Estimating cost of capital for projects - PowerPoint

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					Estimating cost of capital
      for projects
 Hurdle rates for firms vs. projects

• The investment decision typically involves evaluation of specific
  projects (e.g., open a new store, purchase a new machine, etc.)

• Large corporations have several divisions and must choose
  among projects proposed by division managers

• Which hurdle rate should we use in evaluating the contribution
  of each project to firm value?

• We follow the WACC approach to estimate cost of capital for
  specific projects/divisions in a firm
        How do we define a project?

• A project is any proposal that results in the use of the firm’s
  scarce resources
    –   Entry into a new business area or market
    –   Acquisition of another firm
    –   New ventures
    –   Changes in the way existing ventures or projects are run
    –   Best way to deliver a service


• Projects are classified based on
    – Impact on other projects (mutually exclusive, prerequisites)
    – Ability to generate revenues or reduce costs
 Example 1: Which project to choose?

• Suppose that the cost of equity for Alpha Corp. is
  10%

• Two division managers are proposing two projects:
   – One in high-tech with expected return 12%
   – The other in telecommunications with expected return 8%


• Which project should upper management select if
  funding is limited?
  What if we use the firm’s cost of
    capital as the hurdle rate?
• The decision depends on the type of projects that are
  under consideration by the firm

• When all projects have the same risk exposure, the
  firm’s cost of capital can be used as the hurdle rate

• If that is not the case, then we will end up
  overinvesting in risky projects and underinvesting in
  safe projects
 What are the sources of risk in an
       investment project?
• Project risk

• Competitive risk

• Sector or industry risk

• International risk

• Market risk
Can project risks be diversified away?

• Investors who finance a firm’s projects should care
  only about the risks that cannot be diversified away

• All risks, except market risk, can be diversified away
  both by the firm and by investors in the firm

• This will be the case for companies with diversified
  projects as well as for investors with diversified
  (domestic and global) portfolios
     How can we tell if the marginal
   investor in our firm is diversified?
• Examine the firm’s distribution of ownership to
  identify if the marginal investor is

   – An individual investor with a significant equity holding

   – An individual investor with a small equity holding

   – A diversified, institutional investor

   – If none of the above, then identifying the marginal investor is
     more complicated
       Identifying the marginal investor

 Stock % held by   Stock % held by            Marginal investor
institutions       insiders
High               Low                        Institutional investor


High               High                       Institutional investor, with
                                              insider influence

Low                High (held by              Insider (often
                   founder/manager of firm)   undiversified)

Low                High (held by wealthy      Wealthy individual
                   individual investor)       investor, fairly diversified

Low                Low                        Small individual investor
                                              with restricted
                                              diversification
  Measuring cost of equity for projects

• Use CAPM with risk-free rate and market risk premium the same

• We need to identify the beta for the project

• Three possibilities
    – The firm’s projects have the same risk exposure (projects are
      homogeneous)

    – The firm has multiple divisions with different risk exposures

    – Each project considered by the firm has a different risk exposure
Case 1: The firm is in a single line
          of business
• This is a simple case since all the projects
  considered by the firm have similar risk

• Use the firm’s cost of capital as the benchmark to
  evaluate investment projects

• Examples: McDonald’s, Dell, Nokia, Kraft

• This should be the rule unless the company tries to
  enter into new business areas
  Case 2: Firms with multiple divisions
       with different risk profiles
• How can we estimate the cost of equity for individual divisions
  within a firm?

• We follow the pure play approach to estimate the beta for a
  firm’s division
    – Identify publicly-traded firms whose primary focus is the same as
      that of the division
    – Obtain these firms’ equity betas and use their debt-equity ratios to
      unlever the equity betas (obtain their asset betas)
    – Use the average asset beta from this group of firms and relever it
      by using the debt-equity ratio of the firm that the division belongs
    – Use this beta in the estimation of cost of equity for the division
 Example 2: Estimating division betas
    with the pure play approach
• Suppose the telephone company US Phone is
  planning to invest in projects in multimedia
  applications

• The company’s equity beta is 0.75 and its debt-equity
  ratio is 0.40

• The following information was obtained about
  companies related to the multimedia business
Step 1: Obtaining financial information on
         comparable traded firms

Company    Equity Beta   Debt/Equity   Business Focus
   A          1.35           0.72         Multimedia
                                          applications
   B          1.08           1.35      Telecommunications

   C          1.05           1.55      Multimedia software

   D          1.00           0.44         Multimedia
                                          applications
   E          0.95           0.55      Telecommunications
                                           & Multimedia
   F          1.15           0.28          Multimedia

   G          2.50           2.06      Multimedia software
                                        and distribution
   H          1.20           0.70         Phone/Cable
Step 2: Obtaining asset (unlevered) betas for
         comparable firms (t = 34%)

  Company    Equity Beta   Debt/Equity   Asset Beta
     A          1.35           0.72         0.92

     C          1.05           1.55         0.52

     D          1.00           0.44         0.77

     F          1.15           0.28         0.97

     G          2.50           2.06         1.06

   Average                                  0.85
 Step 3: Calculating equity beta and cost of
      equity for the multimedia project

• Using the average asset beta from the comparable multimedia
  firms (0.85) we can use US Phone’s debt-equity ratio to obtain
  the relevered beta as follows

                   L  0.851  1  0.340.40  1.07

• Assuming a risk-free rate of 6% and a market risk premium of
  5.5%, we see that the cost of equity is very different if we simply
  use the firm’s equity beta or the relevered beta as shown above

   With firm equity beta ke = 0.06 + 0.75(0.055) = 0.10
   With relevered beta ke = 0.06 + 1.07(0.055) = 0.12
     Case 3: Projects with unique risk
                exposures
• We could argue that each project has its own risk profile

• The correct way to examine this argument is to consider
  whether the benefits of estimating the risk of each project
  exceed the costs of doing so

• The estimation of risk for separate projects is applicable when
    – The project is large compared to the size of the firm
    – The risk profile of the project is different from that of the firm
Estimating the cost of debt for projects

• Firms usually borrow debt and then allocate their borrowings to
  various projects/divisions

• Three approaches to estimate cost of debt

    – Since borrowing takes place at the firm level, not the division level,
      use firm’s cost of debt

    – Examine the project’s capacity to generate cash flows relative to
      financing and estimate the project’s default risk and cost of debt

    – When a project borrows directly, use that project’s default risk
Estimating weights for debt and equity

• When evaluating small projects that can be financed with the
  same debt-equity mix as the overall firm, we can use the firm’s
  debt and equity weights

• When evaluating large projects with different risk profiles from
  that of the firm, we should look for the debt-equity mix from
  comparable firms

• The debt and equity weights for large projects that obtain their
  own financing should be based on the actual amounts borrowed