Chapter 9: Risk and the Cost of Capital

Company and Project Costs of Capital The company cost of capital is dened as the expected return on a portfolio of all the companys existing securities It would be foolish to discount all projects at the company cost of capital

Yet this is till done because projects are treated as average risk OR as a guideline Determining the Company Cost of Capital Blend between Cost of Debt = Interest rate, opp. cost of capital for the investors who hold the rms debt. Smaller than company cost of capital, b/c debt is safer than assets Cost of equity = the expected rate of return demanded by investors in the rms common stock, opp. cost of capital for the investors who hold the rms shares. Larger than the company cost of capital b/c the equity of a rm that borrows is riskier. Weighted-average cost of capital (WACC) since interest is tax-deductible we multiply the debt term by (1-T) Where rD is the average cost of debt rE is the average cost of equity WARNING: you cannot substitute cheap debt for expensive equity; this is because as the debt ratio increases so does the riskiness of the rm, meaning that investors will require a higher return (=increased cost of equity) offsetting the apparent advantage. Measuring the Cost of Equity Regression Analysis R2 = 0.272, means that 27.2% was market risk and 72.8% was diversiable risk Standard error = 0.476 Beta +/-SE gives an interval where the beta is found in 95% of the intervals constructed in this way Estimation errors tend to cancel out when you estimate betas of portfolios, therefore nancial managers turn to industry betas

Analysing Project Risk Instead of calculating the WACC for all of a rm, you use asset beta to measure the riskiness of a certain project. Finding the beta for an industry segment Use comparable or pure plays which are businesses handling only one specic industry, not conglomerates What determines asset betas? NOT Standard deviation Gold prospecting has a relatively high standard deviation, but a relatively low asset beta, as it doesnt bear much market risk Operating Leverage High operating leverage: high xed costs relative to variable costs

Given the cyclicality of revenues (Reected by the revenue), the asset beta is proportional to the ratio of the PV of xed costs to the PV of the project Avoid fudge factors in the discount rate Dont increase the cost of capital (discount rate) in an attempt to offset diversiable risks This penalises less at early cash ows but really blows everything out of proportion for long projects (1.2222>1.122) Rather, do a probability weighted Cash Flow

Certainty Equivalents:

Remember, that r should be adjusted change throughout the evaluation of a project