Chapter 13: Risk, cost of capital,

and capital budgeting

Corporate Finance
Ross, Westerfield, and
Jaffe
Outline

1. The CAPM and the cost of equity

2. The cost of capital
3. Reducing the cost of capital
The cost of equity

 In Chapter 11, we learned that the CAPM

provides an estimate of the required
(expected) return from stock market (equity)
investors’ perspective.
 We learned that this required return can be
used to estimate the cost of equity.
 The cost of equity is a positive function of
beta.
Beta estimate, I

 In Chapter 11, we also learned that we can estimate

the beta of a firm by regressing the excess returns
(the difference between the stock’s returns and the
risk-free rates) of the firm on the excess returns of a
market index, such as the S&P 500 Index. The
slope term is the firm’s beta estimate.
 We usually use most recent 60 monthly returns for
this estimation.
 Of course, we can find the beta estimate from many
internet sites as well, e.g., finance.yahoo.com.
Beta estimate, II

 The word “estimate” of course says something about the

uncertain nature of the beta estimate; it is subject to
estimation error.
 As a result, some practitioners like to use the industry’s
average beta as a proxy for the firm’s beta as well, even
though the firm’s beta can be directly estimated.
 If you believe the operations of the firm are similar to the
operations of the rest of the industry, it is a good idea to use
the industry’s average beta to reduce estimation error.
 If not, then use the firm’s beta estimate for calculating the
cost of equity.
Cost of capital

 For corporate capital budgeting purpose, we often

discount a project’s free cash flows (to the firm) by
its cost of capital.
 Free cash flows (FCFs): the cash flows available
to the firm’s suppliers of capital, including debt
and equity, after all operating expenses (including
taxes) have been paid and investments in working
capital and fixed assets have been made.
 Firm = debt + equity.
WACC, I

 Because FCFs are available to debt-holders

and equity-holders, the applicable discount
rate needs to be an aggregate of the cost of
debt and the cost of equity.
 The most popular choice of this applicable
discount rate is called WACC (weighted
average cost of capital).
 WACC is a function of the cost of debt and
the cost of equity.
WACC, II

 WACC = we × re + wd × rd × (1 – corporate tax

rate).
 re is the cost of equity (via the CAPM or other
pricing models).
 rd is the cost of debt; if the firm uses corporate
bonds to finance all of its long-term debt, we
can use YTM as an estimate of the cost of
debt.
WACC, III

 we is the capital structure weight of equity.

 wd is the capital structure weight of debt.
 E is the market value of equity; D is the
market value of debt.
 we = E / (E + D), and wd = D / (E + D).
Weighted cost of debt, I

 A corporation may have multiple issues of

bonds outstanding.
 rd is often the weighted average of YTMs of
many issues.
 The weights can be market value weights or
book value weights.
Weighted cost of debt, II

 Example: DEF Inc. has 2 issues of bonds

outstanding. Bond A has a book value of 100
million, market value of 120 million, and a YTM of
5%. Bond B has a book value of 200 million, market
value of 180 million, and a YTM of 5.5%.
 Book value weight: rd = [100/(100+200)] * 5% + [200/
(100+200)] *5.5% = 5.34%.
 Market value weight: rd = [120/(120+180)] * 5% +
[180/(120+180)] *5.5% = 5.30%.
WACC example
 The market capitalization of EMN is $3.947 billion.
EMN use corporate bonds as the main source of L-T
debt. The market value of bonds is $1.519 billion.
The weighted average of YTMs is 6.2%. The beta of
EMN is 0.8. The risk-free rate is 4.26%. The
expected market premium is 8.7%. The corporate
tax rate is 35%.
 re = 4.26% + 0.8 × 8.7% = 11.22%.
 we = 3.947 / (3.947 + 1.519) = 72%. wd = 28%.
 WACC = 0.72 × 11.22% + 0.28 × 6.2% × (1 – 0.35) =
9.21%.
WACC estimates on the web

 www.valuepro.net.
Mini-case report due (cancelled)

 Please submit your report for mini-case: The

Cost of Capital for Goff Computer, Inc., pp.
426-427, in 1 week.
 Work on problems 1, 2, 4 (using only market
value weights), and 5 (using only market
value weights).
End-of-chapter

 Concept questions: 1-10.

 Questions and problems: 1-15 (excluding
book-weight (sub-)problems).