Cost of Capital

Question 1

Company cost of capital: WACC

Answer 1

the discount rate for the firm’s average risk projects.
The company’s cost of capital can be understood as the expected return on a portfolio of all the company’s existing securities. The portfolio usually includes debt and equity.

Question 2

Asset betas and the company cost of capital

Answer 2

Alternatively to WACC, we can use asset beta to compute the company CoC.
According to CAPM’s formula, a firm’s CoC depends on its asset beta and thus on the systematic risk of its existing assets.
The asset beta can be expressed as the weighted average of the equity and debt beta

Question 3

Asset betas as a function of equity and debt betas

Answer 3

Equity beta: use CAPM
Debt beta: for investment grade debt often assumed to be zero; even nearly risk-free bonds have a positive beta

Question 4

Determinants of asset betas

Answer 4

• Cyclicality: cyclical firms are high-beta firms
• Operating leverage (fixed costs/ variable costs of a project): firm with high FC or commitments will have higher project beta
• Time horizon of the project: projects with long-term CF are more sensitive to changes in the risk-free rate or market risk premium

Question 5

Cost of debt (debt vs equity)

Answer 5

equity: shareholders are entitled to receive what is left after all claimants are paid off (upside potential)
debt: bondholders are entitled to receive a promised payment each year (interest) and repayment of the principal at maturity (no upside potential, only downside risk)
- a major source of risk of debt is the default (repayment) risk
- borrowers with higher default risk should pay higher interest rates on debt

Question 6

Cost of debt - default risk

Answer 6

It’s the probability that companies or individuals will be unable to make the required payments on their debt obligations.
Bond rating agencies base their creditor ratings on analysis of the level and trend of the issuer’s financial ratios (coverage ratios, leverage ratio, liquidity ratios, profitability ratios cash flow-to-debt ratio)

Question 7

Bond default risk

Answer 7

also called credit risk is measured by 3 major bond rating agencies (Moody’s, S&P, Fitch) the ratings issued by these companies estimate a bond’s riskiness or safety
- higher ratings are associated with lower credit spreads (lower cost of debt)
Bond rating generally predicts defaulting firms

Question 8

Estimate default spreads for cost of debt

Answer 8

1. build a sample of bonds comparable to the debt we want to value: similar industry, similar ratings or financial ratios, similar maturity, etc; focus on liquid bonds without features such as convertibility
2. estimate the average yield of sample: estimate yield to maturity of the bonds; apply weighting if similarity among bonds is not given

Question 9

WACC

Answer 9

even though first, taxes were ignored, interest expenses are normally tax-deductible. For every dollar in interest, the firm pays, it receives a tax deduction, thus the cost of debt has to be adjusted

Question 10

WACC covers overall risk and the tax shield of debt, but:

Answer 10

• WACC formula is correct only for projects that are just like the firm undertaking them (average projects)
• WACC is incorrect for projects which are riskier or safer than the average. Also incorrect for projects changing the firm’s debt ratio
• WACC is based on a firm’s current characteristics, but managers use it to discount future CF - only correct if the firm’s business risk and debt ratio are to remain constant

Question 11

Valuation of the entire firm (using WACC in DCF valuations and adjusted PV)

Answer 11

working capital (accounts payable, accounts receivable, etc). Important to check the validity of WACC by looking at similar firms – check for robustness
- adjusting WACC when leverage or business risk differs

Question 12

Valuation with taxes: adjusted PV

Answer 12

adjusted present value (APV). If your firm does rebalance, APV might not be such a good use.
APV calculates a series of PVs

Question 13

Valuation of projects

Answer 13

Project cost of capital: for valuing a project we need to use the expected return for projects with similar risk characteristics. The company cost of capital works only for projects that are carbon copies of the firm.
The best comparison for one particular line of business will be to consider pure plays in that line of business

Question 14

Pure plays

Answer 14

= firms in the same line of business, not involved in any other type of business, and publicly traded (CoC of a pure play = for your project)
- pure play = focused firms, not conglomerates
- use segment reporting to differentiate focused companies from conglomerates
- segments are usually differentiated by some industry classification
problems of industry codes: seems arbitrary, leeway, common sense and industry knowledge sometimes better

Question 15

Valuation of projects using NPV, bad outcomes, certainty equivalents

Answer 15

PV equals the sum of all discounted payoffs
NPV subtracts the required investment from the PV

Question 16

alternative valuation tool: Internal Rate of Return (IRR)

Answer 16

the discount rate at which the NPV = 0.
A simple investment rule is then to accept investments that offer an IRR in excess of their opportunity cost of capital
how to calculate: graphical method, trial and error method, financial calculator

Question 17

valuation of projects with IRR pitfalls

Answer 17

Finding y isn’t simple if there’s a third period or more. Plugging in a template it can give you two or more IRR. With two values it is either a convex or concave form – you can’t see that from only two IRR – you need to calculate the NPV to see if it’s convex or concave. IRR also ignores the magnitude of the project. So, IRR is lower whereas NPV is higher with comparing a smaller to a larger project. In constraint with two projects, we want to take those that have the highest NPV.

Question 18

the WACC fallacy: empirical evidence

Answer 18

if you underestimate the risk you overinvest and vice versa. The graph on the right shows that people invest more into risky assets, which shows that they underestimate the risk (deciles of beta spread means that there’s more risk). Diversifying acquisitions can be used to lower the risk.

Empirical evidence suggests that firms make investment mistakes by using the wrong cost of capital