# The cost of capital (aka hurdle rate) and NPV - PowerPoint

Document Sample

```					The cost of capital (aka hurdle rate) and NPV
analysis
The Firm

The cash flow generated by those assets represents the
payoff to creditors and shareholders.

Payoff = PV(CF from assets)

The creditors and shareholders want the payoff to be
larger than the initial cost.
Stating the obvious

Calculating PV = discounting CFs
What discount rate to use?

A fair discount rate should reflect:

• perceived project risk
• inflation
• time preference
A question of benchmark

If the project has “average” firm risk, use the default
benchmark
Clarification

“Average” risk = Risk comparable to that of firm’s
other projects
Exemplification

Coca-Cola building a new bottling plant in Lennoxville would
be a project of average risk

Ford planning to launch a satellite would be a project of above
average risk

Sprint expanding in Eastern Europe with the help of
government contracts would be a project of below average
risk
A question of benchmark

The Benchmark is the Weighted Average Cost of Capital

WACC
WACC: Calculation

WACC = we (re) + wd (i) (1-T)

we = weight of equity in total market value
re = cost of equity
wd = weight of debt in total market value
i = cost of debt
T = corporate tax rate
Calculating the cost of equity

Method 1: Dividend growth model
Method 3: Risk-return model
Method 3: HPR approach
Method 4: ROE approach
The cost of equity: Clarification

The cost of equity = The required return on equity
Calculating the cost of equity: Dividend
growth model

Current stock value = PV future dividends

P = D1/(r -g)

D1 = next expected dividend
r = required return
g = expected dividend growth rate
Calculating the cost of equity: Dividend
growth model

r = D1/P0 + g

Required return = dividend yield + capital gains
Where does "g" come from?

We want to know how to estimate the capital
gain (dividend growth) rate
Where does "g" come from?

We know that:

Earnings1 = Earnings0 + (Ret)Earnings0(ROE)

Earnings1/Earnings0 = 1 + (Ret)(ROE)
Where does "g" come from?

If the retention ratio (Ret) remains constant over time,
Earnings1/Earnings0 = Dividend1/Dividend0 = 1+g

Remember,
Earnings1 = Earnings0 [1+(Ret)ROE]
Where does "g" come from?

hence, 1+ g = 1 + (Ret)(ROE), that is,

g = (Ret)(ROE)

The growth in dividend depends on:

•   the proportion of earnings reinvested back into the company
•   ROE
Dividend growth model:

Simple to understand and calculate

Cannot be accurate without a good estimation of g

Assumes the market is efficient
Calculating the cost of equity

Method 1: Dividend growth model
Method 3: Risk-return model
Method 3: HPR approach
Method 4: ROE approach
Risk-return models

The return premium per unit of relative risk has
to be constant:
(r - rf)/b = (rM -rf)/bM

r    = required return on our stock
rf   = risk-free rate
rM = expected return on the market portfolio
b    = the beta of our stock
bM = market beta, always equal to 1
More on risk-return models

CAPM: r = rf +b(rM - rf)

beta = relative measure of risk:
the amount of volatility our stock adds to the volatility of
the market portfolio
Calculating beta

Run regression with market return as independent
variable and our stock return as dependent variable

ri = a + b (rM) + e

estimated b = beta, the measure of relative risk
Beta

beta < 1, our stock has below average risk
beta = 1, our stock has average market risk
beta > 1, our stock has above average risk
Risk-return models

Takes risk into consideration

Beta and the expected market return cannot be estimated reliably
CAPM is elegant and appealing, but otherwise useless
Calculating the cost of equity:

Method 1: Dividend growth model
Method 3: Risk-return model
Method 3: HPR approach
Method 4: ROE approach
HPR approach

Estimate the holding period return:

r = [(PEnd - PBeginning + FVDividends)/(PBeginning)]1/t -1
HPR approach

Simple to calculate

Difficult to select the horizon
Very inaccurate approximation due to market volatility
Calculating the cost of equity

Method 1: Dividend growth model
Method 3: Risk-return model
Method 3: HPR approach
Method 4: ROE approach
ROE approach

Use book/market values to approximate the required
rate of return:

r = NI/Equity
ROE approach

Easy to calculate

Poor approximation due to the volatility of stock
prices
The cost of debt

The yield-to-maturity or the interest on bank loans
Has to be adjusted for the tax-saving effect of debt

cost of debt = i(1-T)
Summary

The hurdle rate has to reflect the risk of the project, not
the source of funds

If the risk of the project is average, use the default
rate:WACC

If the risk of the project is above or below average,
adjust the WACC upward or downward

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 135 posted: 5/31/2010 language: English pages: 32