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Ch12
Outline
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
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.
( 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 firms existing ones, thus the beta of the new project can be assumed to be equal to Stransfields 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.
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 is 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
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=+(RM) using Ordinary Least Square estimation. OLS result for the is the estimate of the beta. Both methods should give you an identical result Using the data in the previous page, compute the General Tools 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
It is frequently argued that one can better estimate a firms 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
Beta
1.51 0.96 0.98
Cerner Corp
Citrix Systems Inc Comshare Inc Informix Corp
1.87
1.29 1.22 2.09
3.34
1.11 1.63 1.82
Veritas Software
Equity Weighted Portfolio
1.94
1.65
Asset
(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
(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 (Asset=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.
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 EqComp 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
1.
2.
3.
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 BS (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 companys 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 corporations 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.
Example
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 firms weighted average cost of capital?
International Paper (IP) is a paper and pulp producing company. We need to figure out this companys 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 firms 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.