Lecture 5 - Cost of Capital Flashcards
Why do we need to work out the cost of capital?
To discount the expected cash flows of a project to their present value
What is the cost of capital?
The opportunity that is foregone by investing in a project rather than financial securities, with the same risk
What level of cost of capital should be used?
If the project is high risk- higher cost of capital
Low risk- lower cost of capital
What can we use to determine COC if the project (asset) beta is know?
The CAPM model
Why do companies the use cost of capital rather than the CAPM model?
Project betas are not available in most cases - therefore use the company cost of capital as the benchmark instead
What is the CAPM formula?
r(project)= rf+B(Rm-Rf)
What is the COC formula?
COC= rassets= rdebt D/V+ requity E/V
What is the consequence of using the company cost of capital rather than the project cost of capital?
Good, low risk investments with truly positive NPVs will be rejected
High risk, bad projects with truly negative NPVs will be accepted
What does the WACC represent?
The company cost of capital reflective of the tax shield of interest
What can we use to determine the cost of equity?
CAPM: r=equity= Rf+ Bequity (Rm-Rf)
How do we estimate equity beta?
By observing the historical beta as the future beta is usually not far off from past beta as the estimate of most stocks is quite stable over time
How do we calculate the beta?
Run a regression of the monthly rates of returns, against the corresponding market returns, the slope of the regression line is an estimate of beta
What does the beta tell us?
On average, how the stock price changed with the market return was 1% higher of lower
Where does diversifiable (firm specific) risk show up?
Scatter of points around the line
What does r2 represent?
The proportion of the total variance that can be explained by market movements (market risk)
Should we use industry betas?
Yes- they are more reliable as they have lower standard errors
What are two instances when the beta may be modified?
1) Thing trading - infrequently traded shares - the beta will be underestimated and in the regression and therefore are adjusted upward
2) Mean reversion - a move to the mean value of one over time
What are the three factors that determine the beta?
Cyclicality: If revenues and expenses are heavily dependent on the state of the business cycle - will have a higher beta
Operating leverage: Higher operating leverage= high risk= higher beta
Other sources of risk: Longer term projects have a higher beta… exposed to more sifts caused by changes in risk free rate or market premium
What is the asset beta? What is the formula?
The beta is the beta of a portfolio of the firms debts and securities:
b asset = b portfolio = b debt (d/v) + b equity (e/v)
What effect will issuing more debt have on the asset beta?
Asset beta remains unchanged
- Higher debt ratio: increases the debt beta (risk of default)
- Higher debt ratio also increases the equity beta (increased risk to shareholders)
- However- weights will change (leverage) so therefore the overall asset beta will stay the same
Do diversifiable risk affect asset betas and discount rates?
NO- as they can be diversified away
How do we work out the fudge factor?
Determine the correct discount rate in order to get the correct present value
Fudge factor = (New discount rate - used discount rate)
When will the fudge factor not be required?
When all cash flows have been thought through and an unbiased forecast is made
