Lecture 8 - Risk and Cost of Capital

Question 1

Maximizing shareholder wealth and opportunity cost

Answer 1

• Corporate objective: maximise shareholder wealth
• Means achieving a return on invested capital that is greater than what shareholders could get elsewhere with an equivalent-risk class
• They could opt to invest elsewhere with comparable risk, potentially yielding higher returns
• If alternative investments offer superior returns for the same risk level, it implies a loss of shareholder wealth by the management team

Question 2

Cost of Capital

Answer 2

• The company’s cost of capital is the opportunity cost of capital for an investment in all the firm’s assets + is the correct discount rate for its average-risk projects
• The cost of capital refers to the rate of return a company must offer investors to entice them to invest in and retain a security
• This rate is established based on the returns provided by other securities of similar risk levels

Question 3

Importance of accurate cost of capital in investment assessment

Answer 3

• It is important to use the correct cost of capital as a discount rate when assessing investment opportunities
• Overestimation of the cost of capital may lead to unnecessary constraints on investments as potentially viable projects might be wrongly rejected
• Underestimation of the cost of capital could result in the undertaking of value-destructive investment ventures, as projects may be mistakenly accepted

Question 4

Cost of capital estimation

Answer 4

If the company has no debt, then the company cost of capital equals its cost of equity, the expected return on the company’s common stock

Question 5

Market Capitalisation

Answer 5

Allows us to infer the market value of a company’s assets

Question 6

Beta of all assets

Answer 6

• The beta of the equity of a no-debt company is the beta of all assets of this company
• Shareholders bear all the risks of the assets of the no-debt company

Question 7

Asset beta

Answer 7

The change in the return on a portfolio of all the firm’s securities (debt and equity) for each additional 1% change in the market return

Question 8

The calculation of cost of capital without asset beta

Answer 8

• The debt beta is typically unobservable or assumed to be 0
• Cost of debt refers to the average cost of borrowing for a business + you can use observable interest rates for that

Question 9

The impact of debt on cost of capital

Answer 9

• Debt amplifies shareholders risk
• Shareholders bear both business and financial risk because borrowing increases the volatility and the beta of equity and therefore increases the cost of equity

Question 10

Matching cost of capital to project risk

Answer 10

• The company’s overall cost of capital serves as the appropriate discount rate for new projects when their risk aligns with the existing business
• If a new project carries higher risk, it warrants a higher cost of capital for accurate valuation
• Conversely, if the risk associated with a new project is lower, a lower cost of capital should be employed for proper assessment
• Aligning the cost of capital with project risk ensures accurate evaluation + prudent decision-making in project selection
• Using the company’s overall cost of capital to evaluate all its projects can lead to incorrect decisions
• The opportunity cost of capital depends on the use to which that capital is put

Question 11

Estimating beta and company of capital (cost of debt)

Answer 11

• For companies with relatively safe debt, we can assume a debt beta of 0 and use the promised yield to maturity on the debt as an estimate of its expected return
• “In general, the cost of debt is estimated by calculating the yield to maturity (YTM) on each of the firm’s outstanding bond issues. We then compute a weighted average YTM, with the estimated YTM for each issue weighted by its percentage of total debt outstanding”

Question 12

Setting cost of capital for specific business lines

Answer 12

• When establishing a cost of capital for a particular line of business, companies often seek out “pure plays” in that industry
• Pure plays are publicly traded companies dedicated to a single activity closely resembling a division within a more diversified firm
• For instance, a railway company planning to construct new headquarters should benchmark the project’s asset beta against companies specialising in commercial real estate, not against the asset beta of railways
• Comparing with pure plays ensures a more accurate assessment of risk and facilitates better decision-making in capital allocation for specific business endeavours

Question 13

Determinants of asset betas

Answer 13

1. Cyclicality
2. Operating Leverage

Question 14

Cyclicality

Answer 14

• Cyclical firms = firms whose revenues and earnings are strongly dependent on the state of the business cycle (tend to be high-beta firms)
• This strong dependence on the business cycle causes the cash flows and profitability of cyclical firms to fluctuate more significantly compared to noncyclical firms
• You should demand a higher rate of return from investments whose performance is strongly tied to the performance of the economy
• Cash flow and earnings’ betas link fundamentals with systematic risk
• They measure the sensitivity of a company’s cash flows/earnings to changes in the overall market conditions
• Unlike traditional betas that measure changes in security returns, we measure cash flow/earnings changes

Question 15

Operating Leverage

Answer 15

Refers to the degree to which a company’s fixed costs contribute to its overall cost structure

Question 16

What does operating leverage measure?

Answer 16

• It measures the sensitivity of a company’s operating income or earnings before interest and taxes (EBIT), to changes in its sales revenue
• Variable costs depend on the rate of output while fixed costs don’t
• Projects with costs that do not decline along with sales will have higher beta
• Projects that require future investment outlays and long-term cash flows typically bear higher systematic risk

Question 17

Diversifiable risk does not affect betas

Answer 17

• The risks of the project are not all things that can go wrong
• All these risks are diversifiable + do not affect cost of capital
• They affect cash flows so adjust them
• E.g. a drug trial might not yield positive results but this is a zero-beta event not affecting asset betas and thus the discount rates used to analyse projects

Question 18

Unbiased cash flow forecasting and adjusting cost of capital

Answer 18

• Objective: enable unbiased forecasts of project cash flows, accounting for potential adverse outcomes
• Approach: develop forecasts considering all potential scenarios, encompassing both favourable + unfavourable outcomes
• Adjusting Cost of Capital: only modify the project’s cost of capital if changes in cash flows impact the perceived riskiness by diversified investors
• Rational decision-making: ensure decisions are based on comprehensive cash flow assessments + adjustments in cost of capital reflect genuine changes in project risk
• Fudge factors in discount rates are dangerous because they displace clear thinking about future cash flows