CF Project Risk WACC(2)

7/27/2019 CF Project Risk WACC(2)

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Corporate Financial Policy:

Cost of Capital, Project Risk and WACC

Jide Wintoki

Fall 2013

Jide Wintoki (University of Kansas) Business Investment (FIN 468) Fall 2013 1 / 13
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Lecture Outline

Weighted Average Cost of Capital (WACC)

The WACC and the CAPM

The effect of leverage on beta

Asset betas and project discount rates

Equity risk premium

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Project Discount Rate and WACC

Project discount rate is easy to determine if we assume project issimilar to the firms existing assets.

In this case, the appropriate discount rate equals the weighted

average cost of capital (WACC)

WACC is the simple weighted average of the required rates of returnon debt and equity, where the weights equal the percentage of eachtype of financing in the firms overall capital structure.

WACC =

D

D+ E

(1 Tc)rd +

E

D+ E

re

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Finding the WACC for a company with equity and debt

Example

The S.D. Williams Company has 1 million shares of common stockoutstanding which currently trade at a price of $50 per share. Thecompany believes that its stockholders require a 15% return on theirinvestment. The company also has $47.1 million (par value) in 5-year

fixed-rate notes with a coupon rate of 8% and a yield to maturity of 7%.The current market value of the 5-year notes is $49 million. What is thecompanys WACC if the corporate tax rate is 35%?

E = 1m $50 = $50m; re = 15% = 0.15

D = $49m; rd = 7%=0.07; Tc = 35% = 0.35

WACC =

$49

$99

(1 0.35)0.07 +

$50

$99

0.15 = 9.8%

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Finding the WACC for companies with complex capital

structures

A firms capital structure may consist of debt, preferred stock and

common stock

WACC =

D

D+ E+ P

(1Tc)rd+

E

D+ E+ P

re+

P

D+ E+ P

rp

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The Link between WACC and the CAPM

WACC is consistent with CAPM

CAPM can be used to compute WACC for a levered firm.

Any asset that generates cash flows has a beta that establishes therequired return on the asset through the CAPM.

WACC represents the rate of return that a company must earn on itsinvestments to satisfy both bondholders and stockholders

The CAPM establishes a direct link between required rates of return ondebt and equity and the betas of these securities

A =

D

D+ E

d +

E

D+ E

e

Debt beta is typically quite low for healthy, low-debt firms.

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The Link between WACC and the CAPM

If the firm has zero debt, the asset beta equals the equity beta.

For firms that use debt, e > A.

Holding the asset beta the risk of the firms assets constant, themore money the firm raises by issuing debt, the greater its financial

leverage, and the higher its equity beta.

e = A

1 +

D

E

If we include taxes.

e = A

1 + (1 Tc)

D

E



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The effect of leverage on beta - a numerical example

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Discount Rate for Unique Projects

What if a company has diversified investments in many industries?

In this case, using a firms WACC to evaluate an individual projectwould be inappropriate.

Use the projects asset beta adjusted for desired leverage.

Example

Assume GE is evaluating an investment in the oil and gas industry.

GE would examine existing firms that are pure plays (public firmsoperating only in oil and gas industry).

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Data for Berry Petroleum and Forest Oil

Say GE selects Berry Petroleum and Forest Oil as pure plays:

Berry Petroleum Forest Oil

Stock beta 0.65 0.90

Fraction Debt 0.14 0.39

Fraction Equity 0.86 0.61D/E 0.16 0.64

Asset Beta* 0.56 0.55* Assumes debt beta = 0 and no taxes

Operationally similar firms, but Berry Petroleums e = 0.65 andForest Oils e = 0.90

Why so different? Reason: Forest Oil uses debt for 39% of financing;Berry Petroleum: 14%.

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Converting Equity Betas to Asset Betas for Two Pure Play Firms

To determine the correct A to in calculating discount rate for the

project, GE must convert pure play e to A, then average.Previous table lists data needed to compute unlevered equity beta.

Unlevered equity beta strips out the effect of financial leverage.Therefore it is always less than or equal to equity beta.

A =e

1 + DE

Berrys A = 0.56, Forests A = 0.55, so average A = 0.55

GE capital structure consists of 20% debt and 80% equity (D/E ratio= 0.25). Compute relevered equity beta:

Ge = A

1 +

D

E

= 0.55(1 + 0.25) = 0.69



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Converting Equity Betas to Asset Betas for Two Pure Play Firms

Using CAPM, compute the rate of return GE shareholders require for

the oil and gas investment.

Assume risk-free rate of interest is 6% and expected risk premium onthe market is 7%:

E(R) = 6% + 0.69(7%) = 10.8%.

One more step to find the right discount rate for GEs investment inthis industry: calculate project WACC

GEs financing is 80% equity and 20% debt. Assume investors expect

6.5% on GEs bonds:

WACC =

D

D+ E

rd+

E

D+ E

re = 6.5%(0.2)+10.8%(0.8) = 9.9%

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CF Project Risk WACC(2)