Topic 6: WACC Flashcards
Security Market Line graph is…
Project beta = ?
Compare project beta for project with debt and project without debt. Which is higher.
Graph of cost of equity (the most variable input) vs the security beta
Project beta = sum of operating risk and financing risk.
- no debt project: beta reflects operating (business) risk)
- project with debt: beta will be higher and reflect impact of financial risk
CAPM: Key implications (2)
- Project’s systematic risk is incorporated into the discount rate via ?
- Project specific risk (non systematic) should be incorporated into ?
- Project’s systematic risk is incorporated into the discount rate via CAPM
- Project specific risk (non systematic) should be incorporated into expected cash flows
2 steps to ensure cost of equity matches the operating risk and financial risk status of project or business
- FInd companies that match operating risk of our project / business (“pureplays”). Calculate their beta
- Adjust this beta to reflect financing risk of our project
Asset Beta
- Asset beta describes systematic operating risk.
- The extent to which a project’s operating risk is correlated with the market
- Operating risk describes the component of total risk due to a firm’s assets.
Adjust for different financial structures
Financial risk = ?
Impact on equity holders = ?
Financial risk = effect of debt finance on firm’s operations
- increases variability of rate of return of equity holders
- increases financial risk carried by equity
- increases rate of return required by equity
Equity Beta
- beta for shares
- incorporates operating & financial risk
- AKA leveraged beta or company beta
Asset beta
- risk of firm if it were all equity financed
- AKA unlevered beta
- for all equity firm; asset beta and equity beta are the same
Debt beta
- cost of the debt of the entity. Can be implied by CAPM
Market and Beta: segmented vs not segmented (integrated) in global markets
MARKET
- if segmented, then international investing created diversification and foreign projects may therefore have lower cost of eq
- if markets are integrated (global); all of company’s investments will have a lower cost of equity than that estimated using domestic market index
BETA
- segmented mkt: calc beta of foreign investment vs home index. Beta of intl project could be low, adding diversification benefits
- integrated mkt: measure beta relative to global index. Beta depends on size of global linkages betw country & project
Premium for FX Risk
Premium for Political Risk
Premium for FX Risk
- if use fwd rates to convert CFs to base currency when valuing foreign project; no need to add premium for FX risk
Premium for Political Risk
- eg investments in EM.
- ** little financial logic to this ***
- better to adjust CFs for political risk - improved transparency; focus on political risk highlights tax law & restrictions that affect CFs; political risk prob declines as project and mkt mature - a premium n discount rate causes exponential adjustment.
Incorrect decisions can be made when overall cost of capital is used to evaluate a project when risk differs to that of the firm.
2 critical parameters:
- beta for the project
- target cap structure
Use comps to estimate
steps to est project cost of capital
- find comparable companies
- remove effect of financing to get asset beta
- estimate asset beta
- be careful of betas from other countries - diff currency; diff mkt index
- est tgt cap structure for project
- choose valuation method (WACC, APV, FTE)
- estimate discount rates
Discount rates:
- WACC:
- APV (or MM WACC)
- FTE:
- WACC: derive eq beta, then CAPM to get cost of equity, then use WACC formula
- APV (or MM WACC): use asset beta to determine ungeared cost of eq using CAPM and value debt benefits separately
- FTE: calc eq beta then use CAPM to derive est cost of eq, then calc geared CFs for valuing eq
