T2 Lecture 1 Slides - S

ESTIMATING THE COST OF B&DM, 5e
CAPITAL (REVISION) Chapter 12
Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

CHAPTER OUTLINE
12.1 The Equity Cost of Capital

12.2 The Market Portfolio
12.3 Beta Estimation
12.4 The Debt Cost of Capital
12.5 A Project’s Cost of Capital
12.6 Project Risk Characteristics and Financing
12.7 Final Thoughts on Using the CAPM

1
LEARNING OBJECTIVES (1 OF 4)
§ Estimate a company’s cost of capital using the CAPM equation for

the Security Market Line.
§ Describe the market portfolio and how it is constructed in practice.
§ Discuss the attributes of a value-weighted portfolio.
§ Describe common proxies for the market return and the risk-free
rate.

2
§ Define alpha and beta and explain how they are generally
estimated.
§ Compare the use of average return versus beta and the SML to
estimate cost of equity capital.
§ Estimate the cost of debt, given a company’s yield to maturity,
probability of default, and expected loss rate.
3 Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

3
§ Discuss the difference between the yield to maturity and the cost of
debt when there is low versus high default risk.
§ Calculate the cost of debt given a company’s debt beta, the risk-
free rate, and the market risk premium.
§ Illustrate the use of comparable companies’ unlevered betas or
unlevered cost of capital to estimate project cost of capital.

4
§ Discuss the advantages of using several companies’ betas to

estimate a project beta.
§ Define operating leverage and discuss its influence on project risk.
§ Calculate the weighted average cost of capital.
§ Discuss strengths and weaknesses of the CAPM.

5
Pool Concept 4captial
WEIGHTED AVERAGE COST OF CAPITAL
Shareholders Debtholders
Equity Debt
Cost of Equity Cost of Debt

(rE) “Pool” of (rD)
Capital
Weighted Average Cost of
Capital (rwacc)
Minimum return
from investments
t finalreturn
True return7minimum
Investments return
6
dividend
iydividend records estimate 不均
GmthrdeiPast
Constant dividend
THE EQUITY COST OF CAPITAL
§ Using Constant Dividend Growth Model (CDGM):

ustcteii
Annomematrs OR
!"#! (1 + ')
)"
+'
tmnmpany
§ Rather than looking backward at historical growth, one common
approach is to use estimates produced by stock analysts, as these
estimates are forward-looking.
shareholder's return many comes from dividend

dividend constant
keep
lmstantamonntlanstantgmthrate
7
y
Dividend rate model
growth
not good dividend
all shareholders want is
assume
dividend
Company manana constant
disregarding mk of company operation
Dividend return what shareholders get
CAPM
look at risk
t should
get
Determine the return she
holders
12.1 THE EQUITY COST OF CAPITAL
§ The Capital Asset Pricing Model (CAPM) is a practical way toe.g.Hangsengmdx
estimate. Betnmarhetnnk
§ The cost of capital of any investment opportunity (i) equals the
expected return of available investments with the same beta.
70Market
It
index
§ The estimate is provided by the Security Market Line equation:
Bloomagenhn relative在báey
ngg.tk
From r = r + " × (% &
i f − (! )
nl
% &'(
hamhompanyi mk for premium

market
mkfree
nnr BR Mkpemumhrsecungi
ritiehorernmentbmd's
ratelmn
rate_
8
TEXTBOOK EXAMPLE 12.1 – COMPUTING THE
EQUITY COST OF CAPITAL (2 OF 2)
Problem
GD
§ Suppose you estimate that Disney’s stock (DIS) has a volatility of
卯上㗊㗊焭
20% and a beta of 1.29.
highermarketrisk
§ A similar process for Chipotle (CMG) yields a volatility of 30% and
a beta of 0.55.
§ Which stock carries more total risk? Which has more market risk?
§ If the risk-free interest rate is 3% and you estimate the market’s
expected return to be 8%, calculate the equity cost of capital for
Disney and Chipotle. Which company has a higher cost of equity
capital?
3 129 3 945
DIS ⼆ 8
CMG ⼆18 3 1.8513 575
9
n3klaHfatwDeg.ntnestrate badaw.anpetntnms
GDh.tn
due tomarket tutor e.g.interestrate
Betamarket risklong
poormarketing 7only affectunlmktxmarhetmk
dueto market 在在
pzs 器器 whenreturnMe
dueto markethtns
CMG
High low
thenreturn Me Mainly
didualproblems
company in
A Return should be earned based on market risk

Totakhystematntmgsamatil
Solution
Det ined
§ Total risk is measured by volatility; therefore Chipotle stock has more
total risk than Disney.
on A
§ Systematic risk is measured by beta. Disney has a higher beta, so it
has more market risk than Chipotle.
§ Given Disney’s estimated beta of 1.29, we expect the price for
Disney’s stock to move by 1.29% for every 1% move of the market.
Therefore, Disney’s risk premium will be 1.29 times the risk premium
of the market, and Disney’s equity cost of capital (from Eq. 12.1) is

10
Solution
§ Chipotle has a lower beta of 0.55. The equity cost of capital for
Chipotle is
§ Because market risk cannot be diversified, it is market risk that

determines the cost of capital; thus Disney has a higher cost of
equity capital than Chipotle, even though it is less volatile.

11
ALTERNATIVE EXAMPLE 12.1 (1 OF 4)
Problem
§ Suppose you estimate that Walmart’s stock has a volatility of 16.1%
and a beta of 0.20.
§ A similar process for Johnson & Johnson yields a volatility of 13.7%
and a beta of 0.54.
§ Which stock carries more total risk? Which has more market risk?
§ If the risk-free interest rate is 4% and you estimate the market’s
expected return to be 12%, calculate the equity cost of capital for
Walmart and Johnson & Johnson. Which company has a higher cost
of equity capital?

12
market
a
in portfolio
rz rftBiIEIRml.RU
12.2 THE MARKET PORTFOLIO (1 OF 3)
§ Market Capitalization
§ The total market value of a firm’s outstanding shares
MVi = (Number of shares of i outstanding) x (Price of i per share) = Ni x Pi

13
marketweighted
§ Value-Weighted Portfolio 120⼗5在们
§ A portfolio in which each security is held in proportion to its
market capitalization

14
§ Most practitioners use the S&P500 as the market proxy, even though
it is not actually the market portfolio.
§ What about HK?
Ekm
§ Hang Seng Index
Hosts
§ Hong Kong All Ordinaries Index 20stocks done
by
§ Other indexes valueweighed

15
Other related Hang Seng stock indexes:
•Hang Seng China Enterprises Index (恒生中國企業指數)

•Hang Seng China-Affiliated Corporations Index (恒生香港中資企業指數)
•Hang Seng Freefloat Index Series
•Hang Seng China H-Financials Index (恒生中國H股金融行業指數)
•Hang Seng Mainland 100 (恒生中國內地100)
•Hang Seng Mainland 25 (恒生中國內地25)
•Hang Seng HK 35 (恒生香港35)
•Hang Seng REIT Index (恒生房地產基金指數)
•Hang Seng Corporate Sustainability Index Series (恒生可持續發展企業指數系列)
•Hang Seng Composite Index (恒生綜合指數系列)
•Hang Seng Composite Industry Indexes (恒生綜合行業指數)
•Hang Seng Composite Size Indexes (恒生綜合市值指數)
•Hang Seng Short & Leveraged Index Series (恒生短倉及槓桿指數系列)
•Hang Seng China A Industry Top Index (恒生A股行業龍頭指數)
•Hang Seng China 50 Index (恒生神州50指數)
•Hang Seng China AH Premium Index(恒生AH股溢價指數)
•Hang Seng China AH Index Series (恒生AH指數系列)
•Hang Seng Total Return Index Series (恒生股息累計指數系列)
•Hang Seng Dividend Point Index Series (股息點指數系列)
•Hang Seng Global Composite Index
•Hang Seng Tech Index (恆生科技指數)

16
THE MARKET RISK PREMIUM (1 OF 2)
§ Determining the Risk-Free Rate

§ The yield on U.S. Treasury securities
§ Surveys suggest most practitioners use 10- to 30-year treasuries
§ The Historical Risk Premium
§ Estimate the risk premium (E[RMkt] − rf) using the historical
average excess return of the market over the risk-free interest
rate
䲜 4點
§ What about HK?
Rf § Exchange Fund Notes

§ Hang Seng Index returns Tracker fund
Ekm
17
TABLE 12.1 HISTORICAL EXCESS RETURNS OF THE
S&P500 COMPARED TO ONE-YEAR AND TEN-YEAR
U.S. TREASURY SECURITIES
*Based on a comparison of compounded returns over a ten-year holding
period.

18
THE MARKET RISK PREMIUM (2 OF 2)
A Fundamental Approach
§ Using historical data has two drawbacks:
§ Standard errors of the estimates are large
§ Backward looking, so may not represent current expectations
§ One alternative is to solve for the discount rate that is consistent with
the current level of the index

19
12.3 BETA ESTIMATION 與
Eyjiei Bi
⼆
Using Historical Returns

§ Recall, beta is the expected percent change in the excess return of
the security for a 1% change in the excess return of the market
portfolio.
§ Using scatter plots or linear regressions.

20
12.4 THE DEBT COST OF CAPITAL (1 OF 4)
§ Debt Yields Versus Returns

elostcfdbt § Yield to maturity (YTM) is the IRR an investor will earn from
holding the bond to maturity and receiving its promised payments.
otpnmned
rates§ If there is little risk the firm will default, yield to maturity is a
upon reasonable estimate of investors’ expected rate of return.
§ If there is significant risk of default, yield to maturity will
overstate investors’ expected return.

21
YTM⼆lost4Debt
§ Debt’s Yield to Maturity pin xooo IN
§ For valuation
§ Zero-coupon bonds tiiiit
of
cost debt
_True
§ Coupon bonds
NIFA iiiiǎrnt
ctp
elumpsum
couponasannuity Gpr torture

lump sum
前列
2⼗
I
22
⼆⼗
l
ZERO-COUPON BONDS
§ The YTM is the single discount rate that equates the present value of
the bond’s remaining cash flows to its current price
§ Yield to Maturity of an n-Year Zero-Coupon Bond
Eq . 6.3
uation

23
TEXTBOOK EXAMPLE 6.1 – YIELDS FOR
DIFFERENT MATURITIES (1 OF 2)
Problem
§ Suppose the following zero-coupon bonds are trading at the prices
shown below per $100 face value. Determine the corresponding
spot interest rates that determine the zero coupon yield curve.
Maturity 1 Year 2 Years 3 Years 4 Years

Price $96.62 $92.45 $87.63 $83.06
鳳 100

24
TEXTBOOK EXAMPLE 6.1 – YIELDS FOR
DIFFERENT MATURITIES (2 OF 2)
Solution Positiveyield ameifromatungthaeion
斷
Using Eq . 6.3, we have
uation
negativeyieldcurve
1
25
COUPON BONDS
§ Yield to Maturity of a Coupon Bond
expressed as simpleinterest
Rateless than a year
interest
morethan a year expressed as compounding
Rate Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
26
Eg6 peryear
614 1.5 per3months
is No 2 1 1236 for2year
YIELD TO MATURITY OF A COUPON BOND (1 OF 3)
no.thupms 2x5 10
Problem
N
§ The U.S. Treasury has just issued a five-year, $1000 bond with a 5%
coupon rate and semiannual coupons.
N
§ If this bond is currently trading for a price of $957.35, what is the
bond’s yield to maturity?
15 25 15 25141000
100
hupm
ˊ
與 ym 3 x2
6 peryear
27
Solution
§ Because the bond has 10 remaining coupon payments, we compute
its yield y by solving:
§ We can solve it by trial-and-error or by using the annuity

spreadsheet:

28
Solution
§ Therefore, y = 3%. Because the bond pays coupons semiannually,
this yield is for a six-month period. We convert it to an APR by
multiplying by the number of coupon payments per year. Thus the
bond has a yield to maturity equal to a 6% APR with semiannual
compounding.
assume nodefalutrnk
Blank NPER R ATE PV P MT FV Excel Formula
Given 10 blank −957.35 25 1,000 blank
o
Solve for Rate blank 3.00% blank blank blank = RATE (10, 25,
−957.35, 1000)

29
§ Consider a one-year bond with YTM of y. For each $1 invested in

the bond today, the issuer promises to pay $(1 + y) in one year.
§ Suppose the bond will default with probability p, in which case bond
holders receive only $(1 + y − L), where L is the expected loss per
$1 of debt in the event of default.
§ So the expected return of the bond is
hrneh
§ The importance of the adjustment depends on the riskiness of the
bond.

30
TABLE 12.2 ANNUAL DEFAULT RATES BY DEBT
RATING (1983–2011)
Rating: AAA AA A BBB

ihaiey
BB B CCC CC−C
Default Rate:
3
Average 0.0% 0.1% 0.2% 0.5% 2.2% 5.5% 12.2% 14.1%
In Recessions 0.0% 1.0% 3.0% 3.0% 8.0% 16.0% 48.0% 79.0%
Source: “Corporate Defaults and Recovery Rates, 1920-2011,” Moody’s Global Credit Policy,
February 2012.
非 0
肱ultr

31
nothighvaluebutnm
te.ro
Debt Betas
§ Alternatively, we can estimate the debt cost of capital using the
CAPM .
§ Debt betas are difficult to estimate because corporate bonds are
traded infrequently.
§ Chapter 21 shows a method for estimating debt betas
§ One approximation is to use estimates of betas of bond indices by
rating category.

32
TABLE 12.3 AVERAGE DEBT BETAS BY RATING
AND MATURITY*
By Rating A and above BBB BB B CCC
Eitherbased on
Avg. Beta <0.05 0.10 0.17 0.26 0.31
䬆
maturity
By Maturity
Avg. Beta
(BBB and above)
Blank
1-5 year
0.01
5-10 year
0.06
10-15 year
0.07
>15 year
Source: S. Schaefer and I. Strebulaev, “Risk in Capital Structure Arbitrage, “Stanford

0.14
GSB working paper, 2009.
* Note that these are average debt betas across industries. We would expect
debt betas to be lower (higher) for industries that are less (more) exposed to
market risk. One simply way to approximate this difference is to scale the
debt betas in Table 12.3 by the relative asset beta for the industry (see Figure
12.4 on page 425).

33
TEXTBOOK EXAMPLE 12.3 – ESTIMATING THE
DEBT COST OF CAPITAL (1 OF 2)
Problem
§ In mid-2015, homebuilder KB Home had outstanding 6-year bonds
with a yield to maturity of 6% and a B rating.
Default rnk
§ If corresponding risk-free rates were 1%, and the market risk
premium is 5%, estimate the expected return of KB Home’s debt.

34
DEBT COST OF CAPITAL (2 OF 2)
hctdefult 5.5
Etputelossrate 60
Solution
§ Given the low rating of debt, we know the yield to maturity of KB
Home’s debt is likely to significantly overstate its expected return.
Using the average estimates in Table 12.2 and an expected loss
rate of 60%, from Eq. 12.7 we have
theyieldthatreally
carrybyBratmgmefant
rd = 6% - 5.5% (0.60) = 2.7%
bond
§ Alternatively, we can estimate the bond’s expected return using the
C A P M and estimated beta of 0.26 from Table 12.3. In that case,
rd = 1% + 0.26 (5%) = 2.3% Beta
§ Both estimates approximation confirm that the expected return of K B
Home’s debt is well below its promised yield.
35
12.5 A PROJECT’S COST OF CAPITAL (1 OF 4)
terms4bnnness nature
n 1 in
All-Equity Comparables
§ Find an all-equity financed firm in a single line of business that is
comparable to the project.
§ Use the comparable firm’s equity beta and cost of capital as
estimates. Here of
redcost equity
ìlunlereredustt Eqmgbiigg
f fi
RE Rwml
l
Znrestmentf
Investment Rulunheredcostot
capth 36
Rwm Ru if no tax
36
Bhedonuqmredrel
hphyedmthemktbysimiliar useRwmc
RwAll similarreturn companies
marketluquiud return
DRNACLLNDfrom Benchmark me at least benchmarkfromthe

findBeta _All equity.financedRmRFRA AE
Levered Firms as Comparables in terms4business nature
§ For levered firms, the cash flows generated by the firm’s assets are
used to pay both debt and equity holders.
§ As a result, the returns of the firm’s equity alone are not
representative of the underlying assets; in fact, because of the firm’s
leverage, the equity will often be much riskier.
§ Thus, the beta of a levered firm’s equity will not be a good estimate
of the beta of its assets and of our project.
lost4equity
Et ⼝ A Costofequitywith nithmtbmomng
RE 冊 Rnknnu hung
37
㖌㖄
37
liquidate
11 gi
FIGURE 12.3 USING A LEVERED FIRM AS A

COMPARABLE FOR A PROJECT’S RISK
Projuti Dehtt king
Revised
⼆ RNML
Return

38
BETA OF A PROJECT FROM A SINGLE-
PRODUCT FIRM (1 OF 3)
Problem
§ You have just graduated with an M B A, and decide to pursue your
dream of starting a line of designer clothes and accessories.
§ You are working on your business plan, and believe your firm will
face similar market risk to Lululemon (LULU).
§ To develop your financial plan, estimate the cost of capital of this
opportunity assuming a risk-free rate of 3% and a market risk
premium of 5%
Rf
Elkmlpnf

39
debt
check
Solution if company
the hasborn
mng_no
§ Checking Yahoo! Finance, you find that Lululemon has no debt. Using
five years of weekly data, you estimate their beta to be 0.80. Using
LULU’s beta as the estimate of the project beta, we can apply Eq.
1
12.1 to estimate the cost of capital of this investment opportunity as
⼆ Rn4lum
l
investmentsimilarto
your
lululemm use7 as thereturn
fromyourproject
40
§ In other words, rather than investing in the new business, you could
invest in the fashion industry simply by buying LULU stock.
§ Given this alternative, to be attractive, the new investment must have
an expected return at least equal to that of LULU, which from the
CAPM is 7%.

41
Estimating the Beta of a Project from a Single-Product Firm

Problem
assume You have just invented a new low-cost, long-lasting rechargeable
equity battery for use in electric cars. You are working on your business plan,
and believe your firm will face similar market risk to Seguin Inc, which
Betacrn has a beta of 1.3. To develop your financial plan, estimate the cost of
capital of financing your firm assuming a risk-free rate of 2.5% and a
market risk premium of 6.5%
25 1
兆 5 10.95

42
The Unlevered Cost of Capital

§ Expected return required by investors to hold the firm’s underlying
assets
§ The weighted average of the firm’s equity and debt costs of capital
can be calculated as:
RwAll ⼆
1 RhAll of one company

Ruct anothercompany
43 43
Unlevered Beta
§ Because the beta of a portfolio is the weighted-average of the
betas of the securities in the portfolio, we have a similar expression
for the firm’s asset or unlevered beta, which we can use to estimate
the beta of our project:
is i

44
TEXTBOOK EXAMPLE 12.5 – UNLEVERING THE
COST OF CAPITAL (1 OF 4)
Problem
§ Your firm is considering expanding its household products division.
You identify Procter & Gamble (PG) as a firm with comparable
investments.
§ Suppose PG’s equity has a market capitalization of $144 billion
and a beta of 0.55.
BE
§ PG also has $37 billion of AA-rated debt outstanding, with an
average yield of 3.1%.
§ Estimate the cost of capital of your firm’s investment given a risk-
free rate of 3% and a market risk-premium of 5%.

45
COST OF CAPITAL (2 OF 4) 3.1 Rft BYEIRM Rt
Solution
⼆
37⼗Bok
Because investing in the division is like investing in PG’s assets by
holding its debt and equity, we can estimate our cost of capital based
on PG’s unlevered cost of capital.
First, we estimate PG’s equity cost of capital based on PG’s unlevered
cost of capital. First, we estimate PG’s equity cost of capital using the
CAPM as Re = 3% + 0.55(5%) = 5.75%.
RE CAPM
Because PG’s debt is highly rated, we approximate its debt cost of
capital using the debt yield of 3.1%. Thus, PG’s unlevered cost of wml
capital is RP
ostofapin
了吼⼗PIG
gut
should
unheredtrm
based
on
飈叫松
46
Solution
Alternative, we can estimate PG’s unlevered beta. Given its high rating,
if we assume PG’s debt is zero we have
pǖss
Asset BE BD him Assumption
lorerall Beta
Taking this result as an estimate of the beta of our project, we can
compute our project’s cost of capital from the C A PM as
rU = 3% + 0.438(5%) = 5.19%
CAPM
47
Solution
§ The slight difference in rU using the two methods arises because in
the first case, we assumed the expected return of PG’s debt is equal
to its promised yield of 3.1% (which overestimates the cost of debt,
as we pointed out in Section 12.4).
§ While in the second case, we assumed the debt has a beta of zero,
which implies an expected return equal to the risk-free rate of 3%
according to the C A PM (which underestimates the cost of debt,
because PG’s debt is not risk free). The truth is somewhere between
the two results.
在e Beta Debt to
Yield3，1 tmk
3，1 3 5 1BD
lookBoxo05 Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
48
⼆
CASH AND NET DEBT HD EtD_All marketvaluebased
nor
p
§ Some firms maintain high cash balances
§ Cash is a risk-free asset that reduces the average risk of the firm’s
assets.
§ Because the risk of the firm’s enterprise value is what we’re
concerned with, leverage should be measured in terms of net debt
Net Debt = Debt – Excess Cash and Short-Term Investments
Debttash⼆Netdebt NML
comefromdebt hasexcesscash
t financial not
risk only If company
E.g.hn debt
If company into
40mlas lnhatmedbtlloom
4omigdbtauaten.mu
49
cash
maturity
ieshortterminvestments stocks I besoldwithout

can
losingitsvalue
shutterm treasurynote
TEXTBOOK EXAMPLE 12.6 – CASH AND BETA
(1 OF 2)
器器晶 has debt

no
company
__hnanuànsk
Problem
§ In early 2018, Microsoft Corporation had a market capitalization of
$716 billion, $89 billion in debt, and $133 billion in cash.
cash the beta of
Dbeta was 1.04, estimate
§ If itsEestimated equity
Microsoft’s underlying business enterprise.
i
BE⼆1，04

50
TEXTBOOK EXAMPLE 12.6 – CASH AND BETA
(2 OF 2)
歲 Ii legally havedebt4
89N
Bu⼆
朂 BE⼗
havenodebt
Solution
§
Debt cash ftinacg
Microsoft has net debt = (89−133) = −$44 billion. Therefore,
cashcoversdebt
Microsoft’s enterprise value is (716−44) = +672 billion, which is the

total value of its underlying business on a debt-free basis and
excluding cash.
§ Assuming Microsoft’s debt and cash investments are both risk-free,
we can estimate the beta of this enterprise value as
unlerered
Betalmset
Beta
§ Note that in this case, Microsoft’s equity is less risky than its
underlying business activities due to its cash holdings.
Usually BE 7Bu Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
51
Problem
§ Apple’s market capitalization in mid-2016 was $484 billion, and its
beta was 1.03. At that same time, the company had $55 billion in
cash and $69 billion in debt.
§ Based on this data, estimate the beta of Apple’s underlying business
enterprise.

52
INDUSTRY ASSET BETAS
§ We can combine estimates of asset betas for multiple firms in the

same industry.
§ Doing this will reduce the estimation error of the estimated beta for
the project.
Beware ofwhere youstand in the industry

ie upper tier lower tier

53
TEXTBOOK EXAMPLE 12.7 – ESTIMATE AN
INDUSTRY ASSET BETA (1 OF 3)
Problem
§ Consider the following data for U.S. department stores in mid-2009,
showing the equity beta, ratio of net debt to enterprise value (D/V),
and debt rating for each firm. Estimate the average and median
asset beta for the industry.
Company Ticker Equity Beta D/V Debt Rating

Dillard’s DDS 2.38 0.59 B
JCPenney JCP 1.60 0.17 BB
Kohl’s KSS 1.37 0.08 BBB
Macy’s M 2.16 0.62 MiBB
l l
Nordstrom JWN 1.94 0.35 BBB
Saks SKS 1.85 0.50 CCC
Sears Holding SHLD 1.36 0.23 BB
54
Solution
只是
§ Note that D/V provides the fraction of debt financing, and (1−D/V)
the fraction of equity financing, for each firm. Using the data for
debt betas from Table 12.3, we can apply Eq. 12.9 for each firm.
For example, for Dillard’s:
o
overallBeta
§ Doing this calculation for each firm, we obtain the following
estimates:

55
Bu
腻 _narnw
Grange
abustfurther
to fit yourown
The large difference in the firms’ equity beta are mainly due to differences in case
leverage. The firms’ asset beta are much more similar, suggesting that the
underlying business in this industry have similar market risk. By combining
estimates from several closely related firms in this way can get a more
accurate estimate of the beta for investments in the industry.

56
FINANCING AND THE WEIGHTED AVERAGE
COST OF CAPITAL
§ How might the project’s cost of capital change if the firm uses
leverage to finance the project?
§ Perfect Capital Markets
m NML
§ In perfect capital markets, choice of financing does not affect cost
of capital or project NPV
§ Taxes – A Big Imperfection
Tto rutwmc
§ When interest payments on debt are tax deductible, the net cost
before
to the firm is given by AdustmentBrequired
making companion

57
THE WEIGHTED AVERAGE COST OF CAPITAL (1 OF 2)
§ The Weighted Average Cost of Capital (WACC)

D
- ! !
+)*++ = +" + +, − + .
-+! -+! -+! , -
taxrate
§ Given a target leverage ratio,
Ajastmat
if
y then 7to
58
THE WEIGHTED AVERAGE COST OF CAPITAL (2 OF 2)
How does rwacc compared with rU ?

§ Unlevered cost of capital (or pretax W A C C)
§ Expected return investors will earn by holding the firm’s assets
§ In a world with taxes, it can be used to evaluate an all-equity
project with the same risk as the firm
§ In a world with taxes, W A C C is less than the expected return of the
firm’s assets.
§With taxes, W A C C can be used to evaluate a project with the
same risk and the same financing as the firm.

59
WACC (1 OF 3)
Problem
E
I D
§ Dunlap Corp. has a market capitalization of $100 million, and $25
million in outstanding debt.
§ Dunlap’s equity cost of capital is 10%, and its debt cost of capital is
6%.
§ What is Dunlap’s unlevered cost of capital (i.e. rU)?
§ If its corporate tax rate is 25%, what is Dunlap’s weighted average
cost of capital (i.e. rwacc)?

60
WACC (2 OF 3)
Solution
Dunlap’s unlevered cost of capital, or pretax WACC, is given by
E D 100 25
rU =
E+D
rE +
E+D
rD =
125
10% +
125
6% = 9.2% 7以⼆0
Thus, we would use a cost of capital of 9.2% to evaluate all-equity financed

project with the same risk as Dunlap’s assets.

61
WACC (3 OF 3)
Solution
§ Dunlap’s weighted average cost of capital, or WACC, can be calculated
using either Eq.12.12 or 12.13:
i
OR
§ We can use the WACC of 8.9% to evaluate with the same risk and the
same mix of debt and equity financing as Dunlap’s assets. It is a lower rate
than the unlevered cost of capital to reflect the tax deductibility of interest
expenses.

62
Problem
§ Cavo Corp’s equity cost of capital is 15%, and its debt cost of
capital is 7%.
§ The corporate tax rate is 34%.
§ The firm has $100 million in debt outstanding and a market
capitalization of $250 million.
§ What is Cabo’s unlevered cost of capital (rU)?
§ What is Cavo’s weighted average cost of capital (rwacc)?

63
12.7 FINAL THOUGHTS ON USING THE CAPM
(1 OF 2)
§ There are a large number of assumptions made in the estimation of

cost of capital using the C A PM.
§ How reliable are the results?

64
12.7 FINAL THOUGHTS ON USING THE CAPM
(2 OF 2)
§ The types of approximation are no different from those made

throughout the capital budgeting process.
§ Errors in cost of capital estimation are not likely to make a large
difference in N PV estimates.
§ CAPM is practical, easy to implement, and robust.
§ CAPM imposes a disciplined approach to cost of capital estimation
that is difficult to manipulate.
§ CAPM requires managers to think about risk in the correct way.
Deviationsare not significant

not perfect
butpatutontofimpertut 65 Copyright © 2020 Pearson Education Ltd. All Rights Reserved.
65
READING AND PRACTICE PROBLEMS
Reading
§ B&DM 5e, Chapter 12
Practice problems
§ Problems 2, 9, 15, 17, 18, 19, 20, 22, 23, 26, 27

66

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ESTIMATING THE COST OF B&DM, 5e

CAPITAL (REVISION) Chapter 12

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12.1 The Equity Cost of Capital

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§ Estimate a company’s cost of capital using the CAPM equation for

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3 Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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§ Discuss the advantages of using several companies’ betas to

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Cost of Equity Cost of Debt

§ Using Constant Dividend Growth Model (CDGM):

shareholder's return many comes from dividend

hamhompanyi mk for premium

A Return should be earned based on market risk

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§ Because market risk cannot be diversified, it is market risk that

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12 Copyright © 2020 Pearson Education Ltd. All Rights Reserved.

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•Hang Seng China Enterprises Index (恒生中國企業指數)

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§ Determining the Risk-Free Rate

Rf § Exchange Fund Notes

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Using Historical Returns

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§ Debt Yields Versus Returns

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couponasannuity Gpr torture

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Maturity 1 Year 2 Years 3 Years 4 Years

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§ Yield to Maturity of a Coupon Bond

§ We can solve it by trial-and-error or by using the annuity

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§ Consider a one-year bond with YTM of y. For each $1 invested in

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Rating: AAA AA A BBB

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Source: S. Schaefer and I. Strebulaev, “Risk in Capital Structure Arbitrage, “Stanford

GSB working paper, 2009.

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12.5 A PROJECT’S COST OF CAPITAL (2 OF 4)

FIGURE 12.3 USING A LEVERED FIRM AS A

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Estimating the Beta of a Project from a Single-Product Firm

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The Unlevered Cost of Capital

1 RhAll of one company

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ieshortterminvestments stocks I besoldwithout

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