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MGMT543 HNANCE Handout 10 Cost of Capital and Capital Budgeting Evgeny Lyandres Chris Downing Fall 2005 Objectives 39 Understand the concept of cost of equity capital 0 Learn how to estimate beta 0 Discuss the determinants of beta 0 Discuss the relation between capital budgeting and project risk 0 Discuss the concept of weighted average cost of capital Cost of equity capital From the shareholders perspective the expected return is the cost of equity capital Ru 2 0391 B1RML 51 To estimate the cost of equity capital we need to calculate the equity beta Theoretically this calculation is straightforward B C0vRiRM 1 VarRM Cost of equity capital 0 However the following problems may arise in practice 1 Betas may vary over time 2 The sample size may be inadequate 3 Betas are in uenced by changing nancial leverage and business risk 4 The equity of the rm is not publicly traded Cost of equity capital Solutions Problems 1 and 2 can be mitigated by more sophisticated statistical techniques Problem 3 can be reduced by adjusting for changes in business and nancial risk Problem 4 can be solved by looking at average beta estimates of comparable rms Estimating the cost of capital You work for Continental Airlines Continental is considering expanding service to a new market that is currently served by a single regional airline You have estimated cash ows for this decision but you need a discount rate for your NPV calculation As a starting point you need to calculate Continental39s cost of capital Step 1 estimate Continental equity beta The rst step in estimating a discount rate is to determine the systematic risk or beta Since Continental is a publicly traded company we can use historical stock returns to calculate its equity beta To estimate an equity beta estimate a marketmode regression Ru 2 0391 BiRM 81 Market model regression of Continental returns on SampP returns Prices Returns Date Continental SPX Continental SPX OcerD 37 75 1429 40 24 01 0 49 Sep700 30 44 1436 51 V10 47 5 35 Aug700 34 00 1517 68 V13 38 B 07 JU700 39 25 1430 83 0 84 1 83 JunyDD 39 00 1454 E30 8 24 2 39 MayrDD 42 50 1420 60 52 82 2 19 Apr700 27 81 1452 43 0 00 3 08 Miami 27 81 1498 58 48 80 9 87 Petrol 18 B9 1386 42 V15 28 2 01 Jan 00 22 06 1394 48 31 19W 5 09quot Dec 99 32 08 1489 25 14 75 5 77quot Nov 99 27 94 1389 07 0 43 1 92quot Oct 99 28 06 1362 93 8 90 8 25quot Sep 00 2B 25 1282 71 14 80 2 88quot Aug 99 30 81 1320 41 13 53 0 83quot Jul 99 35 B3 1328 72 18 20 3 20 JUI7799 43 56 1372 71 V10 30 5 44 8 Mayr99 48 5B 1301 84 Market model regression of Continental returns on SampP returns Scatter plot m Continental returns Beta of Continental Measurement error in beta Estimating beta for similar firms for example firms in the same industry can help reduce some of the measurement error in beta In this problem we might want to examine the betas for other national airlines to see if our beta estimate for Continental is comparable to the betas of similar firms National airline betas Deta 126 US Airways 134 United 112 American 129 Northwest 120 Let s use the average of all six national airlines as an estimate of Continental s beta Project vs company betas By using the Continental equity beta to calculate a discount rate for our project we are implicitly assuming that the new project has the same market risk as the company as a whole For our scaleexpansion project this is probably not a bad assumption For other projects it might be a bad assumption Project vs company betas Suppose you thought of expanding into a lowvolume airline market had market risk that was similar to the risk of a regional airline rather than the risk of Continental In this case you should ignore the beta of Continental and estimate the beta of a typical regional airline Regional airline equity betas Atlas Air 139 Mesa Air 138 Midwest 129 Comair 139 Let s use the average of four regional airlines as an estimate of Continental s beta A final decision on beta We now have at least three choices for beta Continental s beta National airlines average beta Regional airlines average beta The nal choice of beta requires some judgment For today let s go middle of the road and say that Estimate the required rate of return on equity The CAPM tells us that ERi Rf BiERM Rf Since we estimated beta to calculate the required rate of return we need to know the riskfree rate R and the market risk premium ERMRf Riskfree rate The current riskfree rate can be observed directly by looking at the return on a riskfree government bond 39The rate on a 1year Treasury is 32 and the rate on a 10year Treasury is 54 Let s use the average for this problem Market risk premium The market risk premium is an expected value that cannot be observed directly We can use historical data on the market risk premium to estimate this expected value the consensus seems to be close to 8 Required return on equity Putting these results together gives us a required return on equity for Continental ERi Rf BiERM Rf Step 3 the effects of leverage We have estimated Continental required return on equity to be However what we really want to know is Continental required return on investment or return on assets The required return on equity will be higher than the required return on assets because of the effects of leverage For simplicity the following analysis assumes no taxes Continental as a portfolio of debt and equity Think of Continental as a portfolio of debt and equity V E D Then Continental required return on assets or the weighted average cost of capital WA 00 is equal to the weighted average of the return on equity and the return on debt where the portfolio weights are given by E V and D V E D WACCZRA ZvRE VRD Continental as a portfolio of debt and equity We now have all the inputs to calculate Continental cost of capital or return on assets except for RD Continental s cost of debt or borrowing rate For most firms RD can be approximated by the coupon rate on the firm s recently issued bonds Assume for Continental this rate is 7 Then E D Continental as a portfolio of debt and equity Assume that Continental has 6710 million shares outstanding The price per share in October 2000 is 3775 The value of Continental s debt is 2229M Continental as a portfolio of debt and equity Assume now that Continental decides to repurchase 10M of its outstanding shares Assuming that its business risk and the return on debt remain constant how would the share repurchase affect its expected return on equity and its equity beta The effect of capital structure on expected returns If we think of a firm as a portfolio of debt and equity then it is easy to see how capital structure affects expected returns E D RA ZvRE l VRD D RE RAERA RD The effect of capital structure on debt and equity betas If we think of a firm as a portfolio of debt and equity then it is also easy to see how capital structure affects betas E D BA VBD BE BAElt A BDgt