Project Rate of Return

Asset Beta and Equity Beta

 Session Plan
 Divisional WACC
 Project Specific WACC
 Equity Beta
 Asset Beta
 Application of CAPM to arrive at project’s
WACC

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 Divisional WACC & Project-Specific
WACC – Equity Beta & Asset Beta

 Most firms are multi-business or multidivisional firms.

Reliance Industries Ltd (apart from its subsidiaries) is
engaged in oil and gas, petroleum refining, polyester
etc. HUL is engaged in soaps and detergents,
beverages and foods
Since different businesses are likely to have different
business risks and capacities,it is justified that divisional
WACC be computed. Application of CAPM to find out the
WACC of division is very popular method of arriving at
project’s required rate of return

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 Divisional WACC & Project-Specific
WACC – Equity Beta & Asset Beta

 To explore the relationship between equity beta and asset beta,

we will initially ignore taxes. Look at Zenith Limited which has the
following balance sheet :
Equity : 50 Assets : 100
Debt : 50
If you buy all the securities of Zenith (its entire equity as well as debt),
you will own all its assets. So the beta of your portfolio () of Zenith’s securities is
equal to the beta of Zenith’s assets( P )
P=

Now, the beta of your portfolio is simply the weighted arithmetic average of the betas
of its components, viz., equity (E) and debt (D)
P = E E + DD

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Hence
E D
bA = bE + bD
E+D E+D
 

D
bE = bA + (bA - bD) E

If the beta of debt, bD, is assumed to be zero (this means that debt is considered
to be risk-free)
 

D D
bE = bA + bA = bA 1+
E E
Conisdering taxes,
D
bE = bA 1+ (1 – T)
E
This means
bE
bA =
Levered and unlevered beta
For start ups or new firms beta needs to
be indirectly assessed as they are not
listed on exchange.
This method is normally adopted to
get the appropriate discount rate.
The asset beta depends upon the capital
structure of the company. Thus leverage
plays an important role in identifying
asset beta
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 Procedure for Calculating a Project’s Required
Rate of Return

1. Find a sample of firms engaged in the same line of business.

2. Obtain equity betas for the sample firms.
3. Derive asset betas:
bE
 bA =
 [ 1 + D/E (1-T)]
4. Find the average of the asset betas.
5. Figure out the equity beta for the proposed project
bE = bA [ 1 + D/E (1 – T ) ]

6. Estimate the cost of equity for the proposed project, using the CAPM
rE = Rf + [ E (RM ) - Rf ] bE

7. Calculate the project’s required rate of return:

r = WE rE + WD rD ( 1 – T)
A
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 Illustration
 Diversified Limited is evaluating a granite project for which it proposes to
use a debt-equity ratio of 1.5:1. The pre-tax cost of debt is 15 percent and
the tax rate is expected to be 30 percent. The risk-free rate is 12 percent
and the expected return on the market portfolio is 16 percent. The project’s
required rate of return may be calculated as follows:
 Step 1 : Find a sample of firms engaged in similar business According to
the chief executive of Diversified Limited the following firms are engaged
wholly in the same line of business :
Ankit Granites Limited
Bharath Granites Company
Modern Granites Limited
 Step 2 : Obtain equity betas for the sample of comparable firms The equity
betas of the three firms, obtained by regressing their equity returns of the
market portfolio for the past 60 months, are as follows
Ankit Granites Limited : 1.20
Bharath Granites Company : 1.10
Modern Granites Limited : 1.05
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 Illustration contd…
Step 3 : Derive asset betas after adjusting equity betas for financial
leverage
The debt-equity ratios for the three firms, namely, Ankit Granites
Limited
Bharath Granites Company, and Modern Granites Limited are 2.1, 1.6,
and 1.3 respectively. The effective tax rate for all of them is 40 percent.
Their asset betas are derived by using the formula :
bA = bE / [1 + D / E (1-T)]

Ankit Granites Ltd : 1.2/ = 0.53

[1 + 2.1 (0.6)]
Bharath Granites Co. : 1.10/ = 0.56
[1 + 1.6 (0.6)]
Modern Granites Ltd : 1.05/ = 0.59
[1 + 1.3 (0.6)]

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 Illustration contd…
Step 4 : Find the average of asset betas The average of asset betas of Ankit
Granites Limited, Bharath Granites Company, and Modern Granites Limited is :
(0.53 + 0.56 + 0.59) / 3 = 0.56
 Step 5 : Figure out the equity beta for the proposed project The equity beta for the
proposed project is :
E = [1 + D / E (1-T)]
= 0.56 [1 + 1.5 (1 - .3)] = 1.14
Step 6 : Estimate the cost of equity for the proposed project. As per the capital asset
pricing model, the cost of equity for the proposed project is :
Z = x2
rE = Rf + (E(RM ) - Rf) E
= .12 + (.16 - .12) 1.148 = .166
Convex
 
Y=2x+3
Step 7 : Calculate the project’s required rate of return
Linear
The weighted average cost of capital (the required rate of return) for the granite
project of Diversified Limited is :
rA = WE re + WD rD (1 – T)
= [ ( (1/2.5) 0.166 ) + ( (1.5/2.5) (0.15) (0.7) ) ]
= .1294 = 12.94 percent
W=√X
Concave
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 Thanks

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