Chapter 9

RISK AND THE

COST OF CAPITAL

Brealey, Myers, and Allen

Principles of Corporate Finance
11th Global Edition
McGraw-Hill Education Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
9-1 COMPANY AND PROJECT COSTS OF
CAPITAL
• Firm Value
• Sum of value of assets

Firm value  PV(AB)  PV(A)  PV(B)

9-2
9-2
FIGURE 9.1 COMPANY COST OF CAPITAL
• A company’s cost of capital can be
compared to CAPM required return

Required SML
return

5.5
Company cost
of capital
0.2

0
0.5 Project beta

9-3
9-3
9-1 COMPANY AND PROJECT COSTS OF
CAPITAL
• Company Cost of Capital

rassets  COC  rdebt VD   requity VE 

V  DE
D  Market value of debt
E  Market value of equity

rdebt  YTM on bonds

requity  rf  β(rm  rf )

9-4
9-4
9-1 COMPANY AND PROJECT COSTS OF
CAPITAL
• Weighted Average Cost of Capital
• Traditional measure of capital structure, risk and
return

WACC  (1  Tc )r   r  
D
D V
E
E V

9-5
9-5
9-2 MEASURING THE COST OF EQUITY
• Capital Structure (CS)
• Mix of debt and equity within a company
• Expand CAPM to include CS
• r = rf + β(rm − rf)
• requity = rf + β(rm − rf)

9-6
9-6
9-2 MEASURING THE COST OF EQUITY
• Estimating Beta
• SML shows relationship between return and risk
• CAPM uses beta as proxy for risk
• Other methods can also determine slope of
SML and beta
• Regression analysis can be used to find beta

9-7
9-7
FIGURE 9.2A CITIGROUP RETURN

Weekly Data 2010-2011  

beta = 1.83
alpha = -0.31
R-squared = 0.64
Correlation = 0.80
Annualized std dev of market = 19.52
Annualized std dev of stock = 44.55
Variance of stock = 1984.83
Std error of beta 0.14

9-8
9-8
FIGURE 9.2B CITIGROUP RETURN

Wkly Data 2008-2009  

beta = 3.32
alpha = 0.24
R-squared = 0.49
Correlation = 0.70
Annualized std dev of market = 30.11
Annualized std dev of stock = 142.95
Variance of stock = 20436.08
Std error of beta 0.34

9-9
9-9
FIGURE 9.2C DISNEY RETURN

Wkly Data 2010-2011  

beta = 0.33
alpha = 0.02
R-squared = 0.22
Correlation = 0.47
Annualized std dev of market = 19.52
Annualized std dev of stock = 13.68
Variance of stock = 187.13
Std error of beta 0.06

9-10
9-10
FIGURE 9.2D DISNEY RETURN

Wkly Data 2008-2009  

beta = 0.41
alpha = 0.17
R-squared = 0.19
Correlation = 0.44
Annualized std dev of market = 30.11
Annualized std dev of stock = 28.08
Variance of stock = 788.62
Std error of beta 0.08

9-11
9-11
FIGURE 9.2E CAMPBELL’S RETURN

Wkly Data 2010-2011  

beta = 0.33
alpha = 0.02
R-squared = 0.22
Correlation = 0.47
Annualized std dev of market = 13.68
Annualized std dev of stock = 19.52
Variance of stock = 381.22
Std error of beta 0.06

9-12
9-12
FIGURE 9.2F CAMPBELL’S RETURN, %

Wkly Data 2008-2009  

beta = 0.41
alpha = 0.17
R-squared = 0.19
Correlation = 0.44
Annualized std dev of market = 28.08
Annualized std dev of stock = 30.11
Variance of stock = 906.55
Std error of beta 0.08

9-13
9-13
TABLE 9.1 ESTIMATES OF BETAS

Beta Standard Error

Canadian Pacific 1.27 .10

CSX 1.41 .08

Kansas City Southern 1.68 .12

Genesee & Wyoming 1.25 .08

Norfolk Southern 1.42 .09

Rail America 1.15 .14

Union Pacific 1.21 .07

Industry portfolio 1.34 .06

9-14
9-14
9-2 MEASURING THE COST OF EQUITY
• Beta Stability
% IN SAME % WITHIN ONE
RISK CLASS CLASS
CLASS 5 YEARS LATER 5 YEARS LATER

10 (High betas) 35 69
9 18 54

8 16 45
7 13 41

6 14 39

5 14 42
4 13 40
3 16 45
2 21 61
1 (Low betas) 40 62
Source: Sharpe and Cooper (1972)

9-15
9-15
9-2 MEASURING THE COST OF EQUITY
• Company cost of capital (COC) is based on
the average beta of the assets
• The average beta of the assets is based on
the % of funds in each asset
• Assets = debt + equity

D E
β assets  β debt     β equity   
V  V 

9-16
9-16
9-2 MEASURING THE COST OF EQUITY
• Expected Returns and Betas Prior to Refinancing

Expected 20
return (%)
Requity = 15
Rassets = 12.2

Rdebt = 8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity

9-17
9-17
9-2 MEASURING THE COST OF EQUITY
• Company cost of capital (COC) is based on
average beta of assets
• Average beta of assets is based on the % of
funds in each asset
• Example
• 1/3 new ventures β = 2.0
• 1/3 expand existing business β = 1.3
• 1/3 plant efficiency β = 0.6
• AVG β of assets = 1.3

9-18
9-18
9-2 MEASURING THE COST OF EQUITY
• Company Cost of Capital

Category Discount Rate

Speculative ventures 15.0%
New products 8.0%
Expansion of existing business 3.8% (COC)
Cost improvement, known technology 2.0%

9-19
9-19
9-3 ANALYZING PROJECT RISK

PV(fixed cost)
β revenue  β fixed cost 
PV(revenue)
PV(variable cost) PV(asset)
 β variable cost  β asset
PV(revenue) PV(revenue)

PV(revenue) - PV(variable cost)

β asset  β revenue
PV(asset)

 PV(fixed cost) 
 β revenue 1  
 PV(asset) 
9-20
9-20
9-3 ANALYZING PROJECT RISK
• Allowing for Possible Bad Outcomes
• Example
• Project Z will produce one cash flow, forecasted at $1
million at year 1. It is regarded as average risk,
suitable for discounting at 10% company COC:

C1 1,000,000
PV    $909,100
1 r 1.1

9-21
9-21
9-3 ANALYZING PROJECT RISK
• Allowing for Possible Bad Outcomes
• Example, continued
• Company’s engineers are behind schedule
developing technology for project. There is a small
chance that it will not work. Most likely outcome still
$1 million, but some chance that project Z will
generate zero cash flow next year:

9-22
9-22
9-3 ANALYZING PROJECT RISK
• Allowing for Possible Bad Outcomes
• Example, continued
• If technological uncertainty introduces a 10% chance of zero
cash flow, unbiased forecast could drop to $900,000:

900,000
PV   $818,000
1.1
9-23
9-23
TABLE 9.2 CASH FLOW FORECASTS

9-24
9-24
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Risk, Discounted Cash Flow (DCF), and
Certainty Equivalents (CEQ)

Ct CEQ t
PV  t
 t
(1  r ) (1  rf )

9-25
9-25
FIGURE 9.3 TWO WAYS TO CALCULATE
PRESENT VALUE

9-26
9-26
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example
• Project A expects CF = $100 mil for each of
three years. What is PV of project given 6%
risk-free rate, 8% market premium, and .75
beta?

r  rf  β(rm  rf )
 6  .75(8)
 12%
9-27
9-27
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued
• Project A expects CF = $100 mil for each of
three years. What is PV of project given 6%
risk-free rate, 8% market premium, and .75
beta?
Project A
Year Cash Flow PV @ 12%
1 100 89.3
2 100 79.7
3 100 71.2
Total PV 240.2
9-28
9-28
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued
• Project A expects CF = $100 mil for each of three years.
What is PV of project given 6% risk-free rate, 8%
market premium, and .75 beta?
• Assume cash flows change, but are risk-free. What is new PV?

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

9-29
9-29
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

• 94.6 is risk-free, is certainty equivalent of 100

9-30
9-30
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued
• Project A expects CF = $100 mil for each of three years.
What is PV of project given 6% risk-free rate, 8%
market premium, and .75 beta?

Year Cash Flow CEQ Risk Deduction

1 100 94.6 5.4
2 100 89.6 10.4
3 100 84.8 15.2

9-31
9-31
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued
• Project A expects CF = $100 mil for each of three years.
What is PV of project given 6% risk-free rate, 8%
market premium, and .75 beta?
• Assume cash flows change, but are risk-free. What is
new PV?
• Difference between 100 and certainty equivalent
(94.6) is 5.4%
• This % can be considered annual premium on risky
cash flow
Risky cash flow
 certainty equivalent cash flow
1.054
9-32
9-32
9-4 CERTAINTY EQUIVALENTS—ANOTHER WAY
TO ADJUST FOR RISK
• Example, continued
• Project A expects CF = $100 mil for each of three years.
What is PV of project given 6% risk-free rate, 8%
market premium, and .75 beta?
• Assume cash flows change, but are risk-free. What is
new PV?
100
Year 1   94.6
1.054
100
Year 2  2
 89.6
1.054
100
Year 3  3
 84.8
1.054
9-33
9-33