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Financial Management Spring 2012

Week 14
Risk and the Cost of Capital II

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Topics Covered
Analyzing Project Risk
Certainty Equivalents: Another
Way to Adjust for Risk

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Company Cost of Capital

 Company Cost of Capital (Company CoC) is
based on the average beta of the assets

 STEP 1) Make unbiased forecasts of a project’s

cash flows
– The unbiased forecast is the sum of probability-
weighted cash flows
 STEP 2) Consider whether investors would regard
the projects as more or less risky than typical for a
company or division

 The average beta of the assets is based on the % of

funds in each asset
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Company Cost of Capital

Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6

 Average beta of assets = 1.3

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Capital Structure
Capital Structure (CS): the mix of debt &
equity within a company
Expand CAPM to include CS

r = r f + B ( r m - rf )
becomes
requity = rf + B ( rm - rf )

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Capital Structure & Company CoC

Expected Returns and Betas prior to refinancing

Expected 20
return (%)
Requity=15
Rassets=12.2

Rdebt=8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
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Asset Beta
 A production facility with high fixed costs, relative
to variable costs, is said to have high operating
leverage  high risk

Cash flow = Revenue – FC – VC

 PV(Asset) = PV(Revenue) - PV(FC) – PV(VC)
– Debtholders: receive FC, fixed payment
– Shareholders: receive the net cash flows, get whatever
is left after payment of FC

 The beta of PV(Revenue) is weighted average of

the betas of its components
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Asset Betas

PV(fixed cost)
Brevenue  Bfixed cost 
PV(revenue)
PV(variable cost) PV(asset)
 B variable cost  Basset
PV(revenue) PV(revenue)

 The FC beta=0; whoever received the FC receives fixed

stream of CF
 The Revenue beta = the VC beta; they respond to the same
underlying variable, the rate of output
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Asset Betas

PV(revenue) - PV(variabl e cost)

B asset  B revenue
PV(asset)

 PV(fixed cost) 
 B revenue 1  
 PV(asset) 

 Given the cyclicality of revenue, the asset beta is

proportional to the ratio of the PV(FC) to the PV(Asset)
 Other things being equal, the alternative w/ higher ratio of
FC to project value will have the higher project beta

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Asset Betas
 Example: Nero violins has the following capital
structure
Security Beta Total Market
Value($ millions)
Debt 0 $100
Preferred Stock 0.20 40
Common Stock 1.20 299

– A. What is the firm’s asset beta?

– B. Assume that the CAPM is correct. What discount rate
should Nero set for investments that expand the scale of
its operations w/o changing its asset beta? Assume a
risk-free interest rate of 5% and a market risk premium
of 6%
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Estimating the Cost of Equity

Cost of Equity  rf    E  Rmarket   rf 

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Example
Problem:
 The equity beta for Weyerhaeuser (WY) is 1.2.
The yield on 10-year treasuries is 4.5%, and you
estimate the market risk premium to be 5%.
Further, Weyerhaeuser issue an annual dividend of
$2. Its current stock price is $71, and you expect
dividends to increase at a constant rate of 4% per
year. Estimate Weyerhaeuser’s cost of equity in
two ways.

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Risk, DCF and CEQ

Certainty Equivalents
– In practical capital budgeting, a single discount
rate is usually applied to all future CFs
– Among other things, the use of a constant rate
assumes that project risk does not change over
time, but remains constant year-in and year-out
– This cannot be strictly true for the risks that
companies are exposed to are constantly shifting
 Converting the expected CFs to CEQ

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Risk, DCF and CEQ

 Convert the expected CFs to Certainty Equivalents
 a certain CF level, CEQt has exactly the same
PV as an expected but uncertain CF, Ct

Ct CEQt
PV  
(1  r ) t
(1  rf ) t

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Risk,DCF and CEQ

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Risk, DCF and CEQ

 Example: an office building, CF1=$420,000,
beta=1, rf=5%, market premium=7%
– Discount rate=5+1*7=12%
– PV=420,000/1.12=$375,000
– A real estate company offers to fix the price at which it
will buy the building from you at the end of the year 
removes any uncertainty about the payoff on the
investment
– Interest rate=5%, PV=CEQ/1.05  CEQ=$393,750
– This has exactly the same PV as an expected but
uncertain CF of $420,000
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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil
for each of three years. Given a risk free rate of
6%, a market premium of 8%, and beta of .75,
what is the PV of the project?

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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil
for each of three years. Given a risk free rate of
6%, a market premium of 8%, and beta of .75,
what is the PV of the project?

r  rf  B( rm  rf )
 6  .75(8)
 12%
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Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3
2 100 79.7
r  r f  B ( rm  r f )
 6  .75(8) 3 100 71.2
 12% Total PV 240.2
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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?
Project A
Year Cash Flow PV @ 12%
1 100 89.3 Now compare these
2
3
100
100
79.7
71.2
figures w/ the CFs of
Total PV 240.2 project B, but are RISK
r  r f  B ( rm  r f ) FREE. What is the B’s
 6  .75(8) PV?
 12%

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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?
Note that B’s CFs are lower than A’s, but they are safe!
Project B
Year Cash Flow PV @ 6%
1 94.6 89.3
2 89.6 79.7
3 84.8 71.2
T otalPV 240.2
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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?..
Now assume that the cash flows change, but are RISK
FREE. What is the new PV?
Project B
Project A Year Cash Flow PV @ 6%
Year Cash Flow PV @ 12%
1 94.6 89.3
1 100 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2
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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?..
Now assume that the cash flows change, but are RISK
FREE. What is the new PV?
Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

Since the 94.6 is risk free, we call it a Certainty Equivalent

of the 100.
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Risk, DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?
DEDUCTION FOR RISK

Deduction
Year Cash Flow CEQ
for risk
1 100 94.6 5.4
2 100 89.6 10.4
3 100 84.8 15.2

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Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?..
Now assume that the cash flows change, but are RISK
FREE. What is the new PV?
The difference between the 100 and the certainty equivalent
(94.6) is 5.4%…this % can be considered the annual
premium on a risky cash flow

Risky cash flow

 certainty equivalent cash flow
1.054

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Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?..
Now assume that the cash flows change, but are RISK
FREE. What is the new PV?
100
Year 1   94.6
1.054

100
Year 2  2
 89.6
1.054

100
Year 3  3
 84.8
1.054
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Risk,DCF and CEQ

Example
Project A is expected to produce CF = $100 mil for each of
three years. Given a risk free rate of 6%, a market premium
of 8%, and beta of .75, what is the PV of the project?..
Now assume that the cash flows change, but are RISK
FREE. What is the new PV?
100
Year 1   94.6  By using a constant rate,
1.054
you effectively made a larger
100
deduction for risk from the
Year 2  2
 89.6 later CFs
1.054

100
Year 3  3
 84.8
1.054
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Risk, DCF and CEQ

 Example: when you cannot use a single risk-
adjusted discount rate for long-lived assets
The scientists at Vegetron have come up with an electric
mop, and the firm is ready to go ahead with pilot
production and test marketing. The preliminary phase will
take one year and cost $125,000. Management feels that
there is only a 50% chance that pilot production and
market tests will be successful. If they are, then Vegetron
will build a $1million plant that would generate an
expected annual CF in perpetuity of $250,000 a year after
taxes. If they are not successful, the project will have to be
dropped. Is the project worth it?

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