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Capital Budgeting and Capital Structure

Financial Management 6301 Dr. Carolyn Reichert


Company Cost of Capital
Firm value = sum of the value of the assets Weighted Average Cost of Capital (WACC)
Opportunity cost of capital for existing assets Use: value new assets with the same risk as the old ones rWACC = rportfolio = (B/V)rB + (S/V)rS V = B + S where V, B and S are all market values rS = rf + ßS(rm - rf) rS = ro + [(B/S)(ro - rB )] Exclude taxes for now (so tax rate = 0)


Asset beta
Beta of a portfolio of all of the firm’s debt & equity Relationship between asset and equity betas
ßASSET = ßWACC = (B/V)ßB+(S/V)ßS
• Where V = B + S • V, B and S are all market values

Can rearrange to get βS = βo + [(B/S)(βo - βB )] No tax adjustment

No-Tax Cost of Capital
Unlevered Cost of Capital ro:
Expected return investors want from a project if it was all-equity financed

No tax world (M&M): ro = rWACC Unlevered cost of capital and asset beta are the same for the levered and unlevered firm.
Affected only by business risk


Affected by financial risk. Debt has a market value of $50M and a return of 6%.Cost of Capital Implications You can lever and unlever the WACC. The return on debt does not change 6 3 . Return on equity and equity beta are different for the levered and unlevered firm. find the new return on equity. If they issue $50M to re-buy equity. The risk-free return is 3% and the market risk premium is 9%. Equity has a beta of .75. Firms with more debt have higher equity betas 5 Cost of Capital Example Coyote Corporation has a value of $200M. Find the original weighted average cost of capital.

75% = 8.75% Original WACC rWACC = (50/200)6% + (150/200)9.81% + 2. rS = 3% + .81% + (100/100)(8.81%-6%) = 8.75(9%) = 9. Equity beta: Slope of the characteristic line 8 4 . Choice of market index Least-squares regression produces a line of best fit called the characteristic line.81% New return on equity • • • • rWACC = 8.Cost of Capital Answer Find the return on equity.81% = (100/200)6% +(100/200) rS Can use rS = ro + [(B/S)(ro .62% 7 Measuring Equity Betas Linear regression of the stock's returns against the corresponding market returns.rB )] rS = 8.81% 11.

27 β = 1.Regression Information Intercept (Jensen’s Alpha) Simple measure of performance If α > rf (1-ß). stock did worse than expected R2 is the proportion of variance that can be explained by market risk (1-R2): proportion of variance that is firm specific 9 Measuring Betas Dell Computer Dell return (%) Price data: Dec 97 . stock did better than expected If α = rf (1-ß). Market return (%) 10 5 .61 Slope determined from plotting the line of best fit.Apr 04 R2 = . stock did as well as expected If α < rf (1-ß).

week. month) Shorter: More data but more noise Use different adjusting methods Simple adjustment towards one Adjust using fundamental information about the firm 12 6 .Beta Estimation: Problems Want predicted beta Assume betas move towards one in the long term Estimate betas from the bottom up Use firm characteristics to estimate beta Sample size may be inadequate Use more sophisticated statistical techniques Financial leverage & business risk change over time Estimation error Use Industry betas (more reliable) 11 Differences in Published Betas Use different time periods Longer: more data but firm changes over time Shorter: Easily influenced by specific events Use different return intervals (day.

A diversified firm's cost of capital does not measure the risk of any specific division 14 7 .Determinants of Asset Beta Look at the business risk Cyclical firms have higher betas • Cyclical firms do well in the expansion phase of the business cycle and poorly in the contraction phase • Cyclicality is not the same as variability Consider product type • Firms with discretionary products have higher betas Higher operating leverage results in higher betas • Magnifies the effect of cyclicality on beta 13 Division Betas Use an industry beta to estimate a division's cost of capital.

Avoid fudge factors 15 Accounting Betas Regress changes in firm (division) earnings against changes in earnings for the market Problems Accounting earnings are smoothed (bias beta) • Bias up for safe firms and down for risky firms Influenced by accounting decisions Few observations for regression (quarterly data) 16 8 .Atypical Projects If a similar asset is traded. estimate beta from past price data or comparable firms Use accounting earnings Use bottom-up beta estimation Use fundamental risk considerations to get a rough estimate of beta.

Bottom-Up Betas Identify businesses that comprise the firm or project Estimate unlevered betas for other firms in the same business (comparables) Weighted average of unlevered betas (use market values. sales) Lever the estimate using the debt/equity ratio 17 Optimal Capital Budget & Risk True cost of capital depends on how funds are used Cost of capital (WACC) is appropriate for projects with similar risk to the firm’s average risk Cost of capital rule: Invest if project return > cost of capital Not average risk: Use CAPM with project beta Account for project risk CAPM rule: Invest if project return > required return based on the project’s beta 18 9 .

CAPM A project has an IRR of 18%. The project has a beta of 1. Knight’s cost of capital (WACC) is 15%.2. market risk premium is 10% Using the company cost of capital (WACC).0 19 WACC vs. The risk-free return is 5%. will they take the project? Using the CAPM to determine the required return. will they take the project? 20 10 .Cost of Capital vs. CAPM Required return 15 SML Company Cost of Capital (WACC) 5 0 Project Beta 1.

WACC vs. Using CAPM: r = 5% + (1.2×10%) = 17% Accept the project since the IRR of 18% > CAPM of 17%.βB )] 22 11 . CAPM Answer COC rule: Accept the project since the IRR of 18% > cost of capital of 15%. 21 Weighted Average Cost of Capital Weighted-average of the cost of funds Affected by tax savings and the financing decision  S   B rWACC =  rS +  (1 − TC )rB V V Beta relationships become βASSET = βWACC = [(S/V)βS ] + [(B/V)(1-TC)βB] βS = βo + [(B/S)(1-TC)(βo .

In this case rWACC = ro = rS and βWACC = βo = βS Levered firm: The business risk of the assets has not changed Unlevered cost of capital for the assets has not changed Additional asset (PVITS) generated as a result of the financing decisions made by the firm. 23 Evaluating Levered Investments Value is created by good investment decisions Destroy value by poor financing decisions Financial policy should support business strategy Three Valuation Approaches: Weighted Average Cost of Capital (WACC) Adjusted Present Value (APV) Flow to Equity (FTE) 24 12 . Result: Business risk of the assets does not change.Tax Impact on Return and Beta Unlevered firm: Present value of the interest tax shields (PVITS) = 0. Debt impacts value through tax savings.

retained earnings and common stock rWACC = [(E/V)rE ]+[(S/V)rS]+[(B/V)(1-TC)rB]+ [(P/V)rP] Added term for preferred stock P Equity split into retained earnings (E) and stock issue (S) Proportions must add to 1 Not all securities may be used (omit terms) 25 Components: Debt and Preferred Debt: Find yield to maturity. use effective rate.General form of the WACC Weighted-average of the component costs of debt. preferred stock. This is rB Cost of debt is reduced in the WACC equation because interest is tax-deductible Preferred: rP = Dividend divided by the net price Net price is the price less issue costs 26 13 . If it is compounded semiannually.

rf)] Non-dividend paying stocks: P0= Pt/(1+r)t so rE = [(Pt/P0)(1/t)] -1 rE = bond yield + risk premium 27 Component: Issue Common Stock Constant growth with the net price rS = (D1/Pnet) + g Net price is the price less the issue costs Issue costs are also called flotation costs 28 14 .Component: Retained Earnings Opportunity cost Dividend valuation model: rE = (D1/P0) + g CAPM: rE = rf + [βS(rm .

Common: rs =     3.25×12%×(1-. Growth rate is 8%. Find weighted average cost of capital. 29 WACC Answer: Nook Debt: yield = rB = 12%.3% 30 15 . Flotation costs are 5% to issue stock.80  + .4)) + (. Tax rate is 40%.08   40 × (1 − .80 next year.75×18%) 15.WACC Example: Nook Nook plans a $100 million expansion using 25% debt and 75% common stock issue. Current stock price is $40.05)  Flotation costs are another name for issue costs Net price = 40×(1-. Debt: Bonds with a 12% yield Stock: Expect dividends of $3.05) = 38 Get rWACC = (.

Weighted Average Cost of Capital WACC value ∞ UCFt =∑ (1 + rWACC )t t =1 where UCFt is after-tax unlevered cash flow and rWACC is the weighted average cost of capital. 31 WACC Steps Steps Calculate unlevered cash flows Calculate WACC Find NPV by discounting cash flows at the WACC Only appropriate as a discount rate when Project & Firm: Same systematic business risk Project & Firm: Same debt capacity Firm: Target debt to value is relatively stable 32 16 .

33 APV Steps Steps Calculate unlevered cash flows Find NPV by discounting cash flows at the unlevered cost of capital Adjust for the PV of financing side effects Only appropriate as a discount rate when Project’s debt level is known over the life of the project 34 17 .Adjusted Present Value (APV) APV value = base-case NPV + NPV of financing Base-case NPV = project value if use only equity ∞ =∑ t =1 UCF t t + PV(Financi ng effects) (1 + r 0) where UCFt is after-tax unlevered cash flow and ro is the unlevered cost of capital.

Financing Side Effects Financing Side Effects Tax deduction for interest Effects of subsidized financing Issue costs for new debt and equity Financial distress costs 35 Flows to Equity (FTE) FTE: PV of cash flows to stockholders in the levered firm discounted by rS. after-interest cash flow to levered equity and rS is return on levered equity. Levered Equity value = ∑ ∞ t =1 LCFt t (1 + r S ) LCFt is after-tax. FTE = Levered Equity Value – Firm’s Investment 36 18 .

Debt ratio (debt to value) is 58.000. APV and FTE to find the project’s value. Tax rate is 30%. Cat has a value of 7.000 every year forever. LCF = Unlevered cash flows – [(1-Tc)× rB×B] Find cost of levered equity rS = ro + (B/S)(1-Tc)(ro .rB). 38 19 .000.8%.600. Use WACC. With no debt. Unlevered cost of capital is 16%.000. LCF is cash flow to stockholders after interest and taxes are paid.000 in debt with interest rate of 10%.Flows to Equity (FTE) Steps Find levered cash flows (LCF). Subtract the amount of cash supplied by the firm 37 Example: Levered Project for Cat A project costs $6 million EBIT is $1. This is affected by business and financial risk Find value of the LCF discounted at rS. Issue $5.

For cost of equity: use M&M With Tax rS = 16% + (5M/3.5M)(22%) rWACC = 13.3)(16%-10%) = 22% rWACC = (5M/8.18% V =(UCF/ rWACC) – 6M V =($1.12M Get WACC.5M)(1-.3(5M) = $1. 2.5M = $2.6M(1-. 3.5M Adjusted present value APV = base-case NPV + NPVF APV = 1M + 1. Base-case NPV: All-Equity Value UCF = $1.120.000/.000 40 20 .5M 39 Levered Project WACC Answer UCF = 1.I = (1.12M/.16) .5M)(1-.1318) – 6M = $2.500.5M/8.3)(10%) + (3.000 NPV = (UCF/ro).6M = 1M Present value of the financing side effect NPVF = PVITS = TC(rBB)/rB = TCB = .3) = 1.120.Levered Project APV Answer 1.

120.8% VU = (1.588/.3×5M) = 8.588.3) = 770.1×5M))×(1-. Find Levered Cash Flows (LCF) LCF = UCF – [(1-TC)× rB×B] LCF = 1. Cat gets the value of the remaining cash flows 41 Flow-to-Equity Answer #1 1.000 OR USE LCF = (EBIT-rBB)(1-TC) LCF = (1.588/(1-.428 OR USE B/V = .rB) = 0.427(1-.10)] rS = 22% 42 21 .16) = 7M Once the project is taken.5M = 1.588) = .Unlevered Cash Flow and Value UCF = 1.412 = 1.1×5M] = 770.000 – [(1-.3)×.5M VL = 8.5M = 58. Find cost of levered equity B/S = 5M/3.12M VL = VU + (TC×B) = 7M + (.000 2.427 rS = ro + (B/S)(1-T)(ro .3)(.5M = S + B = S + 5M so S = 3.3) = 1.6M(1-.6M-(.5M Notice that B/VL = 5M/8.16-.12M/. so B/S = .16+[1.

Levered Equity Value = LCF/rS= $770.000/.5M . & FTE All three determine value in the presence of debt financing APV Initial Investment Cash Flows Discount Rates PV of financing All UCF ro Yes WACC All UCF rWACC No FTE Equity Portion LCF rS No 22 . Subtract the cash supplied by the firm. WACC. so firm supplies 6M-5M = $1M 5.$1M = $2.500.22= $3. Invest $6M but borrow $5M. FTE value = $3.000 43 Summary: APV.Flow-to-Equity Approach #2 3.5M 4.

Tax rate is 30%. WACC: most common method used FTE: used for firms with extensive leverage Use APV if the project’s level of debt is known over the life of the project (constant debt level). APV: Special situations like subsidies and leases 45 Non-Perpetual Debt Example A project costs $6 million Unlevered after-tax cash flows of $3.10 Use WACC. Kit issues $5. Debt-to-Equity = B/S = 2.000.000 in 3-year debt with an interest rate of 10%. APV and FTE to find the project’s value.000 every year for 3 years. Unlevered cost of capital is 16%.Rule of Thumb Use WACC or FTE if the firm’s target debt-tovalue ratio applies to the project over its life (constant debt ratio).120. 46 23 .

028 = $1.007.323 and B/V = . 2.1.10×(1-.443 48 24 .3)(10%)] + [.82%] = 12.82% B/S = 2.1 so S/V = .16.677 rWACC = [(.76% Value with WACC: NPV(.3120000.1 ×5M = 150. Cost of equity: use M&M With Tax rS = 16% + [2.3)(16%-10%)] = 24. Base-case NPV: All-Equity Value NPV(.007.3 ×.3120000.$6M = $1.175 + 373.3120000.-150000) = 373.677)(1-.$6M = $1. PV(.3120000) .12M Get WACC.3120000.323×24.1276.380.3.APV Non-Perpetual Debt Answer 1.203 47 Levered Project WACC Answer UCF = 3.175 Present value of interest tax shield Interest Tax Shield = Tc ×rB ×B =.397.3120000) .028 Adjusted present value APV = base-case NPV + PVITS APV = 1.000 3.

16-.000 = (2.82% 49 Flow-to-Equity Approach #2 3. Find cost of levered equity B/S = 2. FTE value = $2.850. Levered Equity Value NPV(.354 50 25 .000 in years 1 & 2 LCF = 2.354 4. Invest $6M but borrow $5M.000) in year 3 Must repay the loan 2. so firm supplies 6M-5M = $1M 5.354 .1×5M] LCF =2.rB) = 0.120.2770000.770.10)] rS = 24.850.230.FTE Non-Perpetual Debt 1.-2230000) NPV = $2.000-5.000–[(1-. Find Levered Cash Flows (LCF) LCF = UCF – [(1-T)× rB×B] LCF=3.3)×.850. Subtract the cash supplied by the firm.16+[2.10 rS = ro + (B/S)(1-T)(ro .000.2770000.2482.10×(1-.1M = $1.3)(.770.