Corporate Financial Policy: Cost of Capital, Project Risk and WACC

Jide Wintoki

Fall 2013

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

1 / 13

Lecture Outline

Weighted Average Cost of Capital (WACC) The WACC and the CAPM The eect of leverage on beta Asset betas and project discount rates Equity risk premium

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

2 / 13

Project Discount Rate and WACC

Project discount rate is easy to determine if we assume project is similar to the rms existing assets. In this case, the appropriate discount rate equals the weighted average cost of capital (WACC) WACC is the simple weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of nancing in the rms overall capital structure. WACC = D (1 Tc )rd + D +E E re D +E

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

3 / 13

Finding the WACC for a company with equity and debt Example
The S.D. Williams Company has 1 million shares of common stock outstanding which currently trade at a price of $50 per share. The company believes that its stockholders require a 15% return on their investment. The company also has $47.1 million (par value) in 5-year xed-rate notes with a coupon rate of 8% and a yield to maturity of 7%. The current market value of the 5-year notes is $49 million. What is the companys WACC if the corporate tax rate is 35%? E = 1m $50 = $50m; re = 15% = 0.15 D = $49m; rd = 7%=0.07; Tc = 35% = 0.35 WACC = $49 (1 0.35)0.07 + $99
Business Investment (FIN 468)

$50 0.15 = 9.8% $99

Fall 2013 4 / 13

Jide Wintoki (University of Kansas)

Finding the WACC for companies with complex capital structures

A rms capital structure may consist of debt, preferred stock and common stock WACC = D E P (1 Tc )rd + re + rp D +E +P D +E +P D +E +P

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

5 / 13

The Link between WACC and the CAPM

WACC is consistent with CAPM CAPM can be used to compute WACC for a levered rm. Any asset that generates cash ows has a beta that establishes the required return on the asset through the CAPM.
WACC represents the rate of return that a company must earn on its investments to satisfy both bondholders and stockholders The CAPM establishes a direct link between required rates of return on debt and equity and the betas of these securities D d + D +E E e D +E

A =

Debt beta is typically quite low for healthy, low-debt rms.

Jide Wintoki (University of Kansas) Business Investment (FIN 468) Fall 2013 6 / 13

The Link between WACC and the CAPM

If the rm has zero debt, the asset beta equals the equity beta. For rms that use debt, e > A . Holding the asset beta the risk of the rms assets constant, the more money the rm raises by issuing debt, the greater its nancial leverage, and the higher its equity beta. D E

e = A 1 + If we include taxes.

e = A 1 + (1 Tc )

D E
Fall 2013 7 / 13

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

The eect of leverage on beta - a numerical example

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

8 / 13

Discount Rate for Unique Projects

What if a company has diversied investments in many industries? In this case, using a rms WACC to evaluate an individual project would be inappropriate. Use the projects asset beta adjusted for desired leverage. Example
Assume GE is evaluating an investment in the oil and gas industry. GE would examine existing rms that are pure plays (public rms operating only in oil and gas industry).

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

9 / 13

Data for Berry Petroleum and Forest Oil

Say GE selects Berry Petroleum and Forest Oil as pure plays: Berry Petroleum Forest Oil Stock beta 0.65 0.90 Fraction Debt 0.14 0.39 Fraction Equity 0.86 0.61 D/E 0.16 0.64 Asset Beta* 0.56 0.55 * Assumes debt beta = 0 and no taxes Operationally similar rms, but Berry Petroleums e = 0.65 and Forest Oils e = 0.90 Why so dierent? Reason: Forest Oil uses debt for 39% of nancing; Berry Petroleum: 14%.

Jide Wintoki (University of Kansas)

Business Investment (FIN 468)

Fall 2013

10 / 13

Converting Equity Betas to Asset Betas for Two Pure Play Firms

To determine the correct A to in calculating discount rate for the project, GE must convert pure play e to A , then average.
Previous table lists data needed to compute unlevered equity beta. Unlevered equity beta strips out the eect of nancial leverage. Therefore it is always less than or equal to equity beta. A = e 1+
D E

Berrys A = 0.56, Forests A = 0.55, so average A = 0.55

GE capital structure consists of 20% debt and 80% equity (D/E ratio = 0.25). Compute relevered equity beta: Ge = A 1 +
Jide Wintoki (University of Kansas)

D E

= 0.55(1 + 0.25) = 0.69

Fall 2013 11 / 13

Business Investment (FIN 468)

Converting Equity Betas to Asset Betas for Two Pure Play Firms

Using CAPM, compute the rate of return GE shareholders require for the oil and gas investment.
Assume risk-free rate of interest is 6% and expected risk premium on the market is 7%: E (R ) = 6% + 0.69(7%) = 10.8%.

One more step to nd the right discount rate for GEs investment in this industry: calculate project WACC
GEs nancing is 80% equity and 20% debt. Assume investors expect 6.5% on GEs bonds: WACC = D E rd + re = 6.5%(0.2)+10.8%(0.8) = 9.9% D +E D +E
Business Investment (FIN 468) Fall 2013 12 / 13

Jide Wintoki (University of Kansas)

Finding the Right Discount Rate

1

When an all-equity rm invests in an asset similar to its existing assets, the cost of equity is the appropriate discount rate to use in NPV calculations. When a rm with both debt and equity invests in an asset similar to its existing assets, the WACC is the appropriate discount rate to use in NPV calculations. In conglomerates, the WACC reects the return that the rm must earn on average across all of its assets to satisfy investors, but using the WACC to discount cash ows of a particular investment leads to mistakes. When a rm invests in an asset that is dierent from its existing assets, it should look for pure-play rms to nd the right discount rate.
Business Investment (FIN 468) Fall 2013 13 / 13

Jide Wintoki (University of Kansas)