Ch. 6 Estimating the Project Cost of Capital - Capital Budgeting and Investment Analysis

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					            Ch. 6
Estimating the Project Cost of
           Capital
  Capital Budgeting and Investment
               Analysis
           By Alan Shapiro
                Introduction
• The cost of capital for a project is the
  minimum risk-adjusted return required by
  shareholders of the firm for undertaking that
  project
• Unless the investment generates sufficient
  funds to repay suppliers of capital, the firm’s
  value will suffer
           Introduction cont.
• This rate must take account of both the time
  value of money, measured by risk-free rate of
  return and the riskiness of the project’s cash
  flows
• A project whose risk characteristics differ
  from the corporate or divisional norm will
  have its own unique cost of capital
  Risk and the cost of capital for a
              project
• Each project has its own required return,
  reflecting three basic elements
  – the real or inflation adjusted risk-free interest rate
  – An inflation premium approx. equal to the
    amount of expected inflation
  – A Premium for Risk
• The minimum or required return is the
  project’s cost of capital and sometimes
  referred to as a hurdle rate
  Risk and the cost of capital for a
            project cont.
• The cost of capital for a project depends on
  the riskiness of the assets being financed not
  on the identity of the firm undertaking the
  project
Capital Asset Pricing Model (CAPM)
• The only risk that will be rewarded with a risk
  premium will be the asset’s systematic or
  unavoidable risk as measured by the asset’s
  “Beta” coefficient
• CAPM is still the most widely used risk-based
  cost of capital model
• The CAPM asserts that the risk premium for
  any asset equals the asset’s beta multiplied by
  a market risk premium
                 CAPM cont.
• Cost of capital for project i = risk free interest
  rate + Project risk premium



• Long term treasury bond rate = 5.5%
• Estimated beta of project = 1.15
• Diff. between return on market and risk free T
  -bond rate=7%
• Calculate the required rate of return? = 13.6%
  Estimating the Market risk premium
• Historical equity risk premium does not measure the
  forward looking equity risk premium, that is, the risk
  premium that equity investors expect to realize on
  stocks bought today
• Dimson et al. (2002) survey historical risk premium
  for 16 countries over the period 19000-2001 and find
  that MRP falls within the range 3.5% to 5.3%
• Aswath Damodaran
• Pablo Fernandiz
      Estimating the Project Beta
• Find a portfolio of firms that share similar risk
  characteristics and use the firm’s beta to
  proxy for the project beta
• Example: if a steel company decides to enter
  the petroleum refining business, it will
  estimate the average beta of a portfolio of
  firms already in the industry and substitute
  this value for Beta
• Financial risks will differ if they use different
  amounts of debt financing
Financial structure and appropriate
           discount rates
• Debt vs. Equity
• Unlevering is converting a levered equity beta
  to its unlevered or all equity value



• D = market value of debt
• E = market value of equity
• K*=Rf+βa(Rm-Rf) is the all equity rate
  Estimating Carborundum’s cost of capital (Pg. 151)
• Kennecott Copper is considering acquiring
  Carborundum company
• Carbo’s equity beta is 1.16
• T-bond rate is 7.6%
• Market risk premium = 7.5%
• MV of Carbo’s equity= $27 million and MV debt =
  $86.2 million
• If they decide to go ahead with the acquisition, they
  will issue additional debt of $100 mill followed by
  immediately payment of $140 mill div to Kennecott
 Carborundum’s cost of capital (Pg. 151) cont.

• Calculate Carbo’s pre acquisition cost of
  equity as 16.3%
• Unlevering Carbo’s equity beta
• Carbo’s unlevered or asset Beta = 1.00
• Carbo’s D/E would rise from 0.32 to 1.42
• Equity Beta = 1.71
• Cost of equity capital = 20.4%
   The cost of capital for the firm
• A project to be acceptable to the firm’s
  shareholders, it must generate a stream of
  returns sufficient to compensate the suppliers
  of capital in proportion to the amount and
  cost of capital supplied by each. This minimum
  return is the cost of capital to the firm
• Weighted average cost of capital (WACC) is
  used to discount for project’s cash flows
  ignoring financing charges such as interest and
  dividend payments
            The cost of equity capital
• It is the minimum rate of return necessary to
  induce investors to buy or hold the firm’s
  stock
• It is the rate used by shareholders to capitalize
  their portion of corporate CFs
• Alternative: Dividend growth model
•   Estimated cost of equity capital=Dividend yield + Expected dividend growth rate
Example: Estimating HP cost of equity (Pg. 187)

• Risk free = 4.29%
• MRP = 5%
• Beta = 1.35
• Stock price= $20.25
• D1 = $0.36
• Div expected to grow from $0.32 in 2003 to
  $0.50 in 2008, CAGR=9.34%
• Both CAPM and Dividend growth model
        The cost of debt capital
• Yield to maturity (YTM)
• The interest rate on debt equals the nominal
  risk-free rate plus risk premiums sufficient to
  compensate debt holders for the possibility of
  default; The higher the probability of default
  is, the greater the risk premium will be
• Because interest is tax deductible, the true
  cost of debt to the firm is the after tax interest
  rate
            Cost of Debt cont.
• The cost of debt capital equals Kd(1-T) where
  Kd is the interest rate on new debt sold at par
  and T is the firm’s marginal Tax rate
• For profitable firms like Coca-Cola and Merck,
  the after-tax cost of debt is two-thirds of its
  before tax cost
     The cost of preferred stock
• Preferred stock is a hybrid of debt and equity
• Like debt, preferred stock carry fixed
  commitment by the firm to make periodic
  payments
• In case of Bankruptcy, they get their money
  before shareholders but after debt holders
            Calculating WACC
• The component costs of capital vary with the
  firm’s capital structure
• As the fraction of debt in the capital structure
  goes up, the returns to the different sources
  of capital become riskier. This increase in risk
  cause the cost of each capital component to
  rise, offsetting the benefit of cheaper debt
                             WACC %
                Proportion   Before Tax cost After Tax Cost   Weighted cost
Equity          0.60         20              20               12
Debt            0.35         14              8.4              2.94
Preferred stock 0.05         16              16               0.8
                                             WACC =           15.74%



 Debt should be substituted for equity until the
 point at which the advantage of debt are just
 offset by the effect of increasing risk

 The less equity we put in, the higher the interest
 rate charged
            Marginal Weights
• The weights when calculating WACC must be
  marginal weights that reflect the Target
  capital structure
• Target capital structure is the proportions of
  debt and equity the firm plans to use in the
  future
• The market values of debt and equity, not the
  book values should be used
Estimating Galaxy’s WACC (Pg.156)
•   Galaxy maintain capital structure of 70% debt, 10% preferred, and 20%
    common stock
•   Debt
     – $0 to 7,000,000                       10%
     – 7,000,001 to 10,500,000               11%
     – Over 10,500,000                       14%
•   Preferred
     – 0 to 250,000                          18%
     – 250,001 to 375,000                    24%
     – Over 375,000                          28%
•   Common stock
     – O to 2,000,000                        28%
     – 2,000,001 to 5,000,000                32%
     – Over 5,000,000                        40%
     Galaxy WACC Solution (pg.157)
Range %                   Debt %   Preferred %   Common %
0 - 2,500,000             10       18            28
2,500,001 - 3,750,000     10       24            28
3,750,001 – 10,000,000    10       28            28
10,000,001 – 15,000,000   11       28            32
15,000,001 – 25,000,000   14       28            32
25,000,001 and up         14       28            40


   The first $2,500,000 raised consists of
   $1,750,000 debt , $250,000 in preferred
   stock, and $500,000 in common stocks with
   costs of 10%, 18% and 28%
     Galaxy WACC Solution (pg.157)
Range ($)                 WACC
0 - 2,500,000             0.144
2,500,001 - 3,750,000     0.150
3,750,001 – 10,000,000    0.154
10,000,001 – 15,000,000   0.169
15,000,001 – 25,000,000   0.190
25,000,001 and up         0.206
               Flotation costs
• Flotation costs include all legal, accounting,
  printing, marketing, and other expenses
  associated with the new security issue
• Internal funds are usually considered to be
  less expensive than external funds
           Misusing the WACC
• The required return or cost of capital for a
  project depends on the assets being financed,
  not on the identity of the company that
  undertakes the project
• WACC can be used only to value assets the
  firm already owns or new assets of similar risk
  The cost of capital for a Division
• Divisional cost of capital may be valid in some
  cases in which the use of a companywide cost
  of capital would be inappropriate
• Three Stage Process:
  – Identifying corporate proxies whose business
    closely parallels the division’s operations
  – The cost of capital must be estimated for each of
    the proxy firms
  – Averaging the resulting estimates of the individual
    asset betas
    Adjusted present value (APV)
• APV = NPV of project if all equity Financed +
  NPV of financing side effects caused by
  project acceptance
 Arranging low cost financing (pg.163)
• 10 year, $12.5 million loan at 8% interest
• Market interest rate is 15% and marginal tax
  rate is 40%
• Annual after tax interest PMT
  =0.6*0.08*$12.5 million = $600,000



• NPV = $6,398,930
                 APV cont.
• Borrowing money at 8% while the market rate
  is 15% is a good deal
• This analysis captures both tax benefits and
  the interest subsidies
• Interest subsidy = difference between interest
  PMT of loan at market rate and the interest
  PMT at the current rate
• Interest subsidy =$1,875,000-$1,000,000
                  APV cont.
• Annual tax benefit associated with the loan is
  0.4*0.08*$12,500,000 = $400,000 which is the
  annual tax write off associated with the
  interest payment



• Adding the two figures yield a total benefit of
  $6,398,930, the same as the NPV calculated
  previously
     Levered Equity method (LE)
• This approach discounts the levered cash
  flows- that is, the project’s cash flows net of
  debt payments- at the levered cost of equity
  capital, Ke
• This cost of equity capital with leverage is
  estimated using the levered equity beta and is
  the same one that appears in the WACC
                 LE cont.
• The CFs discounted with the LE method are
  the unlevered CFs used in the WACC and APV
  methods less the after-tax debt charges
  associated with the project’s financing
   Giant manufacturing (pg. 165)
• Invest $30 million in new solar power source
• Annual FCF of $4,880,000 in perpetuity
• K*=16%



• Suppose that the project can support a
  permanent addition to debt equal to $6.5
  million. If interest rate on debt is 10% and Tax
  is 30%
                APV method
• In this case the only financing side effect is the
  tax savings provided by the tax deductibility of
  interest payments
• 0.30 * 0.1 * $6,500,000 = $195,000



• 30 Million + 2.5 Million = 32.5 Million
• Using market values, the debt ratio for this
  project is 6.5/32.5 or 20%
WACC method
                 LE method
• We need to combine the levered cost of
  equity which we have already calculated to be
  17.05% with cash flows to equity
• Annual after tax interest expense
  =0.7*0.1*$6.5 million = $455,000
• Subtracting this from$4.888 million in FCF
  yield free cash flow to equity of $4,433,000
• Giant’s initial equity investment $23.5 million
  ($30 million-$6.5 million)
LE method cont.

				
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