FIN 468 Intermediate Corporate Finance Topic 8 Cost of Capital Larry Schrenk Instructor 1 of 22 Topics Excel Linear Regression Project Review Cost of Capital Equity Debt Preferred Shares Excel Linear Regression 3 of 36 Excel Features Linear Regression Linear regression finds the line that best fits a series of points In finance it is often used to find the beta b of a firm s equity In our example we shall find the beta of MMM using the S P 500 as a proxy for the market Since we want to know the sensitivity of the return on MMM to changes in the return on the S P 500 the return on MMM is the dependent variable y axis and the return on the S P 500 the independent variable x axis Excel Features Linear Regression 1 You need to have the returns of the assets arranged in columns Excel Features Linear Regression 2 Click on Data Analysis under the Tools drop down menu to open the Data Analysis window Then select Regression and click on OK Excel Features Linear Regression 3 The Regression window will appear Excel Features Linear Regression 4 In the regression window input the cells for the y variable MMM and the x variable S P 500 Click on the Line Fit Plots box and click on OK Excel Features Linear Regression 5 A new worksheet will appear with the results and a graph Excel Features Linear Regression 6 The blue squares are data points and the pink squares are the corresponding points on the bestfit line Excel Features Linear Regression 7 Here is the same graph with a dashed line drawn though the points Excel Features Linear Regression 8 The summary statistics provide a wealth of information about the regression In particular the beta is the coefficient of the x variable Project Review 13 of 36 Project Review I Provide a brief discussion of the company s products markets and competitors Provide a brief discussion of the top management their qualifications experience and how long they have been with the company Are any of the managers considered a key person that would hurt the firm if they left Provide a brief discussion of any risks the firm may face such as competitive pressure product obsolescence lawsuits etc 14 of 70 Project Review II Perform a ratio analysis of at least the last 3 years Comparative industry Trends over time Explain major changes and deviations from industry Create a pro forma 5 year income forecast Calculate FCF over next five years and a terminal value Estimate firm s cost of equity capital using one or more of the following methods CAPM Discounted Cash Flow Own Bond Yield Plus Risk Premium 15 of 70 Cost of Capital 16 of 36 Cost of Capital 17 Rate of return that the suppliers of capital bondholders and stockholders require as compensation for their contributions of capital Leverage and Marginal Cost 18 As firms take on more debt financial leverage increases increasing the riskiness of the firm and causing lenders to require a greater return Additional debt may therefore increase cost of capital The marginal cost is the cost to raise the additional funds for the potential investment project Firm vs Project Cost of Capital Cost of capital for entire company Cost of capital for a specific project 19 Important for firm security valuation WACC must be adjusted for the riskiness of the project Target Weights 20 Assume current capital structure is correct Estimate capital structure based on historical trends Use average of comparable companies capital structure Choosing the Discount Rate The numerator focuses on project cash flows CF3 CFN CF1 CF2 NPV CF0 2 3 1 r 1 r 1 r 1 r N The denominator is the discount rate Reflect the opportunity costs of the firm s investors The denominator should Reflect the project s risk Be derived from market data 21 Cost of Equity Capital 22 of 36 Where Do We Stand Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows This chapter discusses the appropriate discount rate when cash flows are risky Asset Betas and Project Discount Rates 24 When a firm uses no leverage its equity beta equals its asset beta An unlevered beta simply tells us how risky the equity of a company might be if it used no leverage at all Finding the Right Discount Rate 1 2 25 When an all equity firm invests in an asset similar to its existing assets the cost of equity is the appropriate discount rate to use in NPV calculations When a firm with both debt and equity invests in an asset similar to its existing assets the WACC is the appropriate discount rate to use in NPV calculations The Cost of Equity Capital From the firm s perspective the expected return is the Cost of Equity Capital E r r E r r i rf i M rf To estimate a firm s cost of equity capital we need to know three things 1 Risk Free Rate 2 Risk Premium 3 Beta rrf E rM rrf i Example Suppose the stock of Stansfield Enterprises a publisher of PowerPoint presentations has a beta of 2 5 The firm is 100 percent equity financed Assume a risk free rate of 5 percent and a market risk premium of 10 percent What is the appropriate discount rate for an expansion of firm E this ri r E i r rf Mr rf E ri 5 2 5 10 E ri Example Suppose Stansfield Enterprises is evaluating the following independent projects Each costs 100 and lasts one year Project Project Project s IRR NPV at b Estimated 30 Cash Flows Next Year A 2 5 150 50 15 38 B 2 5 130 30 0 C 2 5 110 10 15 38 IRR Project Using the Security Market Line Good A project 30 B 5 C SML Bad project Firm s risk beta 2 5 An all equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital Estimation of Beta Market Portfolio Portfolio of all assets in the market In practice a broad stock market index such as the S P Composite is used to represent or proxy the market Beta Sensitivity of a stock s return to the return on the market portfolio Estimation of Beta Problems 1 Betas may vary over time 2 The sample size may be inadequate 3 Betas are influenced by changing financial leverage and business risk Solutions Problems 1 and 2 can be moderated by more sophisticated statistical techniques Problem 3 can be lessened by adjusting for changes in business and financial risk Look at average beta estimates of comparable firms in the industry Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry That s not to say that a firm s beta can t change due to Changes in production Changes in operating leverage Deregulation