Lecture Note 9 (Ch12) | Cost Of Capital | Beta (Finance)

Lecture note 9


Cost of equity capital Estimating beta from historical data Cost of capital with debt (1) - Adjusted Present Value Cost of Capital with debt (2) - Weighted average cost of capital

The cost of equity capital
To think of what is an appropriate discount rate, consider a firm that has some extra cash. The firm can take two actions. (1) Pay out the cash as dividend or (2) reinvest the cash in a project. Which action would the stockholder prefer? If the company takes action (1), the stock holders receive the cash. Then, the stock holders can invest the money elsewhere by themselves. Suppose that the stock holders invest the cash in an asset with a similar risk as the project that the company was considering, then the investor can expect to earn the expected return given by Expected Return = RF + β*(Risk Premium) -------------------(a)

This means that, if the company takes action (2), the stock holder would demand the return as big as the return given by (a). In other words, the project should be undertaken only if the expected return is greater than (a). Another way to look at (a) is that, the expected value given by (a) is the opportunity cost of capital (the extra cash). The above discussion implies that, the appropriate discount rate is given by (a). The next slide summarizes this finding.

The cost of equity (contd)
Suppose that the company’s beta is given by β. The company is all equity financed. Suppose that the company is considering to invest in a new project, whose beta-risk is similar to the risk of the firm. Then the appropriate discount rate is given by Capital Asset Pricing Mode (CAPM)
R  RF  β ( R M  RF )

Where RF is the risk free rate, and market-risk premium.

( R M  RF )

is the

Cost of equity capital, (contd) -ExampleSuppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. The company is considering a new project. The new project is similar to the firm’s existing ones, thus the beta of the new project can be assumed to be equal to Stransfield’s existing beta. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for the new project.

Cost of equity capital, (contd) -ExampleTwo key assumptions we have made so far are (1) the beta risk of the new project is the same as the risk of the firm, and (2) the firm is allequity financed. We will discuss later the case when the company has some debt.

Estimation of Beta from historical data
Definition of beta of security i is the following

i 

Cov( Ri , RM )

 2 ( RM )

Where Ri is the return of the security i, and RM is the market return. Therefore, if we have historical data of the return of company i’s stock and market return, we can estimate the equity beta by computing the sample covariance and sample variance. In the following slide, I will show some necessary steps to compute the beta from the historical data.

Estimation of Beta from historical data -ExampleSuppose we sample the returns on the stock of General Tool Company and the returns on the S&P 500 index for four years.
Year General Tool Company return (RG) S&P 500 Index (RM)

1 2
3 4

-0.1 0.03
0.2 0.15

-0.4 -0.3
0.1 0.2

See Next Page

Estimation of Beta from historical data -Example, ContdThere are two ways to estimate the beta: (1) simply to apply the definition of beta or (2) to run regression RG=α+β(RM) using Ordinary Least Square estimation. OLS result for the β is the estimate of the beta. Both methods should give you an identical result Using the data in the previous page, compute the General Tool’s equity beta using both method. You should be careful when you use the excel function covar( , ) to compute covariance. This function computes  instead of  where the latter is the correct covariance. If you want to use the excel function, you have to correct it by multiplying it by n/(n-1). Alternatively, you can compute the correct covariance by yourself. The excel function for variance computes the correct variance.
n i 1

( X i  X )(Yi  Y ) n


i 1

( X i  X )(Yi  Y ) n 1

Real World Beta
P324-P325 provides estimates of some real world beta. The choice regarding how many years of data one uses to compute beta is arbitrary. If we use too few observations, the estimate becomes less accurate. If there had been a structural change in the risk of the firm, using data from distant-past may give you a biased estimate. Thus, such choice should be based on the situation you are analyzing. Nonetheless, five years of monthly data are said to be a common choice.

Stability of the beta
How stable is the beta? If the beta changes significantly overtime, we may not want to use data from distant past. But this decreases the amount of data to compute beta, thus decreases the accuracy of the beta estimation. Many analysts argue that betas are generally stable for firms staying in the same industry.

Using industry beta
Using its own past data to compute the beta seems to be commonsensical. However, the beta estimated this way may be subject to a large measurement errors due to lack of observations, etc.

It is frequently argued that one can better estimate a firm’s beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta.
See next page

Using industry beta, Example
The following table shows the estimates of the betas of software companies.
Adobe Systems Inc BMC Software Cadence Design

1.51 0.96 0.98

Cerner Corp
Citrix Systems Inc Comshare Inc Informix Corp

1.29 1.22 2.09

Int. Lottery & Totalizator Sys. Inc
Microsoft Corp Oracle Corp Symantec Corp

1.11 1.63 1.82

Veritas Software
Equity Weighted Portfolio


Using industry beta (contd)
Software industry may be a volatile industry. Thus, for example, the financial executive of Adobe System may be uncomfortable to use the beta (1.51) estimated using its own past data only. In such case, industry beta of 1.61 may be a more accurate estimates of the risk. Industry beta is also useful when a company just went to public, and thus does not have much historical data. When using industry beta, one has to make sure that the operation of the firm is similar to the operations of the rest of the firms in the industry.

Financial Leverage and beta
Financial Leverage is the extent to which a firm relied on debt. Levered firm is a firm with some debts in its capital structure. When a firm has a debt, this gives rise to the beta for the overall asset. See next page.

Financial Leverage and beta (contd)
In a similar way we computed the beta for equity capital, we can define the beta for debt capital as a sensitivity of the yield of the debt to the market return. Let βDebt and βEquity be the betas for debt and equity respectively. Then the βAsset, the beta for the overall asset, is defined as the equation in the next slide.

Financial Leverage and beta (contd)
•Overall asset beta is given by

 Asset 

Debt Equity  Debt   Equity Debt  Equity Debt  Equity

     (1)

where Debt is the market value of debt and equity is the market value of the equity. •The beta of debt is very low in practice since debt is a security with fixed payment, and therefore, the yield is less sensitive to the movement in the market. Thus, it is commonplace to assume that the beta of debt is zero. •If we assume that beta of debt is zero, then the equation (1) becomes

 Asset 

Equity  Equity Debt  Equity

     (2)

To see the implication of equation (2), let us see a simple example. See next page

Financial Leverage and beta (contd) -ExampleConsider a tree growing company, Rapid Cedars, which is currently all equity and has a beta of 0.8. The firm has decided to move to a capital structure with one part debt and two parts equity. What is the effect of this change in capital structure on the equity beta? Except changing the capital structure, there is no other changes.
See next page.

Financial Leverage and beta (contd) -ExampleSince only the change is the capital structure, the operation of the firm is unchanged. This means that the overall risk of the firm is unchanged. This in turn means that the asset beta is 0.8 (βAsset=0.8). Now, plug this number into equation (2) to get.
2  Equity 1 2 theref ore 2 0.8   Equity 3 3  Equity  0.8 *  1.2 2

 Asse t 

•Thus, the equity beta increases when the company increases leverage. This result is intuitive. Since the debt holders have the priority to receive the money, in the case of economic downturn, the money that the stockholders receive will be reduced. Thus, debt increases the risk of the equity holder. This increases the equity beta. Next page summarizes this result.

Financial Leverage and beta (contd)
By changing equation (2), we have
 Equity  (1 
Debt )  Asset Equity      (3)

•Since Debt/Equity is always greater than or equal to zero, equation (3) means that equity beta for a levered firm is always greater than its asset beta.

Cost of capital with debt (1) -Adjusted Net Present ValuePrevious discussions indicate that, when we compute the discount value for a levered firm, simply applying the equity beta the CAPM model may not produce an appropriate cost of capital. Using asset beta instead of equity beta is one of a solution. Adjusted Net Present Value is the NPV using the discounted rate thus computed. Next slide shows a typical way to compute the discounted value for Adjusted Net Present Value.

Cost of capital with debt (1), Contd -Adjusted Net Present ValueThe case we consider is the case where the company does not know its own equity beta or asset beta. For such case, first, we obtain the equity beta of a comparable company. Let βEqComp be the equity beta of the comparable company. Now, let B and S be the market value of the debt and equity of the comparable company. Next, compute the Asset beta of the comparable company in the following way. See Next slide




Cost of capital with debt (1), Contd -Adjusted Net Present ValueUsing the equation (2) we can compute the asset beta of the comparable company as
 Asset 
S Comp  Eq BS      (4)

In the presence of the tax, we need to modify (4) as follows. Let t be the tax rate, then the asset beta of the comparable company is given by
 Asset 
S Comp  Eq B(1  t )  S      (5)

Since the risk of company of our interest is similar to this comparable company, this asset beta should be a good approximation to the company of our interest. Finally, plug this asset beta in the CAPM to compute the cost of capital. This adjusts for the presence of leverage.

Cost of Capital With debt (2) -Weighted Average Cost of CapitalWeighted average cost of capital is another way to adjust for the presence of leverage. Suppose that a firm uses both debt and equity to finance its investment. If the company’s borrowing rate is rB and the expected return on equity is rs, what is the overall cost of its capital? . Let B and S be the market values of debt and equity. A straightforward way to compute the overall cost of capital is to take the weighted average of cost of equity and cost of debt, which is given by
S B rS  rB S B S B

As was the case in the Adjusted Present Value case, we need to take the tax into account. We modify this formula to take into account the tax. See Next slide.

Cost of Capital With debt (2) -Weighted Average Cost of Capital with debt-

Suppose that expected return on equity is rs. Let rb be the borrowing rate. Since the interest is tax deductible at corporate rate, after tax return to the debt holders is rb(1-Tc) where Tc is the corporation’s tax rate. In other words, rb(1-Tc) is the after tax cost of debt.
See Next Page

Cost of Capital With debt (2) -Weighted Average Cost of Capital with debt-

Therefore, the appropriate discount rate in the presence of corporate tax is given by the following weighted average cost of capital (WACC) .
S B rWACC = × rS + × rB ×(1 – TC) S+B S+B

Where S is the market value of Equity and B is the market value of debt.

Consider a firm whose debt has market value of $40million and whose stock has market value of $60million. The company plans to keep this equity to debt ratio. The firm pays a 15% rate of interest on its new debt and has an equity beta of 1.41. The corporate tax rate is 34%. The current treasury bill rate is 11%. The market risk premium is 9.5%. What is the firm’s weighted average cost of capital?

Example, Estimating International Paper’s cost of capital.

International Paper (IP) is a paper and pulp producing company. We need to figure out this company’s cost of capital. The debt to value ratio is 32%, i.e., B/(S+B)=0.32 The equity to value ratio is 68%, i.e., S/(S+B)=0.68. The company plans to keep this equity to debt ratio. Risk free rate is 3% Market risk premium is 8.4% debt pays 8% (borrowing rate is 8%) Corporate tax rate is 0.37 Industry average equity beta is 0.82. All the firms in the industry has similar capital structure. Thus, we can use 0.82 as the proxy for the equity beta of International Paper. Exercise: Compute the Weighted Average Cost of Capital of International Paper.

A note
The firm beta versus project beta So far, we assumed that the beta for the project is the same as the beta of the firm. If a company undertakes a project which is very different from the rest of the projects, then you should not use the firm’s beta. Instead, use industry beta whose operation is close to the new project. See the example in the next slide.

Firm beta v.s. project beta -ExampleD.D. Ronnelley Co, a publisher firm, a publisher firm, may accept a project in computer software. Noting that computer software companies have high betas, the publishing firm views the software venture as more risky than the rest of its business. Then, it should discount the project at a rate commensurate with the risk of software companies.

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