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Project Cost of Capital

FINC 361 Fall 2016


Professor Mahdi Mohseni

Recap: cost of equity and cost of debt


1. Cost of equity:

E (ri ) = rf + i (E (rMkt ) rf )

: Measure of exposure to systematic risk

2. Cost of debt:

E (rd ) = r f + d (E (rMkt ) r f )

For bonds, cost of debt is yield-to-maturity (YTM).

Recap: WACC without taxes


Under the MM assumptions:
rwacc

E
D
rE 
rD
E  D
E  D

Recap: WACC with taxes


With tax-deductible interest, the effective
after-tax borrowing rate is rd(1 W) and the
weighted average cost of capital becomes:
rwacc

rwacc

E
D
rE 
rD (1  W c )
E  D
E  D
E
D
D
rE 
rD 
rDW c
E  D

E  D
E  D



Pretax WACC

Reduction Due
to Interest Tax Shield

WACCwithtaxes

Todays agenda:
Project cost of capital
Suppose we know:
a firm's captial struture (debt-equity ratio).
a firm's cost of capital
Question: If this firm would like to undertake a new
project, how should we compute the discount rate for
the new project?
Answer: it depends on the riskiness and capital
structure of the new project!

Project cost of capital


Case 1: Same risk and same leverage as entire firm
Case 2: Same risk and different leverage as entire firm
Case 3: Different risk from entire firm
Industry beta approach

Project Cost of Capital:


Simplest case

Project has:
1. Same risk as entire firm
2. Same financing as entire firm

Use firm-wide WACC with current leverage

Project Cost of Capital:


1st complication:
Same risk but different financing
Project has:
1. Same risk as entire firm
2. Different financing structure than entire firm

In that case, the appropriate discount rate needs


to be computed using the two step approach!
Implicit assumption: Taxes matter

Project cost of capital:


Same risk but different financing
Current
leverage

Target
leverage

Compute project-level WACC with target leverage for


project

When target leverage current leverage

Two step approach


Current
leverage

Step 1: Unlever from current leverage


Step 2: Relever to target leverage
Recall: Cost of equity = CAPM
Implementation through betas!!

Target
leverage

Asset beta

Portfolio Beta = Weighted average Beta of its securities

D
E
L
A = =
D +
E
E+D
E+D
U
E

Asset beta (A)

Beta of the cash flows generated by the assets


Sometimes called the unlevered equity beta EU

Simplified formula
We have:

D
E
L
L
A = =
D +
E
E+D
E+D
U
E

This formular can be applied to different capital


structures. For example:

~
~
D ~L
E ~L
U
A = E = ~ ~ D + ~ ~ E
E+D
E+D

Step 1: Unlever beta

Go from current leverage and equity beta to


underlying asset beta (unlevered equity beta):

E
D
L
L
A = =
E
D +
E+D
E+D
D
1
L
L
E
E
D +
=
D
D
1+
1+
E
E
U
E

D and E are computed using current leverage

Step 2: Relever beta


Now you want the new leveraged equity beta at
the new target debt level, we need to relever the
asset beta (= relever the unlevered equity beta):

~
~ ~
~ L E + D U D ~L
E = ~ E ~ D
E
E
~
~
D U D ~L
= 1 + ~ E ~ D
E
E

Where
~
~
D and E are computed using new target leverage

Final step:
Apply CAPM with the new equity beta

~L
~
rE = rf + E (E (rMkt ) rf )
~
r
Cost of the debt D is usually given.

Then you have all the ingredients to get to the


new WACC:
~
~
rwacc

Where:

E ~
D ~
= ~ ~ rE + ~ ~ rD (1 )
E+D
E+D

~
~
E
D
~ ~ and ~ ~ are computed at the target leverage
E+D
E+D

Project Cost of Capital:


1st complication:
Same risk but different financing
Recap:
Adjust firm-wide WACC to target leverage of project
Requires computation of new cost of equity and cost of debt
A. Cost of equity:
1.
2.

Unlever beta
Relever beta to target leverage

B. Cost of debt:
Depends on data given in the problem
Often assumed to be same as current cost of debt

Project cost of capital:


2nd complication: Different underlying risk
What if:
1. Business is a conglomerate and you need the cost of
capital for one of the divisions
2. Business is entering a new line of business, either
through a new project or through an acquisition

You cannot use the firm-wide WACC


Because it does NOT reflect the project-specific risk
The tendency to use firm-wide WACC for individual
projects is called the WACC fallacy

Conglomerates:
What could be the consequences of applying firm-wide
WACC for projects in different divisions?

Corporal Electric has two divisions:


1. The first division manufactures consumer goods
Suppose consumer goods =1
2. The second division produces gas turbines
Suppose gas turbines =1.5

Assume further:

Each division constitutes 50% of the firm


The firm has no debt (WACC = cost of equity)
Risk-free rate= 5% and market risk-premium = 8%
Use CAPM to get cost of equity

Cost of capital for Corporal Electric


1. For the divisions:
A. Consumer goods:
B. Gas turbines:

rE=5%+1*8%= 13%
rE=5%+1.5*8%= 17%

2. For the entire firm:


Beta of equity is weighted average of divisional betas
E = 0.5 CG + 0.5 GT

E = 0.5 1 + 0.5 1.5 = 1.25

Hence: rE = 0.05 + 1.25 0.08 = 0.15


For what type of projects should we use the
overall discount rate?

Mean
Security Market Line
(SML)
17%

Gas Turbine Division

15%
13%

Explain the misallocation of


capital you will make over time
if you use the firm-wide WACC
for both divisions instead of
their respective cost of capital.

Consumer
Goods Division

5%

1.5

Beta

Empirical evidence
WACC fallacy:
Def.: To apply the firm-wide WACC across all divisions
Wrong discount rate applied in their NPV rule
Leads to distortions in capital budgeting

Evidence:
1. Survey: Bierman (1993), Graham and Harvey (2001)
Most CEOs admit being susceptible to the WACC fallacy

2. Analysis: Krueger, Landier and Thesmar (2011)


Evidence present in a large sample of U.S. firms
Less prevalent in recent yearssuggests there is learning!

Industry beta approach

Project has the same risk profile as comparable firm

Industry beta approach


Suppose you have:
Publicly traded comparable firms in the same line of
business as your project
In practice: Similar business risk same industry

You need to use these comparable firms to


estimate the cost of capital for your project
One useful approach:
Rely on the readily observable equity betas of these
firms to estimate a beta for your project

Using comparable firms to estimate


cost of capital for project
Industry beta
Rely on readily observable equity betas for firms that are
comparable to your project
BUT recognize the need to adjust these equity betas to
reflect the fact that each peer firm has a different leverage
level and leverage increases the risk of equity
We need to get to the underlying asset beta of the industry
Unlever each equity beta!

With a picture:
Industry
firm 1

Industry
firm 2

Step 1: For all peer firms, unlever to get to their


underlying asset beta

Industry beta approach

For each comparable firm, do the following:

1. Take the equity beta

Easy to get (Yahoo!Finance, Bloomberg, etc.)

2. Take the current market leverage


3. Unlever the equity beta to get the asset beta

E
D
L
L
A = =
E
D +
E+D
E+D
U
E

Then compute the average asset beta


You jut obtained the industry asset beta

Gives you an estimate of the systematic risk of comparable


assets to your project

Example: U.S. Department Stores


Equity beta:
Nordstrom: 1.94
Saks: 1.85
Sears Holdings: 1.36

E/(E+D):
Nordstrom: 0.65
Saks: 0.5
Sears Holdings: 0.77

Assume beta of debt = 0


= U = E L
A

E+D

So for every firm, you


compute the asset beta
Asset beta:
Nordstrom: 1.26
Saks: 0.93
Sears Holdings: 1.05

Industry beta (average):


1.08

Industry asset beta

Industries line up as expected in terms of estimated beta


Remark: In the book, they compute the industry asset
beta without the simplification that D=0

Project cost of capital: Final step


1. Use the industry beta as asset beta for your project
2. Adapt to leverage of your project
Two potential cases:
A. Project is all-equity financed (easy case)
No need to relever!
Project cost of capital = Cost of equity with no leverage
Compute CAPM with asset beta and we are done.
Recall: WACC = cost of equity, when there is no debt

Project cost of capital: Final step


B. Project is financed with debt
I.

Relever computed industry asset beta using target


leverage of your project

~
~ ~
~ L E + D U D ~L
E = ~ E ~ D
E
E
II. Compute cost of equity for your project
CAPM with new levered beta

III. Use WACC formula


With an estimated cost of debt, marginal tax rate, the target
debt ratio and the cost of equity estimated just above

With a picture:
Industry
firm 1

Industry
firm 2

Target
leverage
for project

Step 1: Industry asset beta


Step 2: If you have a target leverage for your
project, then relever asset beta to that target

Example Project Cost of Capital


XYZ Corporation is a publicly traded company that specializes in laptop
production. The companys debt-to-equity ratio is 1/6 and it plans to
maintain the same debt-to-equity ratio indefinitely. XYZ firms debt is
riskless, and its equity beta is 2. The risk-free rate is 5%, and the market
risk premium is also 5%. The corporate tax rate for XYZ firm is 40%.
Question 1: Suppose that XYZ is contemplating whether to start a new
laptop production line. This project will have the same capital structure as
the firm. The debt for the new project is riskless. What discount rate should
XYZ use to discount the cash flows from its laptop production project?

Example Project Cost of Capital


XYZ Corporation is a publicly traded company that specializes in laptop
production. The companys debt-to-equity ratio is 1/6 and it plans to
maintain the same debt-to-equity ratio indefinitely. XYZ firms debt is
riskless, and its equity beta is 2. The risk-free rate is 5%, and the market
risk premium is also 5%. The corporate tax rate for XYZ firm is 40%.
Question 2: Now suppose that XYZ is contemplating whether to start a
new laptop production line. It plans to finance this new project equally
with debt and equity. The debt for the new project is riskless. What discount
rate should XYZ use to discount the cash flows from its laptop production
project?

Example Project Cost of Capital


XYZ Corporation is a publicly traded company that specializes in laptop
production. The companys debt-to-equity ratio is 1/6 and it plans to
maintain the same debt-to-equity ratio indefinitely. XYZ firms debt is
riskless, and its equity beta is 2. The risk-free rate is 5%, and the market
risk premium is also 5%. The corporate tax rate for XYZ firm is 40%.
Question 3: Suppose that XYZ is contemplating whether to start
producing electric cars. It plans to finance this new projects equally with
debt and equity. The cost of the debt for the new project is 6%. There are
two publicly traded electric car manufacturers in the market: Firm Smart
and Firm Tesla. Smarts debt-to-equity ratio is 1/2. Its debt is riskless, and
its equity beta is 1. Teslas debt-to-equity ratio is 1/3. Its debt beta is 0.2,
and its equity beta is 1.4. What discount rate should XYZ use to discount
the cash flows from its electric car project?

Summing up
Discount rate:
A key element to valuation and capital budgeting
Appropriate discount rate depends on:
Nature of cash flows (riskiness and maturity)

We have now covered the discount rate for:


1.
2.
3.
4.

Bonds
Equity
Entire firm
All types of projects