Cost of Capital

Spring / Summer 2007

BA 6323

Jeffrey Allen, Ph.D.
Topics in this Section
Capital Market History
Measuring Risk in a Portfolio
Types of Risk
Diversification & Portfolio Theory
Risk and Return Relationships
Measuring the Cost of Equity
Capital Asset Pricing Model (CAPM) & Beta
Company-Specific Costs of Capital

A $1 Investment in 1900
$1
$10
$100
$1,000
$10,000
$100,000
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
D
o
l
l
a
r
s
Common Stock
US Govt Bonds
T-Bills
15,578
147
61
2
0
0
4
A $1 Investment in 1900
$1
$10
$100
$1,000
1
9
0
0
1
9
1
0
1
9
2
0
1
9
3
0
1
9
4
0
1
9
5
0
1
9
6
0
1
9
7
0
1
9
8
0
1
9
9
0
2
0
0
0
D
o
l
l
a
r
s
Equities
Bonds
Bills
719
6.81
2.80
2
0
0
4
Real Returns
Average Market Risk Premia
4.3
4.7
5.1
5.3
5.8
5.9 5.9
6.3 6.4
6.6
7.6
8.1
8.2
8.6
9.3
10
10.7
0
1
2
3
4
5
6
7
8
9
10
11
D
e
n
m
a
r
k
B
e
l
g
i
u
m
S
w
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z
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S
p
a
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C
a
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a
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a
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a
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d
G
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m
a
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y
U
K
A
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a
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N
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U
S
A
S
w
e
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S
o
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t
h

A
f
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A
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i
a
F
r
a
n
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e
J
a
p
a
n
I
t
a
l
y
Risk premium, %
Country
Rates of Return 1900-2003
Source: Ibbotson Associates
-60%
-40%
-20%
0%
20%
40%
60%
80%
1900 1920 1940 1960 1980 2000
Year
P
e
r
c
e
n
t
a
g
e

R
e
t
u
r
n

Stock Market Index Returns
Market Performance
1 1
4
10
12
19
15
24
13
3
2
0
4
8
12
16
20
24
-
5
0
%

t
o

-
4
0
%
-
4
0
%

t
o

-
3
0
%
-
3
0
%

t
o

-
2
0
%
-
2
0
%

t
o

-
1
0
%
-
1
0
%

t
o

0
%
0
%

t
o

1
0
%
1
0
%

t
o

2
0
%
2
0
%

t
o

3
0
%
3
0
%

t
o

4
0
%
4
0
%

t
o

5
0
%
5
0
%

t
o

6
0
%
Return %
# of Years
Histogram of Annual Stock Market Returns
Types of risk
Unique Risk (also called diversifiable risk):
Unique risk associated with the assets owned by the company
Industry risks, e.g. competition, innovation, R&D dependence, etc.
Risk related to outstanding debt (financial leverage)
Age, size and stability of the organization
Market Risk (also called systematic risk):
Economic volatility
Inflation
Political or other events that impact stability or the value of assets
Changes in interest rates
Measuring Risk
Investors must be compensated for volatility (likelihood of
incurring a loss) due to any of the risk factors on the previous
slide
Total risk is measured by variance or standard deviation in
stock returns.
Unique risk, however, can be nearly completely eliminated
in a diversified portfolio
Portfolio Theory
Price changes vs. Normal distribution
Coca Cola - Daily % change 1987-2004
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
-9 -7 -5 -3 -1 0 2 4 6 7
P
r
o
p
o
r
t
i
o
n

o
f

D
a
y
s

% daily change
Portfolio Theory
Standard Deviation vs. Expected Return
Investment A
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y

% return
Portfolio Theory
Standard Deviation vs. Expected Return
Investment B
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y

% return
Portfolio Theory
Standard Deviation vs. Expected Return
Investment C
0
2
4
6
8
10
12
14
16
18
20
-50 0 50
%

p
r
o
b
a
b
i
l
i
t
y

% return
Portfolio Theory
Combining stocks into portfolios reduces the portfolio
standard deviation below the weighted average of the
individual stocks.
Covariance (also measured by correlation coefficient)
between assets makes this possible.
The various weighted combinations of stocks that create
this standard deviations constitute the set of efficient
portfolios or efficient frontier.
Expected Return on a Portfolio
2 2
1 1
r asset, second on
return of rate
x
w asset, second in
portfolio of fraction
+
r asset, first on
return of rate
x
w asset, first in
portfolio of fraction
=
return of
rate Portfolio
(
(
(
(
)
)
)
)
Measuring Risk
Calculating variance and standard deviation










Excel formulas: = var(), =stdev()
21.2% = 450 = variance of root square = deviation Standard
450 = 1800/4 = deviations squared of average = Variance
900 30 - 20 -
0 0 10 +
0 0 10 +
900 30 + 40 +
Deviation Squared Mean from Deviation Return of te Percent Ra
(3) (2) (1)
Reducing Volatility
0
5 10 15
Number of Securities
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Diversification
0
5 10 15
P
o
r
t
f
o
l
i
o

s
t
a
n
d
a
r
d

d
e
v
i
a
t
i
o
n
Market risk
Unique
risk
Number of Securities
Portfolio Risk
2
2
2
2
2 1 12 2 1
12 2 1
2 1 12 2 1
12 2 1 2
1
2
1
w
w w
w w
2 Stock
w w
w w
w 1 Stock
2 Stock 1 Stock

The total variance of a two stock portfolio is the sum of

these four boxes
Portfolio Risk
) r w ( ) r (w Return Portfolio Expected
2 2 1 1

) w w ( 2 w w Variance Portfolio
2 1 12 2 1
2
2
2
2
2
1
2
1

Weighted average of expected returns
Portfolio Risk Example
Example
Suppose you invest 40% of your portfolio in
Exxon Mobil and 60% in Coca Cola. The
expected return on your Exxon Mobil stock is 15%
and 10% on Coca Cola. Your portfolio expected
return is:
% 0 . 12 ) 10 . 60 (. ) 15 . 40 (. Return Expected
Portfolio Risk
2 2 2
2
2
2
2 1 12 2 1
2 1 12 2 1 2 2 2
1
2
1
) 167 (. ) 60 (. w
167 . 224 . 6 .
60 . 40 . w w
Cola - Coca
167 . 224 . 6 . x
60 . 40 . w w
) 224 (. ) 40 (. w Mobil - Exxon
KO XOM






Example
Suppose you invest 40% of your portfolio in Exxon Mobil (XOM) and 60% in
Coca Cola (KO). The expected return on XOM is 15% and 10% on KO. The
historical standard deviation of their annualized daily returns are 22.4%
and 16.7%, respectively. Assume a correlation coefficient of 0.6 and
calculate the portfolio variance (see XL solution).
Efficient Frontier
Return
Risk
Low Risk
High Return
High Risk
High Return
Low Risk
Low Return
High Risk
Low Return
Efficient Frontier
Standard Deviation
Expected Return (%)
Each half egg shell represents the possible weighted combinations for two
stocks.
The composite of all stock sets constitutes the efficient frontier
Efficient
Frontier
Tangent Portfolio
Return
Risk
.
r
f
Risk Free Return =
Efficient Portfolio
Market Portfolio (e.g. NYSE
Composite or S&P 500)
New Efficient Frontier
Standard Deviation
Expected Return (%)
Lending or Borrowing at the risk free rate (r
f
) allows us to exist outside the
efficient frontier.
r
f

T
T = tangent point to the market portfolio
New Efficient Frontier (SML)
Lending vs. Borrowing
The optimal investment (highest risk / reward ratio) lies
on the security market line a combination of the risk-
free asset and the market portfolio.
An investor can invest more than 100 percent of his or her
wealth by borrowing (margin) and increasing both risk and
expected return.
An investor wanting less risk would split his or her
investments between risk-free assets and the market
portfolio (lending portion of SML).
Security Market Line
Return
BETA
r
f
1.0 = market
SML
SML Equation = r
f
+ B ( r
m
- r
f
)
Slope = Beta
Beta as a Measure of Risk
2
m
im
i
B

Covariance of asset
i with the market
Variance of the market
Beta - Sensitivity of a stocks return to the return
on the market portfolio.
Measuring Beta
Dell Computer
Slope determined from plotting the
line of best fit.
Price data: May 91- Nov 97
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)

R
2
= .10
B = 1.87
Measuring Beta
Dell Computer
Slope determined from plotting the
line of best fit.
Price data: Dec 97 - Apr 04
Market return (%)
D
e
l
l

r
e
t
u
r
n

(
%
)

R
2
= .27
B = 1.61
Measuring Beta
General Motors
Slope determined from plotting the
line of best fit.
Market return (%)
G
M

r
e
t
u
r
n

(
%
)

R
2
= .07
B = 0.72
Price data: May 91- Nov 97
Measuring Beta
General Motors
Slope determined from plotting the
line of best fit.
Market return (%)
G
M

r
e
t
u
r
n

(
%
)

R
2
= .29
B = 1.21
Price data: Dec 97 - Apr 04
Measuring Beta
Exxon Mobil
Slope determined from plotting the
line of best fit.
Market return (%)
E
x
x
o
n

M
o
b
i
l

r
e
t
u
r
n

(
%
)

R
2
= .23
B = 0.57
Price data: May 91- Nov 97
Measuring Beta
Exxon Mobil
Slope determined from plotting the
line of best fit.
Market return (%)
E
x
x
o
n

M
o
b
i
l

r
e
t
u
r
n

(
%
)

R
2
= .18
B = 0.51
Price data: Dec 97 - Apr 04
Security Market Line
Return
BETA
r
f
1.0 = market
SML
SML Equation = r
f
+ B ( r
m
- r
f
)
Slope = Beta
r
m
Market Risk Premium
Capital Asset Pricing Model
R = r
f
+ B ( r
m
- r
f
)
Capital Asset Pricing Model
(CAPM)
Market Risk Premium
The market risk premium is the expected return on the
market portfolio less the expected risk-free rate (r
m
r
f
).
The expected premium at this point in time (Jeff Allens
number..) is 6.0 percent.
Testing the CAPM
Avg Risk Premium
1931-2002
Portfolio Beta
1.0
SML
30

20

10

rf
Investor
returns
Market
Portfolio
beta vs. average risk premium
Testing the CAPM
Avg Risk Premium
1931-65
Portfolio Beta
1.0
SML
30

20

10

rf
Investor
Returns
Market
Portfolio
beta vs. average risk premium
Testing the CAPM
Avg Risk Premium
1966-2002
Portfolio Beta
1.0
SML
30

20

10

rf
Investor
returns
Market
Portfolio
beta vs. average risk premium
CAPM and Cost of Capital
Lets first assume that the company is financed solely with
equity.
A firms value can be stated as the sum of the value of its
various assets
etc. PV(B), PV(A) PV(AB) value Firm
Cost of Capital
A companys cost of capital can be compared to the
CAPM required return
Required
return
Project Beta
1.26
Company Cost of
Capital


13

5.5

0
SML
Cost of Capital
10% y technolog known t, improvemen Cost
COC) (Company 12.5% business existing of Expansion
20% products New
30% Ventures e Speculativ
Rate Discount Est. Category
Adjustments to the required return are
often ad hocwe can do better
Calculating the cost of capital
Cost of Debt: After-tax yield of outstanding debt
r
debt
= avg. yield to maturity
Cost of Equity: Risk-free rate + risk premium
r
equity
= risk-free rate + beta (market risk premium)

WACC: r
debt
(1-t)(D/V) + r
equity
(E/V)
where V = D (total value of debt) + E (market value of equity)
(we use market values for the weights if available)
Cost of capital (example)
Suppose a firm has $3M debt outstanding yielding 8.5
percent. The stock price is $35 and the firm has 200,000
shares outstanding. The equity beta of the firm is 1.25,
the current risk-free rate is 5 percent. Assume the risk
premium for holding the market portfolio is expected to
be 6 percent. At a tax rate of 34 percent, what is the
cost of capital?
T. Medical Cost of Capital
Example: Technol Medical has 1M shares of stock
outstanding which currently trade at $12 per share. The
company also has 100,000 shares of preferred stock
outstanding which pay a $3 dividend and currently trade at
$21.38 per share. The firm has publicly traded bonds with
10 years remaining to maturity, 10% coupon payments, a
total face value of $5M which currently trade at $985 per
bond. The equity beta is estimated at 1.2, the risk-free rate
is seven percent, t = 34%, and the market risk premium is
six percent. What is the WACC for T.Medical?
Nike, Inc. : Cost of Capital Case
Read through Exhibits 1-5 in the case
In groups of two, calculate the WACC for Nike
independently of the analysis by Ms. Cohen
Note any improvements you would make to Ms. Cohens
analysis
PepsiCo Inc.: Cost of Capital
How has the company performed over the past 10 years?
How have the segments performed?
What is your estimate of the cost of capital for each
division of the company (soft drinks, restaurants & snack
foods)