Chapter 13

Risk, Cost of Capital, and Valuation

 Know how to determine a firm’s cost of equity
capital
 Understand the impact of beta in determining the
firm’s cost of equity capital
 Know how to determine the firm’s overall cost of
capital
 Understand the impact of flotation costs on capital
budgeting

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13.1 The Cost of Equity Capital
13.2 Estimating the Cost of Equity Capital with the CAPM
13.3 Estimation of Beta
13.4 Determinants of Beta
13.5 The Dividend Discount Model Approach
13.6 Cost of Capital for Divisions and Projects
13.7 Cost of Fixed Income Securities
13.8 The Weighted Average Cost of Capital
13.9 Valuation with RWACC
13.10 Estimating Eastman Chemical’s Cost of Capital
13.11 Flotation Costs and the Weighted Average Cost of Capital
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 Earlier chapters on capital budgeting focused on the
appropriate size and timing of cash flows.
 This chapter discusses the appropriate discount rate

when cash flows are risky.

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 Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholder’s
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets, the
expected return on a capital-budgeting project should be at least as great as the
expected return on a financial asset of comparable risk.

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 From the firm’s perspective, the expected return is
the Cost of Equity Capital:

R s  R F   (R M  RF)
• To estimate a firm’s cost of equity capital, we
need to know three things:
1. The risk-free rate, RF

2. The market risk premium, R M  R F

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 Suppose the stock of Stansfield Enterprises, a
publisher of PowerPoint presentations, has a beta of
1.5. The firm is 100% equity financed.
 Assume a risk-free rate of 3% and a market risk

premium of 7%.
 What is the appropriate discount rate for an

expansion of this firm?

R s  R F  (R M  RF)
R s  3 %  1 .5  7 %
R s  1 3 .5 %
 13-7
 Treasury securities are close proxies for the risk-free
rate.

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 Method 1: Use historical data

 Method 2: Use the Dividend Discount Model

R s  D 1
 g
P
◦ Market data and analyst forecasts
approach on a market-wide basis
can be used to implement the DDM



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Market Portfolio - Portfolio of all assets in the economy.
In practice, a broad stock market index, such as the
S&P 500, is used to represent the market.

Beta - Sensitivity of a stock’s return to the return on the

market portfolio.

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 C o v ( R i, R M )

V ar ( R M )
• Problems
1. Betas may vary over time.
2. The sample size may be inadequate.

3. Betas are influenced by changing financial leverage and business
risk.
• Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and
financial risk.
– Look at average beta estimates of comparable firms in the industry.
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 Most analysts argue that betas are generally stable for
firms remaining in the same industry.
 That is not to say that a firm’s beta cannot change.

◦ Changes in product line

◦ Changes in technology
◦ Changes in financial leverage

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 It is frequently argued that one can better estimate a
firm’s beta by involving the whole industry.
 If you believe that the operations of the firm are

similar to the operations of the rest of the industry, you

should use the industry beta.
 If you believe that the operations of the firm are

fundamentally different from the operations of the rest

of the industry, you should use the firm’s beta.
 Do not forget about adjustments for financial leverage.

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 Business Risk
◦ Cyclicality of Revenues
◦ Operating Leverage
 Financial Risk

◦ Financial Leverage

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 Highly cyclical stocks have higher betas.
◦ Empirical evidence suggests that retailers and automotive
firms fluctuate with the business cycle.
◦ Transportation firms and utilities are less dependent on the
business cycle.
 Note that cyclicality is not the same as variability—
stocks with high standard deviations need not have
high betas.
◦ Movie studios have revenues that are variable, depending
upon whether they produce “hits” or “flops,” but their
revenues may not be especially dependent upon the
business cycle.
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 The degree of operating leverage measures how
sensitive a firm (or project) is to its fixed costs.
 Operating leverage increases as fixed costs rise and

variable costs fall.

 Operating leverage magnifies the effect of cyclicality

on beta.
 The degree of operating leverage is given by:

DOL =  EBIT Sales

×
EBIT  Sales
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 Firm A Firm B
Present Future Present Future
Sales 100 200 100 200
Variable Cost 80 160 70 140
Fixed Cost - - 10 10
EBIT 20 40 20 50
% change in 100% 100%
sales
% change in 100% 150%
EBIT

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 Q. A firm sells products for Rs 100 per unit,
has variable costs of Rs 50 per unit and fixed
operating costs of Rs 50,000 per year. Show
the level of EBIT that would result from sale
of (i) 1,000 units (ii) 2,000 units and (iii)
3,000 units.

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 If sales of Rs 2,000 units are used as a base for
comparison, the OL is:

Terrible Average Excellent

-50% +50%
Sales in Units 1,000 2,000 3,000
Sales Revenue 1,00,000 2,00,000 3,00,000
Less: variable cost 50,000 1,00,000 1,50,000
Contribution 50,000 1,00,000 1,50,000
Less: Fixed operating 50,000 50,000 50,000
cost
EBIT ZERO 50,000 1,00,000
-100% +100%

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 When proportionate change in EBIT as a result of
given change in sales is more than the
proportionate change in sales, operating leverage
exists.

 The greater the DOL, the higher is the operating

leverage and higher is the operating risk.

 DOL = Percentage change in EBIT

Percentage change in sales

Example = +100% -100%

+50% -50%
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Sales-Variable Cost
Sales – VC-FC
or
Q(P-V)
Q(P-V)-F

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 Partap chemicals is operating at a sales level
of Rs 400 lakh. Partap chemicals has a
variable cost of Rs 250 lakh (62.5%) and fixed
expense of Rs 100 lakh. What changes in
profit do you expect if the sales (a) rise by 5%
and (b) decline by 5%?

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 Figures in Rs lakh
Current Level 5% increase 5% decrease
Sales 400 420 380
VC (62.5%) 250 262.50 237.50
FC 100 100 100
Profit 50 57.50 42.50
% change +15% -15%

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 Total
 EBIT
$ costs

Fixed costs
 Sales
Fixed costs
Sales

Operating leverage increases as fixed costs rise

and variable costs fall.
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13-26
  Operating leverage refers to the sensitivity to the
firm’s fixed costs of production.
 Financial leverage is the sensitivity to a firm’s fixed

costs of financing.
 The relationship between the betas of the firm’s

debt, equity, and assets is given by:

Asset = Debt × Debt + Equity × Equity

Debt + Equity Debt + Equity
• Financial leverage always increases the equity beta relative
to the asset beta.

13-27
Consider Grand Sport, Inc., which is currently all-
equity financed and has a beta of 0.90.
The firm has decided to lever up to a capital structure
of 1 part debt to 1 part equity.
Since the firm will remain in the same industry, its
asset beta should remain 0.90.
However, assuming a zero beta for its debt, its equity
beta would become twice as large:
1
Asset = 0.90 = × Equity
1+1
Equity = 2 × 0.90 = 1.80
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 A company has Rs 1,00,000, 10% debentures
and 5,000 equity shares outstanding.
Company is in 35% tax bracket.
 Assuming three levels of EBIT (i) Rs 50,000,

(ii) 30,000 (iii) 70,000. Calculate the change

in EPS (base level of EBIT = Rs 50,000).

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 Terrible Average Excellent
-40% +40%
EBIT Rs 30,000 Rs 50,000 Rs 70,000
Less: interest 10,000 10,000 10,000
EBT 20,000 40,000 60,000
Less: Taxes 7,000 14,000 21,000
EAT 13,000 26,000 39,000
EPS 2.6 5.2 7.8
-50% +50%

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 When proportionate change in EPS as a result of
given change in EBIT is more than the
proportionate change in EBIT, financial leverage
exists.

 The greater the DFL, the higher is the financial

leverage and higher is the financial risk.

 DOL = Percentage change in EPS

Percentage change in EBIT

Example = +100% -100%

+50% -50%
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 Rs  D 1
g
P
 The DDM is an alternative to the CAPM for calculating
a firm’s cost of equity.
 The DDM
 and CAPM are internally consistent, but
academics generally favor the CAPM and companies
seem to use the CAPM more consistently.
◦ The CAPM explicitly adjusts for risk and it can be used on
companies that do not pay dividends.

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 Interest rate required on new debt issuance (i.e., yield to
maturity on outstanding debt)
 Adjust for the tax deductibility of interest expense

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13-35
 Q2. Advance Inc is trying to determine its
cost of debt. The firm has a debt issue
outstanding with 13 years to maturity that is
quoted at 95% of face value. The issue makes
semiannual payments and has a coupon rate
of 7%. What is the company’s pretax cost of
debt? If the tax rate is 35%, what is the after
tax cost of debt?

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 Preferred stock is a perpetuity, so its price is equal to
the coupon paid divided by the current required
return.
 Rearranging, the cost of preferred stock is:
◦ RP = C / PV

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13-37
A company issues 20,000 irredeemable preference share at 8%
whose face value is Rs.50 each at 4% discount. Find out the Cost
of Preference Share Capital.

Solution: Dividend on Preference share (Dp) = 50*8/100 = 4

Discount = 50*4/100 = 2
Net Proceeds (NP) = 50-2 = 48
Kp = Dp/NP
=4/48
= 8.33%

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A preference share issues at 12% worth Rs 60,000 at 5% discount and after 6
years it redeem at 10% premium. The flotation cost is 5% and tax rate is 20%.
Find out the cost of preference share capital.

Solution:
Dividend on preference share (Dp) = 60,000*12/100 = Rs.7200
Discount = 60,000*5/100 = Rs.3000
Flotation Cost = 60,000*5/100 = Rs.3000
Net Proceeds (NP) = Rs. (60,000-3000-3000) = Rs. 54,000
Premium amount = 60,000*10/100 =Rs. 6000
Redemption Value = Rs. (60,000+6000) = Rs. 66,000
Kp = Dp+ ((RV-NP)/n)/ (RV+NP)/2
= 7200+ ((66,000-54,000)/6) / (66,000+54,000)/2
= 9200/60,000
= 15.33%

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Find out the cost of 10, 500 irredeemable preference shares if
issues at 2% premium of Rs.60 each. The dividend paid by the
company is Rs. 6 each. The flotation cost is Rs. 8 per share.

Solution: Premium amount = 60*0.02 = 1.2

Issue price = 60 + 1.2 = 61.2
 Net proceeds = 61.2 - 8= 53.2
 Kp = Dp/NP
= 6 / 53.2
= 11.27%

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  The Weighted Average Cost of Capital is given by:

Equity Debt
RWACC = × REquity + × RDebt ×(1 – TC)
Equity + Debt Equity + Debt
S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B

• Because interest expense is tax-deductible, we

multiply the last term by (1 – TC).
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 The value of the firm is the present value of expected
future (distributable) cash flow discounted at the
WACC
 To find equity value, subtract the value of the debt
from the firm value

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13-42
 First, we estimate the cost of equity and the cost of
debt.
◦ We estimate an equity beta to estimate the cost of
equity.
◦ We can often estimate the cost of debt by observing
the YTM of the firm’s debt.
 Second, we determine the WACC by weighting these
two costs appropriately.

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13-43
 The industry average beta is 0.82, the risk free rate is 2%,
and the market risk premium is 7%.
 Thus, the cost of equity capital is:

RS = RF + i × ( RM – RF)

= 2% + 0.82×7%

= 7.74%
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13-44
  The yield on the company’s debt is 5%, and the firm
has a 35% marginal tax rate.
 The debt to value ratio is 32%

S B
RWACC = × RS + × RB ×(1 – TC)
S+B S+B
= 0.68 × 7.74% + 0.32 × 5% × (1 – 0.35)
= 6.30%
6.30% is International’s cost of capital (i.e., WACC). It should
be used to discount any project where one believes that the
project’s risk is equal to the risk of the firm as a whole and the
project has the same leverage as the firm as a whole.

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 Q5. Mullineaux Corporation has a target
capital structure of 70% common stock and
30% debt. Its cost of equity is 11.5% and cost
of debt is 5.9%. The relevant tax rate is 35%.
What is the company’s WACC?

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 Q6. Miller manufacturing has a target debt to
equity ratio of 0.55.Its cost of equity is 12.5%
and cost of debt is 7%. If the tax rate is 35%,
what is the company’s WACC?

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 Filer manufacturing has 8.3 million shares of common stock
outstanding. The current share price is $53, and the book
value per share is $4. The company also has two bond issues
outstanding. The first bond issue has a face value of $70
million and a coupon rate of 7% and sells for 108.3% of par.
The second issue has a face value of $60 million and a
coupon rate of 7.5% and sells for 108.9% of par. The first
issue matures in 8 years, the second in 27 years.

a. What are the company’s capital structure weights on a book

value basis?
b. What are the company’s capital structure weights on a market
value basis?
c. Which are more relevant, the book value or market value
weights?

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 Q11. Given the following information for
Huntington Power Co., find the WACC. Assume the
company tax rate is 35%.

 Debt: 10,000 5.6% coupon bonds outstanding, $1000 par

value, 25 years to maturity, selling for 97 percent of par; the
bonds make semi annual payment.

 Common Stock: 425,000 shares outstanding, selling for $61

per share; the beta is 0.95.

 Market: 7% market risk premium and 3.8% risk free rate

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 A firm has capital structure exclusively comprising of ordinary
shares amounting to Rs 10,00,000. The firm now wishes to raise
additional Rs 10,00,000 for expansion. The firm has four
alternative financial plans:

(a) Can raise entire amount from equity capital.

(b) Can raise 50% as equity capital and 50% as 5% debentures.
(c) Can raise entire amount as 6% debentures.
(d) Can raise 50% as equity capital and 50% as 5% preference capital.

Assume existing EBIT is Rs1,20,000 and the tax rate is 35%.

Outstanding ordinary shares 10,000 and the MPS is Rs 100 under
four alternative.
Which financing plan should the firm select?

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 The Saunders Investment Bank has the following financing
outstanding. What is the WACC for the company?

 Debt: 50,000 bonds with a coupon rate of 5.7% and a current price
quote of 106.5; the bonds have 20 years to maturity. 2,00,000 zero
coupon bonds with a price quote of 17.5 and 30 years until maturity.

 Preferred stock: 125000 shares of 4 percent preferred stock with a

current price of $79, and a par value of $100.

 Common stock: 23,00,000 shares of common stock; the current

price is $65, and the beta of the stock is 1.20.

 Market: The corporate tax rate is 40 percent, the market risk

premium is 7 percent, and the risk free rate is 4%.

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 Flotation costs represent the expenses incurred upon the
issue, or float, of new bonds or stocks.
 These are incremental cash flows of the project, which

typically reduce the NPV since they increase the initial

project cost (i.e., CF0).
Amount Raised = Necessary Proceeds / (1-% flotation cost)
 The % flotation cost is a weighted average based on the

average cost of issuance for each funding source and the

firm’s target capital structure:
fA = (E/V)* fE + (D/V)* fD

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13-52
 Southern Alliance needs to raise $55 million to
start a new project. The company will generate no
internal equity for the foreseeable future. The
company has a target capital structure of 65%
common stock, 5 percent preferred stock, and 30%
debt. Flotation costs for issuing new common stock
are 7%; for new preferred stock, 4% and for new
debt, 3%. What is the true initial cost figure
Southern should use when evaluating its project?

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 How do we determine the cost of equity capital?
 How can we estimate a firm or project beta?
 How does leverage affect beta?
 How do we determine the weighted average cost of
capital?
 How do flotation costs affect the capital budgeting
process?

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