.e. last 30-50 years
• Find average stock return
• Find average return on riskless assets (governmental bonds)
• Use the difference of the historical averages to use as a premium looking
forward
• PWC: Currently 5 % is commonly used in Norway – but this
changes as the riskiness changes.
• KPMG Netherlands: Market risk premium as per 30 September
2018: 5.5 %
• https://www.pwc.no/no/publikasjoner/risikopremien-2018.html
• https://assets.kpmg/content/dam/kpmg/nl/pdf/2018/advisory/equit
y-market-risk-premium-research-summary-september-2018.pdf
 III. Estimation of Beta
Beta measures the volatility of an assets return relative to the
total market, and is thus a measure of the risikiness relative to
the market

How to estimate Beta:

𝐶𝑜𝑣(𝑅𝑖 ,𝑅𝑀 ) 𝜎𝑖,𝑀
1. Using the Beta formula on returns: 𝛽𝑖 = 2 = 2
𝜎 (𝑅𝑀 ) 𝜎𝑀
2. In Excel (or another spreadsheet) you could also plot the
return of the asset and the market return in a scatterplot,
add a trendline and the slope of the trendline is the Beta
3. Regress asset returns against market index returns and
find Ri = a + b Rm where a is the intercept and b is the
slope of the regression which equals the Beta
Estimation of Beta
Set-up for estimating Betas
• Decide the estimation period
• Longer period gives more data, but firms change over time. 2-5
years of data are typically used
• Decide on the ferquency of the data (daily, weekly, monthly)
• Higher frequence gives more data, but also suffer from noise.
Typical monthly (or weekly) data would be better
• Remember to include dividends in months where these are
paid
• Choose a market index
• Typically a stock-market benchmark index, OSEBX, S&P 500, FTSE
100 etc.
 Be aware of:

• Beta may vary over time

• The sample size (and frequency) matter
• Betas are influenced by leverage and business risk
• Be critical to Betas. Look at averages and compare several comparable
firms
 Use of Industry Beta

• Error in beta estimation on a single equity is much higher

than the error for a portfolio of securities?

• So when to use the industry or the firms beta?

• Similar to the «industry»
➢Use industry beta
• Operations from the firm are different from the «industry»
➢Use firm beta
 Industry Beta vs Firm Beta
• Assume rf=2% and market risk premium of 6%

• Using firm beta of 1.46

• The cost of equity capital:
𝑅𝐸 = 2% + 1.46 × 6% = 10.75%

• Using industry beta of 0.985

• The cost of equity capital:
𝑅𝐸 = 2% + 0.985 × 6% = 7.91%
 Exercise
Samsung Electronics is a Korea-based company principally engaged in the
manufacture and distribution of electronic products. They want to expand
even more and invest in products similar to their existing production line.
The expected annual return on the world market is 11%. The expected
return on the risk-free rate you can achieve is 2% annually. The beta for
Samsung Electronics and its peers is approximately 1,4. Assume Samsung
is 100% equity financed.
a) What is Samsung’s cost of equity capital?
b) For what purpose will you use this number
c) Assume the project will last for 4 years. Below you have the cash flows
for the project (stated in mill USD). Will you invest in this project?
Year 2019 2020 2021 2022 2023
Cash Flow -100 20 30 40 50
15 minutes
The Determinants of Beta

• The Beta is determined by several factors:

• The book explains three:

1. Cyclicality of Revenues
2. Operating Leverage
3. Financial Leverage
 1. Cyclicality of Revenues

• Industry effects: Sensitivity of product or service demand and of

its cost to macroeconomic factors affecting the market:

• Cyclical industries have higher betas than non-cyclical

• Firms selling luxury goods (elastic demand) should have
higher betas than firms selling more basic goods (inelastic
demand)
• Growth firms should have higher betas than mature
companies
• Small firms have higher betas than larger
 2. Operating Leverage
• The proportion of total costs that are fixed
• High operating leverage results in greater earnings variability and
thus higher betas

• Measuring operating leverage

• Fixed costs/Variable costs: Higher proportion – higher operating leverage
• Percentage change in EBIT / Percentage change in Revenues: Higher
number – higher operating leverage

If we cannot calculate the beta, we can examine the projects revenues and
leverage
High beta: cyclical revenue firms (projects) with high operating leverage.
Low beta: weak cyclical and low operating leverage firms (projects)
3. Financial Leverage & Beta

Financial Leverage: Firm with debt in capital

structure

• With debt the fixed costs of a firm increases due to

interest payments. This make earnings to equity
more volatile and thus increases equity beta

• Beta of the assets of a leveraged firm is thus

different from the Equity beta we previous looked at
(𝑅𝐸 = 𝑅𝑓 + 𝛽(𝑅ത𝑀 − 𝑅𝑓 ))
 Beta of a levered firm (Asset beta)

• We know from previous lectures that:

𝑁

෍ 𝑋𝑖 𝛽𝑖 = 𝛽𝑃
𝑖=1

• Thus the total Asset Beta should be the sum of

Weighted Equity Beta and Weighted Debt Beta
𝐸 𝐷
• 𝛽𝑎𝑠𝑠𝑒𝑡 = × 𝛽𝐸 + × 𝛽𝐷
𝐸+𝐷 𝐸+𝐷
• E: Equity
• D: Debt
Beta of the Levered Firm
𝐸 𝐷
𝛽𝑎𝑠𝑠𝑒𝑡 = × 𝛽𝐸 + × 𝛽𝐷
𝐸+𝐷 𝐸+𝐷
• In practice the beta of debt is low. If we assume this beta to be
zero:
𝐸
𝛽𝑎𝑠𝑠𝑒𝑡 = × 𝛽𝐸
𝐸+𝐷
Further: E/(E+D)<1 𝛽𝑎𝑠𝑠𝑒𝑡 < 𝛽𝐸

Rearranging:
𝐷
𝛽𝐸 = 𝛽𝑎𝑠𝑠𝑒𝑡 1+
𝐸
Debt betas

Close to zero:

Berk and DeMarzo 3rd ed.

Exercise
• The value of a company is 100 MNOK. The company has 40
MNOK in debt. The equity beta is 1.2. The beta of debt is 0.
What is the beta of the levered firm?

5 minutes
Financial Leverage and Beta - Example
• A company is currently all equity with a beta of 0,8. The
company decides to change the capital structure, so the
D/E=0,5

• Since the company stays in the same industry, we

still expect the asset beta is still 0,8.

• We assume zero beta for debt, and find the equity

beta:
𝐷
• 𝛽𝐸 = 𝛽𝑎𝑠𝑠𝑒𝑡 1 +
𝐸
1
• 𝛽𝐸 = 0,8 1 + = 1,2
2
Extensions of the Basic Model: Firm Versus Project

• Betas may vary:

• Is it a similar project as existing?:
• Then use the firm beta to discount

• Beta of new project may be greater (even

if it is in the same industry:
• New companies may react greater to
economywide movements.
Estimating Beta of non-traded assets

• You have no relevant stock return data

• Calculate unlevered beta of comparable (traded) firms and
calculate the beta with the firm’s leverage

• Another possibility is to use accounting earnings

Moving from Cost of Equity to Cost of Capital
• From Lecture 1 we know that firms can raise cash in two
ways
• Equity
• Debt

• Most firms use a combination of debt and equity to fund an

investment
• The question is:
• What is the cost of capital spendings? i.e, what interest rate should
we use when calculating the NPV of an investment?
 The Cost of Capital with Debt - WACC
• Assume a firm use both equity and debt to finance its investment
• It pays 𝑅𝐷 for its debt financing (The borrowing rate)
• It pays 𝑅𝐸 for its equity

• What is the overall cost of capital or Weighted average cost of

capital (WACC)
𝐸 𝐷
𝑅𝑊𝐴𝐶𝐶 = 𝑊𝐴𝐶𝐶 = × 𝑅𝐸 + × 𝑅𝐷
𝐷+𝐸 𝐷+𝐸
• WACC after tax:
𝐸 𝐷
𝑅𝑊𝐴𝐶𝐶 = 𝑊𝐴𝐶𝐶 = × 𝑅𝐸 + × 𝑅𝐷 × (1 − 𝑡𝑐 )
𝐷+𝐸 𝐷+𝐸
 WACC – An Example
• Assume a company with debt of €4.4 billion and
market value of equity of €71.4 billion.
• The bond they have on issue is paying an interest
of 6% p.a.
• The company’s shares have a beta of 1.81.
• The effective tax rate is 13.1%
• Assume SML holds (CAPM). The risk premium for
the market is 9.5% and the Treasury bill rate is
4.5%

What is the firms WACC (after tax)?

 Example
𝐸 𝐷
• 𝑅𝑊𝐴𝐶𝐶 = 𝑊𝐴𝐶𝐶 = × 𝑅𝐸 + × 𝑅𝐷 × (1 − 𝑡𝑐 )
𝐷+𝐸 𝐷+𝐸
• E = €71,4 billion
• D = €4.4 billion
• RE = CAPM = 4.5%+ 1.81x 9.5%=21.695%
• RD = 6%
• tc = 13.1%
71.4 4.4
• 𝑊𝐴𝐶𝐶 = × 21.695% + × 6% × 1 − 13.1% = 𝟐𝟎. 𝟕𝟑𝟖%
4.4+71.4 4.4+71.4
WACC – An Example Project
Evaluation
• Assume a firm with a D/E-ratio of 0,6 and a cost of
debt of 15.15%, and cost of equity of 20%. Assume
tax rate of 34%.
• Assume you invest in a warehouse renovation that
cost £50million. This renovation will generate
£12million per year for 6 years.

• Calculate the net present value (NPV) of this

project.
Example project evaluation
𝐸 𝐷
• 𝑅𝑊𝐴𝐶𝐶 = 𝑊𝐴𝐶𝐶 = × 𝑅𝐸 + × 𝑅𝐷 × (1 − 𝑡𝑐 ), D/E=0.6 => 6/10
𝐷+𝐸 𝐷+𝐸
• E = 10
• D=6
• E+D=16
• RE = 20%
• RD = 15.15%
• tc = 34%
10 6
• 𝑊𝐴𝐶𝐶 = × 20% + × 15.15% × 1 − 34% = 𝟏𝟔. 𝟐𝟓%
6+10 6+10
12 12 12 12 12
• 𝑁𝑃𝑉 = −50 + + + + + +
1+16,2% 1+16,2% 2 1+16,2% 3 1+16,2% 4 1+16,2% 5
12
6 =-6.07
1+16,2%
Exercisse
CorpFin ASA is 100% equity financed and have a beta of 1.1. The
expected market risk-premium is 8,5% and the risk-free rate is
4,2%.
a) What is the cost of capital for CorpFin ASA?
b) CorpFin ASA considering changing its capital structure so it has
25% debt financing and 75% equity. The borrowing rate is 6%
after tax. The beta will increase to a level of 1,2 after this
change in the capital structure. What will the total cost of capital
(WACC) be for CorpFin ASA after this change in capital
structure?

10 minutes
Reducing Cost of Capital
Expected return and cost of capital are assumed positively related
to risk

However

Expected return and cost of capital are negatively related to

liquidity as well

• It is difficult to lower the firm’s risk, but easier increase the liquidity
of the firm’s equtity
• A firm can lower its cost of capital through liqudity enhancements
Reducing Cost of Capital
▪ Trading non-liquid shares
reduces the total return

• Liquidity is the Cost of ▪ Investors demand higher

Cost of capital
expected return when investing
buying and selling in stocks with high trading costs.
▪ Risk-return trade off.
• Expensive to trade=low
liquidity

1. Brokerage fees
2. Bid-ask spread
3. Market impact cost

Liquidity
Liquidity and Adverse Selection

• A trader will lose money on a trade if she/he has less

information than its counterparty

• A high ratio of informed to uninformed traders will

increase the bid-ask spread
• Informed traders will pick off the market – uninformed will
not
• Contribute to increase cost of capital
What can Corporations Do?
• Incentive to lower trading costs because this lowers the cost of
capital

1. Bring in more uninformed investors

• Stock splits to attract smaller investors

2. Give out more information

• Narrows gap between informed and uninformed
Security analysts
• Employed by brokerage houses to follow companies in
individual industries
• Distribute information to the house’s clients
• Contribute to narrow gap between informed and uninformed and
reduce bid-ask spreads

• However smaller firms are often ignored

• Higher bid-ask spread and higher cost of capital
• A good advice is to be friendly to analysts and give them as much
information as possible
Estimation of Cost of Capital in Practice
The book states that there are differences between
countries
• Most commonly (by far): CAPM
• Historical returns
• Investors opinion play an important role in many
European countries
• Regulators play an important role in the UK and France
while not considered at all in Germany
 Example: Norwegian Power Utilities
Thore Johnsen Øyvind Nordli Thema Consulting
NHH (2017) BI (2017) (2017)
Asset Beta 0.8 0.7 0.6
Equity Beta 1.5 1.0 1.5
Debt Beta 0.2 0.3 0.0
D/E-ratio 1 0.67 1.5
WACC (after tax) 7.40 % 4.95 % 5.90 %
Thema (2017) Kapitaliseringsrenten i formuesberegningen,
THEMA Report 2017-3.
Thore Johnsen, NHH 2017. Risikotillegget i
kapitaliseringsrenten. Report to the Ministry of Finance
Øyvind Norli, BI 2017. Vurdering av risikotillegget i
kapitaliseringsrenten. Report to the Ministry of Finance

Thore Johnsen, NHH 2017. Risikotillegget i kapitaliseringsrenten. Report to the Ministry of Finance
Measurement of Financial Performance
• Capital budgeting and performance measurement are
essentially mirror images
• Capital budgeting is forward-looking
• Performance measurement is backward-looking

• A popular performance measurement is Return on Assets

(ROA)
• ROA=Earnings after tax/Total Assets x 100%

• However as the asset base increases, the ROA will drop

because it is a percentage number – thus highly profitable
investments will not be made
Example: Bodie’s Blimps
• After-tax earnings 2,000,000 and asset base 2,000,000 => ROA=
100 %
• WACC=20%
• New project earns 1,000,000 per year of an initial investment of
2,000,000 i.e an ROA of 50 % and far over the WACC
2,000,000+1,000,000
• However this will reduce ROA = 75%
2,000,000+2,000,000

• Because the management are rewarded upon ROA the project will
not be invested in
Economic Value Added (EVA®)

Takes into capital costs (WACC)

EVA=(ROA-WACC) x Total Capital

or (since ROA x Total Capital = Earnings after
tax)
EVA= Earnings after tax – WACC x Total Capital
• Monetary number which can be viewed as earnings after
capital costs
Example: Bodie’s Blimps continued
• After-tax earnings 2,000,000 and asset base 2,000,000 => ROE=
100 %
• WACC=20%
• New project earn 1,000,000 per year of an initial investment of
2,000,000 i.e an ROA of 50 % and far over the WACC
2,000,000+1,000,000
• However this will reduce ROA = 75%
2,000,000+2,000,000

EVA performance measure:

• Without new project: (100% - 20%) X 2,000,000 = 1,600,000
• With new project: (75% - 20%) X 4,000,000 = 2,200,000
 Economic Value Added pros &
cons
• EVA can increase investments for firms that are currently
underinvesting.
• And the opposite: Act as a brake for managers that are too focused on
increased earnings that they take on projects without justifying capital
outlays
• Negative EVA: division are destroying more value than they are
creating

• Drawbacks of EVA:
• It is a performance measure only and has little to offer for capital budgeting
1. Focuses only on current earnings
• Capital budgeting (e.g., NPV): projects future (varying) cash flows
• Also NPV take into account WACC
2. Reward managers that create high earnings today
• What about future losses?
• The measure stimulates shortsightedness of the managers
Exercise
A shipping company is 100% equity financed, with a beta of 0.9.
The annual expected return on the market is 14% and the risk-free
rate is 8% p.a.
a) What is the company’s on equity cost of capital?
b) The company changes its capital structure, such that D/V=30%.
This will result in an increase of the beta to a value of 1.1. The
cost of debt capital is 7% pre tax, and the effective tax rate is
20%. What is the WACC?
c) You want to buy a new ship. The price for the vessel is
$50 000 000. Your estimated cash flow from the vessel will be
as in the table below. Will you invest in this vessel?
Year 2017 2018 2019 2020 2021

Cash Flow -50 15 15 20 30

15 minutes