Cost of Capital (Equity Capital)

Topics Covered
72 Years of Capital Market History Measuring Risk, Beta and Unique Risk CAPM and Cost of Capital Introduction to WACC & Capital Structure

The Future Value of an Investment of $1 in 1925

$1,775.34
1000

$59.70
10 Common Stocks Long T-Bonds T-Bills 0.1 1930 1940 1950 1960 1970 1980 1990 2000

$17.48

Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Historical Returns, 19262002

Series Large Company Stocks Small Company Stocks Long-Term Corporate Bonds Long-Term Government Bonds U.S. Treasury Bills Inflation Average Annual Return 12.2% 16.9 6.2 5.8 3.8 3.1 Standard Deviation 20.5% 33.2 8.7 9.4 3.2 4.4
90% 0% + 90%

Distribution

Source: Stocks, Bonds, Bills, and Inflation 2003 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Average Stock Returns and RiskFree Returns

The Risk Premium is the additional return (over and above the risk-free rate) resulting from bearing risk. One of the most significant observations of stock market data is this long-run excess of stock return over the risk-free return. The average excess return from large company common stocks for the period 1926 through 1999 was 8.4% = 12.2% 3.8% The average excess return from small company common stocks for the period 1926 through 1999 was 13.2% = 16.9% 3.8% The average excess return from long-term corporate bonds for the period 1926 through 1999 was 2.4% = 6.2% 3.8%

The Risk-Return Tradeoff

18% 16%

Small-Company Stocks

Annual Return Average

14% 12% 10% 8% 6% 4% 2% 0% 5% 10% 15% 20% 25% 30% 35%

Large-Company Stocks

T-Bonds T-Bills

Annual Return Standard Deviation

Rates of Return 1926-2002

60 40 20

-20
Common Stocks Long T-Bonds T-Bills

-40 -60 26 30 35 40 45 50 55

60

65

70

75

80

85

90

95 2000

Source: Stocks, Bonds, Bills, and Inflation 2000 Yearbook, Ibbotson Associates, Inc., Chicago (annually updates work by Roger G. Ibbotson and Rex A. Sinquefield). All rights reserved.

Measuring Total Risk

There is no universally agreed-upon definition of risk. The measures of risk that we discuss are variance and standard deviation. Variance - A measure of volatility. Average value of squared deviations from mean. Standard Deviation - The standard deviation is the standard statistical measure of the spread of a sample (the square root of the variance). It is the measure of total risk that we use most of the time.

Std Dev
10 20 30 40 50 60 0
19 26 19 35 19 40 19 45 19 50 19 55 19 60 19 65 19 70 19 75 19 80 19 85 19 90 19 95 20 00

Stock Market Volatility 1926-2004

2004

Country Risk Premia (%)

12
Italy

10 8 6 4 2 0

Japan France Germany (ex 1922/3) Australia South Africa Sweden USA Average UK Ireland Canada Spain Switzerland Belgium Denmark Norway

Measuring Risk
Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called diversifiable risk. Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk.

Measuring Risk
Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

Capital Asset Pricing Model

RP = Risk Premium

R = rf + B ( rm - rf )

CAPM
Security Market Line (SML)

Security Market Line

Expected Return Market Return = rm Risk Free Return = rf 1.0 BETA Security Market Line (SML)

ri = rF + i (r M rF )

The Formula for Beta

i =
Cov ( Ri , RM )

( RM )
2

Covariance with the market

im i = 2 m

Variance of the market

Beta
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Beta and CL
1. Market risk is measured by beta, the sensitivity to market changes. 2. The slope of the characteristic line is beta Expected stock return beta
-10% +10%

- 10% -10%

+10%

Expected market return

Copyright 1996 by The McGraw-Hill Companies, Inc

Estimating with regression

Security Returns

ine L ic t ri s c te a ar Ch

Slope = i Return on
market %

Ri =

+ i Rm + e i

Measuring Betas
The SML shows the relationship between return and risk. CAPM uses Beta as the measure for risk. Beta is the slope of the Characteristic Line (CL). Other methods - Regression Analysis can be employed to determine the slope of the CL and thus Beta.

Measuring Betas
Hewlett Packard Beta

Hewlett-Packard return (%)

Price data - Jan 78 - Dec 82

R2 = .53 B = 1.35

Slope determined from 60 months of prices and plotting the line of best fit.

Market return (%)

Measuring Betas
Hewlett Packard Beta

Hewlett-Packard return (%)

Price data - Jan 93 - Dec 97

R2 = .35 B = 1.69

Slope determined from 60 months of prices and plotting the line of best fit.

Market return (%)

Measuring Betas
AT&T Beta Price data - Jan 78 - Dec 82

A T & T (%)

R2 = .28 B = 0.21

Slope determined from 60 months of prices and plotting the line of best fit.

Market return (%)

Measuring Betas
AT&T Beta Price data - Jan 93 - Dec 97

A T & T (%)

R2 = ..17 B = .90

Slope determined from 60 months of prices and plotting the line of best fit.

Market return (%)

Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects
Project
Good A project B C 2.5
An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.

30% 5%

IRR

SML

Bad project Firms risk (beta)

Extensions of the Basic Model

The The

Firm versus the Project Cost of Capital with Debt

The Firm versus the Project

Any

projects cost of capital depends on the use to which the capital is being putnot the source. Therefore, it depends on the risk of the project and not the risk of the company.

Company Cost of Capital

A companys cost of capital can be compared to the CAPM required return.

SML

Required return 13
Possible error

Possible error

Company Cost of Capital

5.5

1.26

Project Beta

Capital Budgeting & Risk

Modifying the CAPM (account for proper risk) Use COC unique to project, if possible, rather than Company COC Take into account Capital Structure (next topic)

Capital Structure
Capital Structure - the mix of debt & equity within a company Expand CAPM to include CS

RP = market risk premium

R = r f + B ( rm - r f )
becomes

Requity = rf + B ( rm - rf )
(because equity returns are observable)

Capital Structure & COC

COC = rportfolio = rassets D E rassets = WACC = rdebt + requity V V D E assets = debt + equity V V
IMPORTANT requity = rf + equity ( rm - rf ) rdebt = rf + debt ( rm - rf ) E, D, and V are all market values

Using an Industry Beta

It is frequently argued that one can better estimate a firms beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firms beta. Dont forget about adjustments for financial leverage (more details coming later in the course).

Utility Example Pinnacle West Corp.

Boston Electric Consolidated Edison DTE Energy GPU Inc. PP&L Resources Average Equity Beta 0.60 0.65 0.56 0.65 0.37 0.57 D/V 0.65 0.46 0.51 0.76 0.39 Asset Beta if Beta Debt = 0 if Beta Debt 0.21 0.35 0.27 0.16 0.23 0.24 = .25 0.37 0.47 0.40 0.35 0.32 0.38

Example: Pinnacle West Corp

Rasset = rf + ( rm - rf ) = .045 + .24(.08) = .064 or 6.4% (7.5% for Pinnacles beta = .38) Assumes riskfree rate of 4.5% and market risk premium of 8%

Other Methods of Estimating Cost of Equity Capital

The EP Method r = EPS / Stock Price The Constant Growth (Gordon) Model r = DIV1 / P 0 + g compute g from earnings, dividend, or cash flow growth or use the sustainable growth estimate

Conclusion
Now compute the cost of capital for Ameritrade Corporation Use the CAPM compute the beta for comparable firms to Ameritrade Compute asset betas from equity betas What is the cost of capital for Ameritrade?