Understanding Company Cost of Capital and the Weighted Average Cost of Capital
Explore topics such as measuring the cost of equity, analyzing project risk, company cost of capital, and weighted average cost of capital (WACC) from the book "Principles of Corporate Finance, 12th Edition" by Brealey, Myers, and Allen. Learn about the importance of capital structure, equity cost, and measuring betas in financial analysis.
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Presentation Transcript
C H A P T E R RISK AND THE COST OF CAPITAL Brealey, Myers, and Allen Principles of Corporate Finance 12th Edition
Topics Covered Company and Project Costs of Capital Measuring the Cost of Equity Analyzing Project Risk Certainty Equivalents - Another Way to Adjust for Risk
Company Cost of Capital A firm s value can be stated as the sum of the value of its various assets The value-additivity principle = = + Firm value PV(AB) PV(A) PV(B)
Company Cost of Capital A company s cost of capital can be compared to the CAPM required return SML Required return 5.7 Company cost of capital 2.0 0 0.53 Project beta
Company Cost of Capital ( ) V ( ) V = = + COC r r r D E assets debt equity IMPORTANT = + V D E E, D, and V are all market values of equity, debt and total firm value = market val ue of debt D = market val ue of equity E = YTM r = on B bonds debt r + ( ) equity r r r f m f
Weighted Average Cost of Capital WACC is the traditional view of capital structure, risk and return ( ) V ( ) 15 + = + WACC 1 ( ) T r r D E c D E V ( ) ( ) = WACC 1 ( 5 . 7 ) 35 . . 30 70 . = 12 0 . %
Capital Structure and Equity Cost Capital structure - the mix of debt & equity within a company Expand CAPM to include capital structure: r = rf+ (rm rf) This becomes: requity= rf+ (rm- rf)
Measuring Betas The SML shows the relationship between return and risk CAPM uses beta as a proxy for risk Other methods can be employed to determine the slope of the SML and thus beta Regression analysis can be used to find beta
Company Cost of Capital 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 = + assets debt equity V V
Capital Structure and COC Expected returns and betas prior to refinancing 13 Expected return (%) requity= 9.8 rassets= 9.1 rdebt= 4.2 0 debt assets equity
Company Cost of Capital: Simple Approach 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 Example 1/3 New ventures = 2.0 1/3 Expand existing business = 1.3 1/3 Plant efficiency = 0.6 Average of assets = 1.3
Asset Betas PV(fixed cost) = + revenue fixed cost PV(revenue ) PV(variabl cost) e PV(asset) + + variable cost asset PV(revenue ) PV(revenue )
Asset Betas PV(revenue - ) PV(variabl cost) e = asset revenue PV(asset) + 1 PV(fixed cost) = revenue PV(asset)
Allowing for Possible Bad Outcomes Example Project Z will produce just one cash flow, forecasted at $1 million at year 1. It is regarded as average risk, suitable for discounting at a 10% company cost of capital: , 1 000 000 , C = = = PV 909 $ 100 , 1 r + 1 1 . 1
Allowing for Possible Bad Outcomes Example- continued But now you discover that the company s engineers are behind schedule in developing the technology required for the project. They are confident it will work, but they admit to a small chance that it will not. You still see the most likely outcome as $1 million, but you also see some chance that project Z will generate zero cash flow next year.
Allowing for Possible Bad Outcomes Example- continued This might describe the initial prospects of project Z. But if technological uncertainty introduces a 10% chance of a zero cash flow, the unbiased forecast could drop to $900,000. 900 000 , = = PV 818 $ 000 , 1 . 1
Risk, DCF, and CEQ CEQ + C + = = PV t r t ) t t 1 ( ) 1 ( r f
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? = ( + ) r r r r f m f = + 6 . 75 ) 8 ( = 12 %
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Project A Year Cash Flow 12% @ PV = ( + ) r r r r f m f 1 100 89.3 = + 6 . 75 ) 8 ( 2 100 79.7 = 12 % 3 100 71.2 Total PV 240.2
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Project A Now assume that the cash flows change, but are RISK FREE. What is the new PV? Year Cash Flow 12% @ PV 1 100 89.3 2 100 79.7 3 100 71.2 = ( + ) r r r r Total PV 240.2 f m f = + 6 . 75 ) 8 ( = 12 %
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV? Project B Project A Year Cash Flow PV @ 6% Year Cash Flow 12% @ PV 1 94.6 89.3 1 100 89.3 2 89.6 79.7 2 100 79.7 3 84.8 71.2 3 100 71.2 Total PV 240.2 Total PV 240.2
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV? Project B Project A Year Cash Flow PV @ 6% Year Cash Flow 12% @ PV 1 94.6 89.3 1 100 89.3 2 89.6 79.7 2 100 79.7 3 84.8 71.2 3 100 71.2 Total PV 240.2 Total PV 240.2 Since the 94.6 is risk free, we call it a certainty equivalent of the 100.
Risk, DCF, and CEQ Example Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? DEDUCTION FOR RISK. Deduction Year Cash Flow CEQ for Risk 1 100 94.6 5.4 2 100 89.6 10.4 3 100 84.8 15.2
