Principles of

Chapter 7 Corporate Finance

Tenth Edition

Risk and the Cost

of Capital

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.
 7-2

Topics Covered
➢Market risk premium
➢Measuring Expected rate of return /
Expected rate of return / Discount rate,
CAPM
➢Measuring Cost of Capital
➢Measuring WACC
➢Project Appraisal with WACC
 7-3

Key terms
▪ Market risk premium: Phần bù rủi ro thị trường.
▪ Risk-free rate: Lãi suất phi rủi ro, thường lấy
lãi suất của tín phiếu kho bạc nhà nước.
▪ Risk-free debt: là khoản nợ có chi phí vay
bằng r(f).
▪ Pretax cost of debt: còn được gọi là r(D).
▪ After-tax cost of debt: còn được gọi là r(D)×(1-
T).
▪ WACC còn có tên gọi khác là after-tax cost of
capital / discount rate.
 7-4

Market risk premium

 7-5

Capital Asset Pricing Model

r = rf + B(rm − rf )

CAPM
 7-6

Company Cost of Capital

➢A firm’s value can be stated as the sum
of the value of its various assets

Firm value = PV(AB) = PV(A) + PV(B)

 7-7

Company Cost of Capital

➢A company’s cost of capital can be
compared to the CAPM required return

SML
Required
return
3.8
Company Cost
of Capital
0.2

0
Project Beta
0.5
 7-8

Company Cost of Capital

rassets = COC = rdebt (VD ) + requity (VE )

V = D+E IMPORTANT
D = Market Value of Debt E, D, and V are all
E = Market Value of Equity market values of
Equity, Debt and
Total Firm Value

rdebt = YTM on bonds

requity = rf + B(rm − rf )
 7-9

Weighted Average Cost of Capital

 WACC is the traditional view of capital

structure, risk and return.

WACC = (1 − Tc )r ( )+ r ( )
D
D V
E
E V
 7-10

Project Appraisal with WACC

 WACC is the traditional view of capital

structure, risk and return.

𝑁𝑃𝑉
𝐶1 𝐶2
= −𝐶0 + + 2
1 + 𝑊𝐴𝐶𝐶 1 + 𝑊𝐴𝐶𝐶
𝐶𝑛
+ ⋯+
1 + 𝑊𝐴𝐶𝐶 𝑛
 7-11

Capital Structure and Equity Cost

Capital Structure - the mix of debt & equity within a
company

Expand CAPM to include CS

r = r f + B ( r m - rf )
becomes

requity = rf + B ( rm - rf )
 7-12

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
 7-13

Measuring Betas
 7-14

Measuring Betas
 7-15

Measuring Betas
 7-16

Estimated Betas

Standard
Beta equity Error
Burlington Northern Santa
Fe 1.01 0.19
Canadian Pacific 1.34 0.23
CSX 1.14 0.22
Kansas City Southern 1.75 0.29
Norfolk Southern 1.05 0.24
Union Pacific 1.16 0.21
Industry portfolio 1.24 0.18
 7-17

Beta Stability
% IN SAME % WITHIN ONE
RISK CLASS 5 CLASS 5
CLASS YEARS LATER 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)
 7-18

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
Bassets = BDebt    + Bequity   
V  V 
 7-19

Capital Structure & COC

Expected Returns and Betas prior to refinancing
Expected return (%)
20

Requity=15
Rassets=12.2

Rrdebt=8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
 Company Cost of Capital 7-20

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 B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6

AVG B of assets = 1.3

 7-21

Company Cost of Capital

Category Discount Rate

Speculative ventures 15.0%
New products 8.0%
Expansion of existing business 3.8% (Company COC)
Cost improvemen t, known technology 2.0%
 7-22

Asset Betas

PV(fixed cost)
Brevenue = Bfixed cost +
PV(revenue )
PV(variabl e cost) PV(asset)
+ B variable cost + Basset
PV(revenue ) PV(revenue )
 7-23

Asset Betas

PV(revenue ) - PV(variable cost)

Basset = B revenue
PV(asset)

 PV(fixed cost) 
= Brevenue 1 + 
 PV(asset) 
 7-24

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:

C1 1,000,000
PV = = = $909,100
1+ r 1.1
 7-25

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.
 7-26

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
 7-27

Table 9.2
 7-28

Risk,DCF and CEQ

Ct CEQt
PV = =
(1 + r ) t
(1 + rf ) t
 7-29

Risk,DCF and CEQ

 7-30

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?
 7-31

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 = rf + B( rm − rf )
= 6 + .75(8)
= 12%
 7-32

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 PV @ 12%
1 100 89.3
2 100 79.7
r = r f + B ( rm − r f )
= 6 + .75(8) 3 100 71.2
= 12% Total PV 240.2
 7-33

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 PV @ 12%
1 100 89.3 Now assume that the
2
3
100
100
79.7
71.2
cash flows change, but
Total PV 240.2 are RISK FREE. What
r = r f + B ( rm − r f ) is the new PV?
= 6 + .75(8)
= 12%
 7-34

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 PV @ 12% 1 94.6 89.3
1 100 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
 7-35

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 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

Since the 94.6 is risk free, we call it a Certainty

Equivalent of the 100.
 7-36

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
 7-37

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?

The difference between the 100 and the certainty

equivalent (94.6) is 5.4%…this % can be considered
the annual premium on a risky cash flow

Risky cash flow

= certainty equivalent cash flow
1.054
 7-38

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?

100
Year 1 = = 94.6
1.054

100
Year 2 = 2
= 89.6
1.054

100
Year 3 = 3
= 84.8
1.054