Cost of Capital and Leverage.

WACC
Chapter 4

Outline
Project selection for a levered firm Beta and cost of equity of a levered firm
Hamada equation

WACC Project selection in a diversified firm

Mensac case

What types of capital do firms use?

Debt Preferred stock Common equity

Existing shareholders New stock

Do different investors ask for the same return?

Example: A company has the following EBIT every year (see the table next page). kRF=4%, the market risk premium is 6%. If the company is all-equity financed, its beta is 1
What is the cost of equity in this case? What is the company value? If there are 1,000 shares outstanding, what is the share price? If company wants to issue 40,000 of debt to buy back some shares, what is the cost of debt and the new cost of equity assuming no taxes?

Example (2)
Economy Bad Avg. 0.25 0.50 5,000 10,000 Good 0.25 15,000

Prob. EBIT

Cost of equity is
4%+6%x1=10%

The company value is

(0.25x5,000 + 0.5x10,000 + 0.25x15,000)/.1 =100,000

The share price is 100

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Example (3)
Probability EBIT Interest EBT Taxes NI EPS Average NI Average EPS Standard deviation Value of equity Share price $ $ $ $ $ $ $ $ 0.25 5,000.00 5,000.00 5,000.00 5.00 10,000 10 3.54 100,000 100.00 $ $ $ $ $ $ 0.5 10,000.00 10,000.00 10,000.00 10.00 0.25 $ 15,000.00 $ $ 15,000.00 $ $ 15,000.00 $ 15.00

$ $

Example (4)
For the levered firm let us assume that the debt is risk-free and check, whether this is the case or not:
Debt Interest rate Number of shares Probability EBIT Interest EBT Taxes NI EPS Average NI Average EPS Standard deviation $ 40,000 4% 600 0.25 5,000.00 1,600.00 3,400.00 3,400.00 5.67 8,400 14.00 5.89 0.5 10,000.00 1,600.00 8,400.00 8,400.00 14.00 0.25 $ 15,000.00 $ 1,600.00 $ 13,400.00 $ $ 13,400.00 $ 22.33

$ $ $ $ $ $ $ $

$ $ $ $ $ $

Example (5)
The cost of equity of the levered firm becomes
cost of equity kLS = EPS/Share price = 14/100 = 14%

Why?
Return to shareholders is riskier now (look at EPS volatility) It should be higher
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Beta and cost of equity of a levered firm: Hamada equation (risk-free debt)
Because the increased use of debt causes both the costs of debt and equity to increase, we need to estimate the new cost of equity The Hamada equation attempts to quantify the increased cost of equity due to financial leverage It uses the unlevered beta of a firm, which represents the risk of a firm as if it had no debt Hamada equation assumes that the debt is riskfree

Hamada equation (contd)

L = U [1 + (1 T)(D/E)] where T is the tax rate; D/E is the debt-equity ratio and U is the beta of equity of an unlevered firm with the same operating cash flow In our example U = 1, D/E = 400/600 = 2/3 L = 1(1+0.67)=1.67 kLS = 4% + 1.67 x 6% = 14 % Notice that
kLS = kUS [1 + (1 T)(D/E)]-kRF (1 T)(D/E)
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Beta and cost of equity of a levered firm: risky debt

If debt is risky, the cost of equity of a levered firm is found using the following equation:

D U k = k + (1 T ) k S k D E
L S U S

where kD is the cost of risky debt. Similarly, for beta we can write

D D = 1 + (1 T ) (1 T ) D E E
L S U S

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Example
The risk-free rate is 6%, as is the market risk premium. The unlevered beta of the firm is 1.0. The total assets are 2,000,000
Find the cost of equity of a levered firm if it has 250,000 of a risk-free debt The same if the beta of debt is 0.2

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Example (2)
For riskless debt we have

L = U[1 + (1 T)(D/E)]

kL = kRF + (kM kRF)L

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Example (3)
For riskless debt we have

L = U[1 + (1 T)(D/E)] L = 1.0[1 + (1 0.4)( 250/ 1,750)] kL = kRF + (kM kRF)L kL = 6.0% + (6.0%)1.0857
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Example (4)
For riskless debt we have

L = U[1 + (1 T)(D/E)] L = 1.0[1 + (0.6)(0.1429)]= 1.0857 kL = kRF + (kM kRF)L kL = 6.0% + (6.0%)1.0857 = 12.51%
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Example (5)
For risky debt we have
kD = kRF + (kM kRF)D=6%+(6%)0.2 =7.2% L = U[1 + (1 T)(D/E)]-(1 T)(D/E)D L = 1.0[1 + (0.6)(0.1429)]- (0.6)(0.1429)0.2 = 1.0857-0.0171 = 1.0686 kL = kU + (1 T)(D/E)(kU - kD) kL = 12% + (0.6)(0.1429)(4.8%) = 12.411%
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How to determine the cost of equity for a new company?

Identify the peer companies For each peer, find its unlevered and cost of equity using their cost of debt and D/E ratio
Try using market values of debt and equity

Find the average unlevered and kSU Find and kSL for your company, using its cost of debt and D/E ratio

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Determining levered cost of equity, kLs

Find kU directly

D kD k + (1 t c ) U E kS = D 1 + (1 t c ) E Find average kUs

L S

Find kLs

D U k = k + (1 tC ) k S k D E
L S U S

)
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WACC

E L D WACC = k S + (1 tc )k D V V if k D = k f , WACC = k
U S

D E + (1 tc ) V V

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Example: Find WACC, given these inputs:

Target D/E ratio = 66.7 % kD = 10% kRF = 7% Tax rate = 40% Market risk premium = 6% Industry Beta = 0.95

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Example: Find WACC

2 L = 0.95 1+ (1 0.4) = 1.33 3 k = .07 +1.33.06 = 0.15 = 15%

L S

.67 1 WACC= .15 + (1 .4) .10 1+ .67 1+ .67 WACC= 11.4%

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WACC Estimates for Some Large U. S. Corporations, Nov. 1999

Company Intel General Electric Motorola Coca-Cola Walt Disney AT&T Wal-Mart Exxon H. J. Heinz BellSouth WACC 12.9% 11.9 11.3 11.2 10.0 9.8 9.8 8.8 8.5 8.2
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Should the company use the composite (company average) WACC as the hurdle rate for each of its projects?
NO! The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. Different projects have different risks. The projects WACC should be adjusted to reflect the projects risk.
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Risk and the Cost of Capital

Rate of Return (%)

Acceptance Region W ACC

12.0 10.5 10.0 9.5 8.0 L A B

H Rejection Region

Risk L

Risk A

Risk H

Risk
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Divisional Cost of Capital

Rate of Return
(%)

13.0

Division Hs WACC

WACC Composite WACC for Firm A Project H

11.0 10.0 9.0

Project L

7.0

Division Ls WACC

RiskL

RiskAverage

Risk

Risk
H

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What are the types of project risk?

Stand-alone risk Corporate risk Market risk

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How is each type of risk used?

Market risk is theoretically best in most situations. However, creditors, customers, suppliers, and employees are more affected by corporate risk Therefore, corporate risk is also relevant

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How to determine the risk-adjusted cost of capital for a particular project or division?
By making subjective adjustments to the firms composite WACC
Not very scientific!

By attempting to estimate what the cost of capital would be if the project/division were a stand-alone firm with the same capital structure. This requires estimating the projects beta

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Methods for Estimating a Projects Beta

Pure play:
Find several publicly traded companies exclusively in projects business Use average of their betas as proxy for projects beta

Difficulties: Sometimes it is hard to find such companies

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Methods for Estimating a Projects Beta

Using Accounting beta (wont use in the class)
Estimate the projects beta by running regression between projects ROA and market ROA (S&P index)

Problems:
Accounting betas are not perfectly correlated with market betas (correlation is about 0.50.6) Normally cant get data on new projects ROAs before the capital budgeting decision has been made
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Example
Find the divisions market risk and cost of capital based on the CAPM, given these inputs
Target debt/value ratio = 40% (D/E = 66.7%) kD = 10% kRF = 7% Tax rate = 40% betaDivision = 1.7 Market risk premium = 6%.
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Example (contd.)
Levered beta = 1.7, so division has more market risk than the company on average (1.33). Divisions required return on equity:
ks = kRF + (kM kRF)Div. = 7% + (6%)1.7 = 17.2% WACCDiv. = wdkd(1 T) + wcks = 0.4(10%)(0.6) + 0.6(17.2%) = 12.72%
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Mensac case

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