Risk, Cost of Capital, and

Capital Budgeting

Chapter 12

1
Where Do We Stand?
 Earlier: size/timing of cash flows.
 Now, appropriate discount rate when cash
flows are risky.

2
The Cost of Equity Capital
Shareholder
Firm with invests in
Pay cash dividend financial
excess cash
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should be at least as great as the
expected return on a financial asset of comparable risk. 3
The Cost of Equity Capital
 Remember, risk/return tradeoff
 Need a measure of opportunity cost
 Capital Asset Pricing Model (CAPM)
 Expected return on an individual security:

Market Risk Premium

4
The Cost of Equity Capital
𝑟 𝑠=𝑟 𝑓 + 𝛽 ( 𝑟 𝑚 − 𝑟 𝑓 )
Expected return

rm

rf

1.0 b

5
The Cost of Equity Capital
Expected return

13.5%

3%

1.5 b

βi  1.5 rf  3% rm  10%

rs  3%  1.5  (10%  3%)  13.5% 6

The Cost of Equity Capital
 From the firm’s perspective, the expected return
is the cost of equity capital:
𝑟 𝑠=𝑟 𝑓 + 𝛽 ( 𝑟 𝑚 − 𝑟 𝑓 )

 To estimate a firm’s cost of equity capital, we

need to know three things:
 The risk-free rate, rF
 The market risk premium, rM – rF
 The company beta, b
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Example
 The stock of Align Technology (designs, manufactures, and
markets the invisalign system for treating the misalignment
of teeth) has a beta of approximately 2.0. The firm is 100
percent equity financed.
 Assume a risk-free rate of 2 percent and a market risk
premium of 8 percent.
 What is the appropriate discount rate for an expansion of
this firm?
𝑟 𝑠=𝑟 𝑓 + 𝛽 ( 𝑟 𝑚 − 𝑟 𝑓 )

8
Example
Suppose Align is evaluating the following independent
projects. Each costs $100 and lasts one year.
Project Project Project’s IRR NPV at
beta Estimated Cash 18%
Flow Next Year

A 2.0 $150 50% $27

B 2.0 $118 18% $0

C 2.0 $110 10% -$7

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 Using the SML

Good A SML
IRR
Project

project

18% B

C Bad project
2%
Firm’s risk (beta)
2.0
An all-equity firm should accept projects whose IRRs exceed the cost of
equity capital and reject projects whose IRRs fall short of the cost of capital.
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Risk-free Rate
 Treasury securities are close proxies
 CAPM is a period model.
 But, projects are long-lived
 So, average period (short-term) rates need to be
used.

11
Market Risk Premium
 Method 1: Use historical data.
 Method 2: Use the Dividend Discount Model.
 Market data and analyst forecasts can be used to
implement the DDM approach on a market-wide
basis.

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Market Risk Premium
 Method 1: Use historical data.
 Method 2: Use the Dividend Discount Model.
 Market data and analyst forecasts can be used to
implement the DDM approach on a market-wide
basis.

13
Estimating Beta

Market Portfolio
Theory: Portfolio of all assets in the economy
Practice: A broad stock market index, such as
the S&P Composite to represent.

Beta - Sensitivity of a stock’s return to the return

on the market portfolio.

14
 Estimating Beta
Cov(ri , rM ) σ i,M
βi   2
• Problems Var(rM ) σM
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.

• Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and
financial risk.
– Look at average beta estimates of comparable firms in the industry.
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Stability of Beta

 Most analysts argue that betas are generally

stable for firms remaining in the same industry.
 But, betas can change
 Changes in product line
 Changes in technology
 Deregulation
 Changes in financial leverage

16
Using an Industry Beta
 Some argue that a better estimate of a firm’s beta
is to use the beta for the whole industry.
 If you believe that the operations of the firm are
similar to the operations of the rest of the
industry, you could use the industry beta.
 If you believe that the operations of the firm are
fundamentally different from the operations of the
rest of the industry, you should use the firm’s beta.

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Determinants of Beta

 Business Risk
 Cyclicality of Revenues
 Operating Leverage
 Financial Risk
 Financial Leverage

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Cyclicality of Revenues
 Highly cyclical stocks have higher betas.
 Ex: Retailers, high tech, and automotive firms fluctuate
with the business cycle
 Ex: Utilities, railroads, food companies are less
dependent upon the business cycle.
 Note that cyclicality is not the same as variability—stocks
with high standard deviations need not have high betas.
 Ex: Movie studios have revenues that are variable (eg,
“hits” or “flops”) but their revenues may not be
especially dependent upon the business cycle.
 Total risk is not systematic risk!

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Operating Leverage

 Degree of operating leverage measures

how sensitive a firm (or project) is to its
fixed costs.
 OL increases as fixed costs rise and
variable costs fall.
 OL magnifies the effect of cyclicality on
beta.

20
Financial Leverage and Beta
 Operating leverage refers to the sensitivity to the
firm’s fixed costs of production.
 Financial leverage is the sensitivity to a firm’s fixed
costs of financing.

21
Financial Leverage and Beta
 The relationship between the betas of the firm’s
debt, equity, and assets is given by:

bAsset = Debt × bDebt + Equity × bEquity

Debt + Equity Debt + Equity

 Notes: If levered firm, asset beta is different than

equity beta. Asset beta is beta of stock if firm is
financed with all equity. Beta of debt is very low
(common to assume 0).
 Financial leverage always increases the equity
beta relative to the asset beta. 22
Financial Leverage and Beta
 Example
 Grand Sport, Inc., which is currently all-equity
financed, has a beta of 0.90.
 The firm has decided to lever up to a capital structure
of 1 part debt to 1 part equity
 Since the firm will remain in the same industry, its
asset beta should remain 0.90
 Therefore, assuming a zero beta for its debt, its equity
beta would become twice as large:

1
bAsset = 0.90 = × bEquity bEquity = 2 × 0.90 = 1.80
1+1
23
Firm versus Project

 Is project risk the same as firm risk?

 Hurdle rate must depend on project!

24
 Capital Budgeting & Project Risk
The SML can tell us why:
Project IRR

SML

Incorrectly accepted
negative NPV projects
Hurdle
rate
Incorrectly rejected
rf positive NPV projects
Firm’s risk (beta)
bFIRM
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value. 25
Capital Budgeting & Project Risk
Suppose GE has a cost of capital, based on CAPM, of about
10%. The risk-free rate is 2%, the market risk premium is 8%,
and the firm’s beta is 1.0.
10% = 2% + 1.0× 8%
Assume (simplified a lot!) that this is a breakdown of the
company’s divisions:
1/3 Aviation b = 1.9
1/3 Healthcare b = 0.9
1/3 Power b = 0.2
average b of assets = 1.0
When evaluating a new gas turbine project, which cost of
capital should be used?
26
Capital Budgeting & Project Risk
SML
Project IRR

17.2%
10%
3.6%

Project’s risk (beta)

0.2 1.0 1.9
r = 2% + 0.2×(10% – 2% ) = 3.6%
27
Also, GE is not all equity-based! So, my example is very simplified.
Cost of Debt

 Interest rate required on new debt issuance (i.e.,

yield to maturity on outstanding debt)
 Adjust for the tax deductibility of interest expense
 Note: Tax Cuts and Jobs Act of 2017 placed limits
on the amount of interest that can be deducted in
certain situations.

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 Cost of Capital with Debt

 The Weighted Average Cost of Capital is given by:

Equity Debt
rWACC = × rEquity + × rDebt × (1 – TC)
Equity + Debt Equity + Debt

S B
rWACC = × rS + × rB × (1 – TC)
S+B S+B

Because interest expense is tax-deductible, we multiply the last

term by (1 – TC).
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Example: Coca-Cola
 First, estimate the cost of equity and the cost of
debt.
 Estimate an equity beta to get the cost of
equity.
 Estimate the cost of debt by using credit
rating
 Alternative: YTMs on existing bonds
 Second, determine WACC by weighting these two
costs appropriately.
30
Example: Coca-Cola

31
Example: Coca-Cola

32
Example: Coca-Cola
 The cost of equity capital with Bloomberg data:

33
Example: Coca-Cola

 From FRED St. Louis Economic Data, A yields are about 3.09%.

34
Example: Coca-Cola

S B
rWACC = × rS + × rB × (1 – TC)
S+B S+B

35
KO: WACC

36
WACC: Some notes

 WACC
 Cost of capital
 If used for a project as hurdle rate

 Project risk is the SAME as firm

 Project utilizes SAME mix of debt and equity
 Constant cost of capital (so mix is constant)
 Weights
 Market values are better than book
 Often use book value of debt with market value of stock

37
Example
 Given the following information for Huntington
Power Co., find the WACC. Assume a 35% tax
rate.
 Debt: 5,000 8% coupon bonds outstanding, 1000
par value, 20 yrs to maturity, trading at 103% of
par with semiannual payments.
 Common stock: 160,000 shares outstanding selling
for $57. Beta is 1.10.
 Market: 7% market risk premium and 6% risk free
rate.
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Valuation
 Remember from capital budgeting:
 Forecast cash flows (no interest)
 Assess risk
 Estimate opportunity cost of capital
 Calculate NPV

 Now, apply to valuing a firm:

 Dividend growth model has too many problems.

39
Valuation

 Free Cash Flow is the amount of cash the firm can

pay out to investors after making all necessary
investments for growth
 Better measure of value creation than dividend
 So, then the value of a business or project is
usually the PV of the expected future FCFs

40
Valuation
FCF1 FCF2 FCFH PVH
PV    ...  
(1  rWACC )1 (1  rWACC )2 (1  rWACC )H (1  rWACC )H

PV (free cash flows) PV (horizon value)

FCFH1
where PVH 
(rWACC  g)

Does this look familiar?

Why is it better than dividend growth model?
41
Valuation Simple Example

 You have the following estimated free cash flows

for Knight Co: FCF1 = $7 million; FCF2 = $45 million;
FCF3 = $55 million; free cash flow grows at a rate
of 4% for year 4 and beyond. If the weighted
average cost of capital is 10%, calculate the value
of the firm.

42
Valuation: Constant Growth
Example
 Now, suppose that Sangria Inc. (company that
sells sangria) wants to acquire a company called
Rio, which makes gourmet picnic baskets. Their
FCF this year (t=0) is $2.5 million and it is assumed
to grow at a constant rate of 5%. Their cost of
capital is 9%. What is the value of Rio?

FCF1
PV0 
rWACC  g
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Valuation: Constant Growth
Example
 PV is PV(business)
 Value of Equity = PV(business) – Debt – Preferred
 Price = Value of Equity/# Shares Outstanding
 So, assume Rio has $36m in debt, $0 in preferred
stock, and 1.5 m shares outstanding.
 How much should Sangria pay?

44
Valuation: Non-constant
Growth Example
 Now, assume that Sangria does not think FCFs will
grow at a constant rate. They prepare the
following forecasts.
 Note that forecast horizon is 6 years. Year 7 is
used for illustration.

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 Valuation: Non-constant
Growth Example
0 1 2 3 4 5 6 7
1 Sales 83.6 89.5 95.8 102.5 106.6 110.8 115.2 118.7
2 Cost of goods sold 63.1 66.2 71.3 76.3 79.9 83.1 87 90.2
3 EBITDA (1-2) 20.5 23.3 24.4 26.1 26.6 27.7 28.2 28.5
4 Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1
5 Profit before tax (EBIT) (3-4) 17.2 13.4 13.8 14.8 14.9 15.4 15.5 15.4
6 Tax 6 4.7 4.8 5.2 5.2 5.4 5.4 5.4
7 Profit after tax (5-6) 11.2 8.7 9 9.6 9.7 10 10.1 10
8 Investment in fixed assets 11 14.6 15.5 16.6 15 15.6 15.6 15.9
9 Investment in working capital 1 0.5 0.8 0.9 0.5 0.6 0.6 0.4
10 Free cash flow (7+4-8-9) 2.5 3.5 3.2 3.4 5.9 6.1 6.6 6.8

PV Free cash flow, years 1-6 20.6 113.4 (Horizon value in year 6)
PV Horizon value 67.6
PV of company 88.2

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Valuation: Non-constant
Growth Example
Example: Rio Corporation – continued
Assumptions

Sales growth (percent) 6.7 7 7 7 4 4 4 3

Tax rate, percent 35%

WACC 9%
Long term growth forecast 3%

Fixed assets and working capital

Gross fixed assets 95 109.6 125.1 141.8 156.8 172.4 188 203.9
Less accumulated depreciation 29 38.9 49.5 60.8 72.6 84.9 97.6 110.7
Net fixed assets 66 70.7 75.6 80.9 84.2 87.5 90.4 93.2
Depreciation 3.3 9.9 10.6 11.3 11.8 12.3 12.7 13.1
Working capital 11.1 11.6 12.4 13.3 13.9 14.4 15 15.4

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Valuation: Non-constant
Growth Example
FCF = Profit after tax + depreciation – investment
in fixed assets - investment in working capital

FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1)

= $3.5 million

48
Valuation: Non-constant
Growth Example
FCF1 FCF2 FCFH PVH
PV    ...  
(1  rWACC )1 (1  rWACC )2 (1  rWACC )H (1  rWACC )H

PV (free cash flows) PV (horizon value)

FCFH1
where PVH 
(rWACC  g)

49
Valuation: Non-constant
Growth Example
 Nervous about impact of horizon value?
 Market Multiple
 EBITDA (and/or EBIT)
 Find mature, public companies whose scale, risk,
and growth prospects today roughly match RIO at
the investment horizon.
 Suppose they sell at multiples of 4.5 times
EBITDA and 7.5 times EBIT.

50
Valuation: Coca-Cola

FY 2012 FY 2013 FY 2014 FY 2015 FY 2016 FY 2017 FY 2018

EBIT 10,779.00 10,228.00 9,708.00 8,728.00 8,626.00 7,599.00 8,700.00
Taxes 2,723.00 2,851.00 2,201.00 2,239.00 1,586.00 5,560.00 1,623.00
Profit After Tax 8,056.00 7,377.00 7,507.00 6,489.00 7,040.00 2,039.00 7,077.00

Depreciation 1,982.00 1,977.00 1,976.00 1,970.00 1,787.00 1,260.00 1,086.00

Investment in NWC
Total Current Assets 30,328.00 31,304.00 32,986.00 33,395.00 34,010.00 36,545.00 30,634.00
Total Current Liabilities 27,821.00 27,811.00 32,374.00 26,929.00 26,532.00 27,194.00 29,223.00
NWC 2,507.00 3,493.00 612.00 6,466.00 7,478.00 9,351.00 1,411.00
Change in NWC 986.00 (2,881.00) 5,854.00 1,012.00 1,873.00 (7,940.00)

Capital Expenditures 2,780.00 2,550.00 2,406.00 2,553.00 2,262.00 1,675.00 1,347.00

Free Cash Flow 5,818.00 9,958.00 52.00 5,553.00 (249.00) 14,756.00

Average Free Cash Flow 5,981.33

51
Valuation: Coca-Cola

ValueLine: Growth estimate in FCFs is 6%.

ValueLine: Growth estimate in Sales is 2.5%.

52
Valuation: Coca-Cola
 First, constant growth:

FCF1
PV0 
rWACC  g

PV is PV(business)
Value of Equity = PV(business) – Debt – Preferred
Price = Value of Equity/# Shares Outstanding
53
Valuation: Coca-Cola
Now, assume two stage model: FCFs will grow at
projected growth in cash flows for 5 years and
then become constant at the projected rate of
growth in sales (Value Line).

Note how important growth rate at horizon is!

BTW, Coca Cola was trading at $47.35 at the end of 2018 and
$50-52 at time data pulled from Bloomberg. What does this
suggest about our analysis?
54
WACC: Reminders

 Remember:
 If you discount at WACC, cash flows have to be
projected just as you would for a capital
investment project.
 Do not deduct interest.
 The value of interest tax shields is picked up in the
WACC formula.
 Subtract value of debt/preferred from total value to
get value of equity.

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Video
 http://www.morningstar.com/cover/videocenter.a
spx?id=617239

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