Corporate Finance (FINA0050) 2023 Block 4vshort

Corporate Finance
Lectures and Seminars
5th October 2023
Corporate Finance: Lectures and Seminars, HEC Liège 2023-2024 – Marie Lambert 1
Corporate Finance
Lectures and Seminars
Block 4 – Cost of capital
Outline
• Module 1 - Required rate on the assets for an all-equity

financed firm: The cost of equity
• Module 2 - Required rate on the assets for a leveraged firm.
Assumption of no corporate tax
• Module 3 - Required rate on the assets for a leveraged firm.
With corporate tax
• Module 4 - Conclusions on WACC, Cost of equity, ROE and
ROC
• Module 5 - WACC, private firms and new projects
Module 1
Required rate on the assets

for an all-equity financed firm:
The cost of equity
• Required rate
– on the assets of the firm
– on one project = small-scale representation of the firm’s
assets
Asset A Equity E
- with Debt = 0, no taxes

• The cost of equity financing
This rate of return can be determined in many ways.
- Typically, one uses expected return formulas from

the CAPM
- One could also use multifactor models (see infra)
• CAPM: getting the expected returns - three inputs
- Riskless asset: an asset for which the investor

knows the expected return with certainty for the time
horizon of the analysis
- The risk premium: premium required by the
investors for investing in the market portfolio, which
includes all risky assets in the market, instead of
investing in a riskless asset
- Beta: measure of the risk added by an investment to
the market portfolio
• CAPM: getting the expected returns, 2 key

questions
– What is beta?
– Which risk-free rate?
• Measure of systematic risk: Beta
- The beta of the market portfolio is 1
- Assets that are riskier than average will have betas

that exceed 1
- Assets that are safer than average will have betas

that are lower than 1
- The riskless asset will have a beta of 0

• Multifactor model
– Size premium
– Country risk premium
• Multifactor model (Fama-French, 1993): Size
premium
– Adding a “small size premium” to CAPM
E(Ri) = [Rf + bi * ERP] + Size premium
Extension of the CAPM: Multifactor model
• Country risk premium (CRP)
– Common practice in the industry
– Might be incorrect from a theoretical standpoint:
• Country risk is a diversifiable risk
• This risk could be reflected in cash flow estimates (using

probabilities of the different scenarios linked to the emerging
country).
• Market portfolio (world versus local) depends on the

shareholder structure.
Extension of the CAPM: Multifactor model
• Country risk premium (CRP) in practice (!) not in
theory…
– Assumption 1: sensitivity to emerging market risk is similar for all
companies in the emerging country (i.e. = 1):
The two
• Add CRPemerging market to CAPM assumptions might
• E(Ri) = [Rf + bi * ERP] + CRPemerging market not yield the same
result! Read the
Not adjusted by bi à “bCRP” = same for all firms = 1 assumption!
– Assumption 2: firm’s sensitivity to emerging market risk is the
same as the firm’s sensitivity to its market (the market portfolio is
considered to be a global index):
• Adjust CRPemerging market with bi

• E(Ri) = Rf + bi * ERP + bi * CRPemerging market
• E(Ri) = Rf + bi * (ERP + CRPemerging market)
Which risk-free rate ?
Getting rid of financial and

economic risks
Financial and economic risks
• Default risk
• Interest rate risk: risk of realisation
• Interest rate risk: risk of reinvestment
• Liquidity risk (bid-ask spread)
• Default risk à Government bonds
To avoid interest
• Interest rate risk: risk of realisation rate risk, one need
to match the
duration of the
• Interest rate risk: risk of reinvestment financial
instruments with
the one of the
• Liquidity risk (bid-ask spread) assets (long-term)
Which risk-free?
Pay attention, bond yield vary

with bond maturity!
Yield curve
Explaning the yield curve
• Expectation hypothesis
• Liquidity hypothesis
Module 2
Required rate on the assets for

a leveraged firm. Assumption of no
corporate tax
• Firm or Project = small-scale representation of the

firm’s assets
Asset A Debt D
Equity E
- with Debt ≠ 0, no taxes
• Computing a project/firm’s cost of capital from the

firm’s financial claims
- The firm must have the same risk profile as the project
being valued and should work in the same business
- The project must then have the same beta
• Traded companies: defining the cost of capital of

the firm
Weighted average cost of capital (WACC)
E D
RWACC = RE + RD
D+E D+E
where RE could be estimated by using the CAPM: the
cost of equity is determined upon the beta of the
equity in the firm
• The cost of capital of the firm
Cost of capital : R (%)

RE = R0 + (R0 − RD) D/E RE
RE is the cost of equity

R0 RWACC
RD is the cost of debt
R0 is the cost of capital for an all-equity firm RD
RWACC is a firm’s weighted average cost of capital.
In a world with no taxes, RWACC for a levered firm
is equal to R0 Debt-equity ratio (D/E)
R0 is a single point whereas RE ,RD ,and RWACC are all entire lines
The cost of equity capital, RE , is positively related to the firm’s debt-equity ratio
The firm’s weighted average cost of capital, RWACC , is invariant to the firm’s debt-
equity ratio Ross, Westerfield and Jaffe (8th edition, p. 433)
• Effect of leverage on equity betas
- The amount of debt financing a firm takes on can

dramatically affect equity betas
vs.
- In absence of corporate taxes, asset beta should not be

affected by the capital structure
• Business risk and financial risk
æ D ö æ E ö
bA = ç b +
÷ D ç ÷b E
èD+Eø èD+Eø
æ Dö æDö
à b E = ç1 + ÷ b A - ç ÷ b D
è Eø èEø
WACC has two components:
1. I got it for cost of equity (see module 1)
2. How do I compute cost of debt?
Required rate on the assets: Cost of debt
• Should be an effective rate

– Risk free-rate + credit spread
– Yield to maturity
• The unknown y is the discount rate that equates the
price of the bond with the discounted value of the
coupons
- Example: A two-year bond with a 10% coupon pays
interest of $100. The bond is reimbursed at its face
value. If the bond is selling at $1,035.67, what return
is a bondholder receiving
à The bond is yielding a 8% return
Module 3
Required rate on the assets for

a leveraged firm with corporate tax
Let’s introduce corporate taxes…
• Firm or Project = small-scale representation of the

firm’s assets
Asset A Debt D
Equity E
- With corporate taxes
• Capital structure with taxes
The levered firm pays less in taxes than does the all-equity
firm. Thus the sum of debt plus the equity of the levered firm is
greater than the equity of the unlevered firm
Ross, Westerfield and Jaffe (8th edition, p. 440)
• Adjusted discount rate
- Weighted average cost of capital of the project:

RWACC = wE rE + wD (1 - TC )rD
Market value of equity over Market value of debt over
market value of all financing market value of all financing
à expected return on equity to investors, r E

à expected return on debt to investors, rD
≠ expected after-tax cost of debt to the firm rD (1 - TC )
• Expected return paid by the firm to its shareholders

= the expected return received by the equity holders
• Expected return paid by the firm to its bondholders

≠ the expected return received by investors
à The tax deductibility of interest implies that the cost of
debt financing to a corporation may be less than the rate of
return on a firm’s debt received by the firm’s debtholders

RE
• Risk-adjusted discount rate .2351
.20 = R0
RWACC
Financial leverage adds risk
to the firm’s equity. As .10 = RD
RD
compensation, the cost of
equity rises with the firm’s 200
risk. Note that R0 is a single 370
Debt-equity ratio (D/E)
point whereas RE ,RD , and
RWACC are all entire lines

• Risk-adjusted discount rate with corporate taxes
- The weighted average cost of capital is normally used as

the risk-adjusted discount rate whenever a firm’s new
projects are in the same general risk class as its existing
projects
- If the project is not a small-scale representation of the

firm’s asset and/or the firm is not traded, use the peer
group method (see module 5)
Quizz
Let’s test the concepts!!
Question #1
• The beta of the equity captures
1. Business risk only

2. Financial risk only
3. Business and financial risks
Question #2
• You are estimating the cost of equity for a US firm which

distributes its products in the emerging markets. You want
to account for this additional country risk.
You are using a risk-free rate of 5.0% and the U.S. equity
market risk premium of 4.5%. The equity beta for the firm
is 1.6 and you estimate a country risk premium for the
country of 2.5% (with a beta equal to one). What is the cost
of equity for this firm after incorporating country risk
premium?
1. 12.2% 2. 14.7%
3. 11.2% 4. 16.2%
Question #3
• Silicon Corp. recently issued a 10-year, 15 percent coupon bond at par

value (annual coupon). Silicon's beta is 0.8; the optimal capital
structure contains 45 percent debt/55 percent equity; and the
marginal tax rate is 40 percent. If the expected return on the market is
18 percent and the risk-free rate is 4 percent, estimate Silicon's
weighted average cost of capital.
1. 13.95 percent 5. 18.76 percent

Module 4
Conclusions on WACC, Cost of

equity, ROE and ROC
Weighted Average Cost of Capital
The appropriate rate is estimated by taking a weighted average of the
required rates of return on debt and equity, weighted by their
proportion of the firm’s market value in the following way
CAPM
Risk-free rate
Beta
Proportion of
Cost of equity
equity
Risk premium
Size/country
premia
WACC
Cost of debt
Proportion of Real cost of (gross)
debt debt
Corporate tax
rate
Firm competitive advantage
• Value creation if the firm’s ROE is superior to the

required return on equity (CAPM) or if the ROIC is
superior to WACC
Residual
ROE > cost of income* > 0
equity (CAPM) V>B
ROIC > WACC * Also called
EVA
Copyright © 2013 CFA Institute
Module 5
WACC, private firms and new projects
• Risk-adjusted discount rate with corporate taxes
- The weighted average cost of capital is normally used as

the risk-adjusted discount rate whenever a firm’s new
projects are in the same general risk class as its existing
projects
- If the project is not a small-scale representation of the

firm’s asset and/or the firm is not traded, you can’t use or
compute the WACC of the firm. In this case, use the peer
group method
Without corporate taxes…
• Beta comparable method: the effect of leverage on

comparisons
æ D ö æ E ö à b E = æç1 + D ö÷ b A - æç D ö÷ b D
bA = ç b +
÷ D ç ÷b E
èD+Eø èD+Eø è Eø èEø
à Unlevering equity beta into an asset beta
à Plug b A into the CAPM to find the risk-adjusted

discount rate
à … OR… use the « Weighted Average Cost of Capital »
• Computing a project’s WACC from a peer group
- The comparison firm must have the same risk profile,

be active in the same business as the project being
valued
- The WACC of the comparison firm can be used to

discount the expected real asset cash flows of the
project
Stage 1 – Collect financial data about a peer group of

firm operating in the same business
Stage 2 – Compute their equity betas (using historical

data)
• Remember this!!

RE = R0 + (R0 − RD) D/E RE
RE is the cost of equity

R0 RWACC
RD is the cost of debt
R0 is the cost of capital for an all-equity firm RD
RWACC is a firm’s weighted average cost of capital.
In a world with no taxes, RWACC for a levered firm
is equal to R0 Debt-equity ratio (D/E)
R0 is a single point whereas RE ,RD ,and RWACC are all entire lines
The cost of equity capital, RE , is positively related to the firm’s debt-equity ratio
The firm’s weighted average cost of capital, RWACC , is invariant to the firm’s debt-
equity ratio Ross, Westerfield and Jaffe (8th edition, p. 433)
Stage 3 – Correct their equity betas by unlevering the

equity betas :
bE
bu =
[1 + D / E ]
Stage 4 – Take the average or median equity betas

values defined at stage 3
Stage 5 – Plug the estimated beta in the CAPM and

determine the unlevered cost of the project
With corporate taxes…
• Peer group method for computing the cost of capital

(with corporate taxes)
Stage 1 – Collect financial data about a peer group of firms

operating in the same business
Stage 2 – Compute their equity betas

Stage 3 – Correct their equity betas by first unlevering the

equity betas and then relevering the betas for the
appropriate D*/E* ratio of the project:
bE
(3.a) bu =
[1 + (1 - TC ) D / E ]

RE
• Risk-adjusted discount rate .2351
.20 = R0
RWACC
Financial leverage adds risk
to the firm’s equity. As .10 = RD
RD
compensation, the cost of
equity rises with the firm’s 200
risk. Note that R0 is a single 370
Debt-equity ratio (D/E)
point whereas RE ,RD , and
RWACC are all entire lines


Stage 3 – Correct their equity betas by first unlevering the

equity betas and then relevering the betas for the
appropriate D*/E* ratio of the project:
bE
(3.a) bu =
[1 + (1 - TC ) D / E ]
(3.b) β L = βu [1+ (1− TC )D * /E*]

Stage 4 – Take the average or median levered betas values

defined at stage 3
Stage 5 – Plug the beta in the CAPM and determine the

(levered) cost of equity
Stage 6 – Plug the cost of equity in the WACC formula and

define the appropriate risk-adjusted discount rate for the
project
Demo and assumptions of step 3…
• Zoom on stage 3 – Details on beta computations
Assets Liabilities and equity
Debt tax shield (TX) ? Debt D

Unlevered asset (UA) D+E-? Equity E
How debt financing and taxes affect the risks of the

various components of the firm’s balance sheet?
- Beta (or expected returns) of the assets is (are) the
portfolio-weighted average of the betas (or expected
returns) of the unlevered assets and debt tax shields
æ UA ö æ TX ö
bA = ç b +
÷ UA ç ÷ b TX
èD+Eø èD+Eø
æ UA ö æ TX ö
rA = ç ÷rUA + ç ÷rTX
èD+Eø èD+Eø
Key assumptions – Hamada’s model
(1) The debt is perpetual; in other words, it is either a

perpetuity or consists of rolled over short-term debt
positions
(2) The debt is default-free and pays the risk-free rate
(3) The face value of the debt and the tax rate do not
change over time
Static perpetual risk-free debt

- Firm’s debt tax shield TC Dr f
TC D =
rf
- Values for TX and UA? Hamada’s model

TX = TC D à UA = D + E - TC D
- Impact on asset betas é D + E - TC D ù

bA = ê ú b UA
ë D + E û
Levered firm with deductible debt interest
Assets Liabilities and equity
Debt tax shield (TX) TcD Debt D
Unleverd asset (UA) D+E-TcD Equity E
• Zoom on stage 3 - Equity Betas and Asset Betas

D
b E = (1 + )b A
E
We know that βA equals to
é D + E - TC D ù
bA = ê ú b UA
ë D+E û
à D é D + E - TC D ù
b E = (1 + ) ú b UA
E êë D + E û
à é Dù
b E = ê1 + (1 - TC ) ú b UA
ë Eû
Quizz
Let’s test the concepts!!
Question #4
• The unlevered beta of the equity captures
1. Business risk only

2. Financial risk only
3. Business and financial risks
Question #5
• You want to value a company in the tech. industry (aggressive sector),

which is not listed. You wrongly define your peer group by selecting
companies in the healthcare sector (more defensive). What is likely to
happen?
1. You will underestimate the company’s equity beta.

2. You will overestimate the company’s equity beta.
3. You will underestimate the company’s WACC.
4. You will overestimate the company’s WACC.
5. Answers 1. and 3. are correct.
Question #6
• One alternative to a regression beta is to use a sector-average beta. In

computing this sector-average beta, you have to come up with a list of
comparable firms. Assume that you are trying to compute the beta for an
Argentine steel company. Which of the following is likely to yield the best
estimate?
1. The beta of another Argentine steel company
2. A simple average of betas of 15 emerging market steel companies
3. A market-cap weighted average of betas of 4 Argentine steel
companies
4. A market-cap weighted average of betas of 12 Latin American steel
companies
5. A market-cap weighted average of betas of 85 emerging market steel
companies
Question #7
You want to value EVO Ltd., a listed company active in the advertising
industry, by discounting the Free Cash Flows to the Firm (FCFFs). EVO’s
corporate bonds were rated BBB at the time they were issued, with a
Yield-To-Maturity (YTM) of 9%. As of today, BBB bonds trade at 4%. EVO
is currently rated BB+, and BB+ rated bonds trade at a spread of 0.5%
over BBB bonds.
• Risk-free rate = 1.5%.
• Leverage (as measured by D/E) = 0.6.
• Unlevered beta = 0.95.
• Tax rate = 30%.
• Expected return on the market = 6.5%.
Based on the following information, which discount rate would you use in
your DCF?
Question #8
You are trying to determine the value of eView Corporation, a private tech
company, using the Discounted Cash Flow (DCF) model based on cash
available to both providers of capital (debt and equity holders).
You have gathered the following information about eView:
– Capital structure: long term debt’s market value is $100 million,
with annual interest payments of 5% and a Yield-To-Maturity
(YTM) of 3.5%; shareholder equity is $55 million.
– Beta: as eView is not listed, you have collected the following data
about eView’s comparable listed companies:
Listed
Beta D/E Tax rate
comparable
Prism 1.1 1.5 35%
Yota 1.3 2.3 35%
xOS 0.9 1.0 35%
Question #8
– Cost of equity: risk free rate is 2%, expected market return is 6%.
– eView’s tax rate is 35%.
What is your estimate of the rate you should use to discount eView’s Free
Cash Flows to the Firm?

Don’t forget – Continuous evaluation
Please complete Block 4 quiz by November 9th at the latest to be accounted for
in your continuous evaluation!
Please complete Seminar 3 on Cost of Capital by November 9th at the latest to

be accounted for in your continuous evaluation!

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Corporate Finance

Lectures and Seminars

5th October 2023

Block 4 – Cost of capital

• Module 1 - Required rate on the assets for an all-equity

Required rate on the assets

- with Debt = 0, no taxes

• The cost of equity financing

This rate of return can be determined in many ways.

- Typically, one uses expected return formulas from

- One could also use multifactor models (see infra)

• CAPM: getting the expected returns - three inputs

- Riskless asset: an asset for which the investor

• CAPM: getting the expected returns, 2 key

• Measure of systematic risk: Beta

- The beta of the market portfolio is 1

- Assets that are riskier than average will have betas

- Assets that are safer than average will have betas

- The riskless asset will have a beta of 0

– Country risk premium

– Adding a “small size premium” to CAPM

E(Ri) = [Rf + bi * ERP] + Size premium

– Might be incorrect from a theoretical standpoint:

• Country risk is a diversifiable risk

• This risk could be reflected in cash flow estimates (using

• Market portfolio (world versus local) depends on the

• Adjust CRPemerging market with bi

Getting rid of financial and

• Interest rate risk: risk of realisation

• Interest rate risk: risk of reinvestment

• Liquidity risk (bid-ask spread)

• Default risk à Government bonds

• Interest rate risk: risk of realisation

• Interest rate risk: risk of reinvestment

• Liquidity risk (bid-ask spread)

• Default risk à Government bonds

• Interest rate risk: risk of realisation

• Interest rate risk: risk of reinvestment

• Liquidity risk (bid-ask spread)

• Default risk à Government bonds

• Interest rate risk: risk of realisation

• Interest rate risk: risk of reinvestment

• Liquidity risk (bid-ask spread)

• Default risk à Government bonds

Pay attention, bond yield vary

Required rate on the assets for

• Firm or Project = small-scale representation of the

- with Debt ≠ 0, no taxes

• Computing a project/firm’s cost of capital from the

- The project must then have the same beta

• Traded companies: defining the cost of capital of

• The cost of capital of the firm

Cost of capital : R (%)

RE is the cost of equity

• Effect of leverage on equity betas

- The amount of debt financing a firm takes on can

- In absence of corporate taxes, asset beta should not be

• Business risk and financial risk

1. I got it for cost of equity (see module 1)

2. How do I compute cost of debt?

• Should be an effective rate

Required rate on the assets for