Week 8

Risk and a firm’s

cost of capital

Fundamentals of Finance

Topics Covered

• A Company’s Cost of Capital

• A Project’s Cost of Capital

• Analyzing Project Risk (More Trouble Than It’s Worth!?)

• Certainty Equivalents—Another Way to Adjust for Risk

A Firm’s Cost of Capital

Context

• We incorporate risk into financial decisions because the discount rate reflects risk. That is, we risk-adjust
the required return on the capital used to finance the firm and its projects

• In previous sessions, we covered how to estimate the value and required return on
• Debt capital
• Equity capital

• We now apply these concepts to valuing firms and their individual projects

• The value-additivity principle: a firm’s value is the sum of its parts/projects

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

The Cost of Capital

• The company’s cost of capital (COC) is the expected return on a portfolio of the company’s outstanding
debt and equity securities. The COC is:
• The opportunity cost of capital for investment in the firm’s assets
• The appropriate discount rate for the firm’s projects that are as risky as the average risk of all projects
the company pursues

• If a company is debt-free (i.e., 100% financed by equity), the COC is the required return on equity
• Examples of purely equity-financed firms: Pinterest, Apple & American Express (in the past)
• Recap from last week: we can estimate the cost of equity using a single factor CAPM model or other
approaches (e.g., multi-factor asset pricing models)

Recap: Measuring the Cost of Equity

• The CAPM is one method that links risk and expected returns for equity (re) as:

re = rf + β (rm – rf)

• The expected returns on equity is determined by its exposure to systematic risk

(measured by β). β can be estimated in regression analysis as follows:

r – rf = β (rm – rf) + εi

• If you wish to estimate β in practice that means:

• You can download financial data from Google, Yahoo Finance, etc.
• Decide on the sample period, the market return (rm) and the risk-free rate (rf)
• Your choices will affect the results. Judgement required to match regression
inputs to investor/client needs. This is not an exact science
• Or you could use already-estimated β’s from financial data providers
The Cost of Capital

• Most firms exhibit a capital structure that blends debt and equity. Example:

Asset value 100 Debt D = 30 at 7.5%

Equity E = 70 at 15%
Asset value 100 Firm Value V = 100

• The values of debt (D) and equity (E) add up to overall firm value (D + E = V)

• Asset value equals firm value

• All values are market values (not accounting values)

• Think of an investor who invested in a a portfolio made up of 30% debt and 70% stocks issued by this firm

Recap: Measuring the Cost of Debt

• We used the rate of return (“yield”) on debt to work out the required return on debt

• If you wish to estimate the cost of debt in practice that means:

If a company has issued bonds If no bonds are outstanding

• The (average) yield to • Infer the cost of debt from

maturity is a suitable financial statements (total
estimate for the cost of debt interest expenses/total
• Use the YTM data published debt)
by financial data providers • Use the YTM on the bonds
• Could be an average of the of (peer) firms with the
YTM on all bonds or an same credit rating
average of longer-term
bonds
The Cost of Capital

• Since most firms blend equity and debt in their capital structure, the firm’s cost of capital is given by an
average of the cost of debt and equity weighted by the proportion of debt and equity in the firm’s capital
structure

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

V = D+E IMPORTANT
D = market value of debt
E, D, and V are the
E = market value of equity
market values of equity,
debt, and firm assets

The Cost of Capital

• The company cost of capital is called the weighted-average after tax cost of capital (WACC)
• The cost of debt (interest) is a tax deductible (cash) expense
• If the corporate tax rate is (Tc), interest payments reduce net profits by (1-Tc)
• If Tc =21%, every £1 in interest payments reduces net profits by £0.79

• WACC is calculated as the after-tax cost of capital

Debt D = 30 at 7.5%
( )+r ( )
WACC = (1− Tc )rD D
V E
E
V
Equity E = 70 at 15%
WACC = (1− .21)7.5 (.30) +15 (.70) Firm Value V = 100

= 12.3%
Example: Tesco’s WACC

Individual Project Risk

More trouble than it's worth!?
Project Risk

• WACC denotes a company’s cost of capital. It is the average

required return across all a firm’s projects

• Use the WACC if the risk of a project is comparable to the Average Project
average risk across the company company risk risk

• But some lines of business pose a different risk relative to

company-wide risk. E.g.:
• Amazon: Amazon.com (low-risk retailer) vs Amazon Web WACC ?
Services (high-risk cloud computing)
• Virgin Group: trains (low-risk) vs airlines (higher risk)
• Vodafone: mobile network operator (low-risk utility) and
health technology (higher risk tech firm)

• In that case, use a project-based required return that

reflects the risk of the project/financial decision

Project Risk

• A company’s cost of capital (COC) is based on the average beta of the assets of a firm. Asset betas
measure how sensitive the COC is to economy-wide factors
• Asset betas are useful when we cannot calculate an equity beta. Usually the case for individual projects.
If used for projects, asset betas are indicators of project risk
æDö æEö
β assets = β debt ´ ç ÷ + β equity ´ ç ÷
èV ø èV ø
βequity sensitivity of required on equity to the market risk premium
βdebt sensitivity of required returns on debt to the default risk premium (i.e., spreads over gvt bonds)
βassets sensitivity of required returns on assets to the economic cycle (cyclicality)

• Goal: Once you know βassets , enter it into a CAPM model like (i.e., replace βequity)
rassets = rf + βassets (rm – rf)
where rm – rf is the market risk premium
Working out Asset Betas for Projects

• Method 1: Because βassets measures the sensitivity of returns to the economic cycle, it makes sense to
assume it is outside the control of individual firms. We can derive βassets from the mix of debt and equity
used to finance the assets. Use project-based betas as follows for debt and equity financing:

βequity Use the equity beta of a stand-alone firm in the same line of business as the project
βdebt Conveniently assume this is zero or close to zero for financially healthy firms

• Example: For a hypothetical project, we have βE = 1.25, and we’ll assume βD = 0.15.
The weights are the fractions of debt and equity financing, D/V = .192 and E/V = .808:

Working out Asset Betas for Projects

• Method 2: Asset betas increase in operational leverage. This matters because, while general sensitivity to
economic cycles (βassets) is outside the influence of companies (i.e., it is exogeneous to firms), operational
leverage can be (endogenously) affected by managers. Think of PV(asset) as the value of a project:

PV(asset) =PV(revenue) − PV(fixed cost) − PV(variable cost)

PV(revenue) = PV(fixed cost) + PV(variable cost) + PV(asset)

• βrevenue is the cyclicality of revenues, and it is a weighted average of the betas of its component parts:

PV(fixed cost)
β revenue = β fixed cost +
PV(revenue)
PV(variable cost) PV(asset)
+ β variable cost + β asset
PV(revenue) PV(revenue)
Working out Asset Betas for Projects

• More convenient assumptions allow us to simplify βassets:

βfixed costs = 0 Recipients of fixed costs (e.g., wages, rent) receive fixed cash flows
βrevenue = βvariable cost Both respond to the same underlying economic factors

PV(revenue)–PV(variable cost)
βasset = β revenue
PV(asset)

⎡ PV(fixed cost) ⎤
= β revenue ⎢1+ ⎥
⎣ PV(asset) ⎦
• This means, for a given cyclicality of revenues (reflected in βrevenue ), βassets is proportional to the ratio of
the present value of fixed costs to the present value of the project. Projects with a higher fixed cost
share to project value have a higher asset beta

Certainty Equivalents
Another Way to Adjust for Risk
Valuation by Certainty Equivalents

• An alternative way of taking risk into consideration without computing cost of capital
• Instead of using higher discount rates for higher-risk projects, we can use certainty-equivalent cash
flows and the risk-free rate to arrive at the same present value
• Intuition: How much of a reduction (“haircut”) in a risky cash flow would you accept in return for
making that risky cash flow risk-free?

• Certainty equivalent (CEQ) cash flows are equivalent risk-free cash flows. They are discounted using the
risk-free rate. The present value is the same as before. No need to estimate the cost of capital

Ct CEQ t
PV = =
(1 + r ) (1 + rf ) t
t

Valuation by Certainty Equivalents

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk-free rate of 6%, a market risk
premium of 8%, and beta of .75, what is the PV of the project?
Project A
r = rf + β(rm - rf ) Year Cash Flow PV at 12%
1 100 89.3
= 6 + .75(8)
2 100 79.7
= 12% 3 100 71.2
Total PV 240.2
Valuation by Certainty Equivalents

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 the cash flows become RISK
FREE. How much of a reduction would you accept in return?

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 and has the same PV, we call it
a certainty equivalent of the 100

Valuation by Certainty Equivalents

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 risk 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
Valuation by Certainty Equivalents

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 risk 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

Valuation by Certainty Equivalents

While the rate is constant in the example below, in principle, you could
derive different annual discount rates for different periods and used
these in a DCF model
Per-period risk is not constant in this approach

100
Year 1 = = 94.6
1.054

100
Year 2 = = 89.6
1.054 2

100
Year 3 = = 84.8
1.054 3
Summary

• The WACC is the discount rate for projects with the same risk as the company’s existing business
• But the WACC is not suitable for all financial decisions:
• Ultimately, it is project risk that counts. The cost of project capital depends on the use to which the
capital is put in individual projects
• Financial managers may understand whether a particular project is above- or below-average
company-level risk by working out asset betas

• If you can calculate the certainty-equivalent cash flows (CEQ) for a project directly, calculating the present
value is easy. All you do is to discount them at the risk-free rate
• You do not need to estimate the cost of capital
• CEQ also allow for different discount rates in different periods (i.e., risk per period is not constant)

• Asset betas and CEQs are conceptually appealing, but difficult to estimate in practice. Hence, the after-
tax WACC continues to be used widely used discount rate

Thank you