Cost of Capital

Week 3
IB125 Foundations of Financial Management
Jesús Gorrín

Key Readings: Hillier et al. Chapters 9.1-9.4, 10.1-10.2, 10.8-10.10, 12.1-12.2

PRESENT VALUE
 Remember: the present value of a stream of expected future
incremental cash flows C1, C2,..., CT
C1 C2 C3 CT
...
0 1 2 3 T
C C C C
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PV = 1
+ 2
+ + ... + T

1+ R (1 + R) 2 (1 + R) 3 (1 + R) T
 But how do we determine the discount rate R?
 How do we adjust the discount rate for risk?
 Discount rate R is the opportunity cost of capital:
 i.e. rate of return that investors could obtain for themselves by investing
instead in a well-diversified portfolio of financial securities with the same level
of risk as the project
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PRESENT VALUE
 Imagine you can invest in one of two projects
 Required investment: £96
 First project is riskless: get £100 in one year
 Second project is risky

50% £150

-£96

50% £50

 Which project do you invest in?

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RISK AVERSION
 What is the expected return of the safe project?
 What is the expected return of the risky project?

E[CF1 ]  I 0
E[ R] 
I0

 A risk neutral person is indifferent between these 2 projects

 A risk averse person would choose safe project
 A risk loving person would choose risky project

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RISK AVERSION

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WHY INVEST IN RISKY PROJECTS?
 Trade-off between risk and return:
 investors prefer more wealth to less wealth, but are risk averse
 hence, return required by investors:
Required
Return
Risk
premium

Risk-free
Return
(Rf)
Risk

E[R] = Rf + Risk Premium

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WHAT DETERMINES THE RISK PREMIUM?
 For risk-averse person, risk premium > 0
 but just how positive should it be…?
 Financial markets provide the answers
 highly efficient at pricing securities

 Suppose that you can invest £96 in the portfolio of market securities, e.g. S&P 500
index

50% £130

-£96

50% £80

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MARKET RISK PREMIUM
 What is the expected return on the market portfolio?
 E[RM] = …
 E[RM] = Rf + Market Risk Premium
 Market Risk Premium = E[RM] - Rf = …

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ESTIMATION OF MARKET RISK PREMIUM
 Estimating the market risk premium:
 Historical arithmetic average of E[RM] − RF
 for most of 20th Century, E[RM] − RF in UK averaged 8% to 9%
 for a variety of macro-economic reasons (e.g. lower, more stable inflation) a
better estimate of market risk premium at start of 21st Century is 4% to 6%

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SENSITIVITY OF A PROJECT TO MARKET RISK
 What is sensitivity of our project returns to the market portfolio returns?

E[RM] E[Ri]
Bullish economy 35.41% 56.25%
Bearish economy -16.7% -47.91%
Difference 52.11% 104.16%

 Sensitivity (β) =…

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INTUITION BEHIND 𝜷
 Beta measures degree to which returns on asset i on average move in step with
returns on the market portfolio

Cov( Ri , RM )
i 
 2 ( RM )

 When the stock market rises (or falls):

 the prices of high- β securities rise (or fall) faster than the market
 the prices of low- β securities rise (or fall) more slowly
 For most UK equities, the value of β lies within 0.7 and 1.3

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SYSTEMATIC VS IDIOSYNCRATIC RISK
 Beta (𝛽) is a measure of a systematic risk
 Systematic risk: risk that cannot be
diversified away
 Diversification: Strategy designed to
reduce risk by spreading the portfolio
across many investments
 Specific Risk: Risk factors affecting only
that firm, also called “diversifiable risk”
 Market Risk: Economy-wide sources of Source: Brealey, Myers and Allen (2011), 10th ed.
risk that affect the overall stock market,
also called “systematic risk”

 only risk that cannot be diversified is

rewarded by financial markets with
additional return

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ESTIMATING BETA
 Traded equities:
 estimate slope of best-fit line in regression of Ri − RF against RM − RF for
time series data of returns

Source: Hillier et al (2013), 2nd European ed.

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ESTIMATING BETA
 Non-traded equities:
 Comparable companies approach
 Similar companies have same systematic risks
 Normally: companies from the same industry
 Take average beta of comparable companies
 Seminar exercise on comparable companies approach

 Which asset has a beta of zero?

 Which asset has a beta of one?

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SECURITIES MARKET LINE
 Graph of expected return E[R] vs. beta is a straight line called Securities Market Line
(SML):

E[R]]
M SML
E[RM]
Slope: E[RM]−RF
RF

0 1 beta

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CAPITAL ASSET PRICING MODEL
 The Securities Market Line is the graph of the Capital Asset Pricing Model (CAPM).

 In other words, the CAPM says that:

 Expected return on asset i = risk-free rate + (beta of asset i) x (market risk premium)

 In symbols, CAPM is written as:


E ( Ri )  R f   i  E ( RM )  R f 

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COST OF CAPITAL
 Cost of Capital: The return the firm’s investors could expect to earn if they
invested in securities with comparable degrees of risk

 Capital Structure: The mix of long-term debt and equity financing

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COST OF EQUITY VS COST OF DEBT
 Return on equity (or: cost of equity) rE
 Appropriate for discounting dividends
 Opportunity cost: expected return on an alternative investment with the
same beta

 CAPM: E (rE )  R f   E  E ( RM )  R f 
 Return on debt (or: cost of debt) rD
 Appropriate for discounting interest and principal repayments

 If debt is investment grade, rD  R f

 If default is not unlikely, D  0


E (rD )  R f   D  E ( RM )  R f 
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WACC FORMULA
 Pre-tax Weighted Average Cost of Capital (WACC)

 WACC = (proportion of debt) x (cost of debt) + (proportion of equity) x (cost of equity)

D E
WACC   rD   rE  rA
DE ED
 D = market value of debt
 E = market value of equity = # shares × price per share

 But: Interest payments on debt are tax deductible

 After-tax Weighted Average Cost of Capital (WACC)
D E
WACC   (1  Tc )  rD   rE  rA
DE ED
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WACC
 WACC represents the overall return on the firm’s assets required by providers of firm’s
capital.

 Company cost of capital = Weighted average of debt and equity returns

 WACC provides a benchmark:

 rate of return required on “average-risk” projects undertaken by company

 Need to use a higher (or lower) rate to discount cash flows from projects with higher
(or lower) risk than “average-risk” project.

 More about WACC when we discuss a firm’s capital structure.

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AFTER-TAX WACC EXAMPLE
 The British TaxSaver plc is financed with
 £150 million (market) equity, cost of equity = 10%
 £100 million debt, long-term borrowing rate = 5%
 Tax rate T = 30%

Market Values (in £ millions) Cost of Equity / Debt

Debt (D) 100 rD 5.00%
Equity (E) 150 rE 10.00%
Firm Value 250 Pre-tax WACC 8.00%

Tax rate T 30.00%

Tax subsidy r D (D/V)T 0.60%
After-tax WACC 7.40%

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CONCLUSIONS
 CAPM (or SML) quantifies the relationship between expected return and systematic risk for any asset
(or portfolio of assets):
 E[Ri]= RF +βi·(E[RM] − RF)
 where exposure to systematic risk is measured by asset’s βi

 Cost of capital is rate of return required by providers of firm’s finance:

 shareholders expect to earn cost of equity on their shareholdings
 lenders expect to earn cost of debt on their loans

 WACC equals weighted average of cost of debt and cost of equity:

 weights equal to the proportions (by market value) of equity and debt financing in the
company’s capital structure
 WACC is a key input to corporate financial decision-making:
 equals return on a firm’s assets required on average by providers of firm’s capital
 reflects overall risk level of firm’s operations

 Cost of debt is reduced by corporate tax shield: interest payments on debt are tax deductible.

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