Internatinal-Finance-Management-【國際財務(wù)管理】Lecture-5-Cost-of-Capital課件

1、Lecture 5 Cost of CapitalLearning ObjectivesLearning ObjectivesEstimate the cost of capitalDistinguish among the cost of capital, the required return to equity, the required return to debtChapters covered: Chapter 12Invest in projectThe Cost of Equity CapitalFirm withexcess cashShareholders Terminal

2、 ValuePay cash dividendShareholder invests in financial assetBecause 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.A firm with excess cash

3、 can either pay a dividend or make a capital investmentCost of CapitalDefinition :the cost of capital is the required return for a capital budgeting project. It is an opportunity cost, it is the return at which investors would provide financing for the capital budgeting projects.The use of cost of c

4、apitalUsing the cost of capital as hurdle rate to compute NPV of a projectUsing the cost of capital as the benchmark for performance measurementUsing the cost of capital of entire firm to calculate the value of the firm, which can be used to estimate the true value of the firm, in case of repurchase

5、 or take overThe cost of capital for a safe projectA project whose cash flow is fixed in real terms current nominal yield on U.S. government bond is 5%, CPI is 2%, we can say the cost of capital for this project in real terms is about 3% This is the appropriate rate for project with given cash flowC

6、ost of capital for risky assetWhat is the required rate of return for projects whose future cash flow is uncertainNeed a hurdle rate compatible to its riskThe hurdle rate is the rate of return on the asset at which the project merely return enough cash flow(including tax shield on the debt) to pay t

7、he shareholder and debtholder the required rate of returnWACCConsider a project which generates pretax cash flow CF, interest rate is I, the project is financed with debt and equity at market value D and E, tax rate is TThe weighted average cost of capital isOne could use WACC as the discount rate t

8、o value a firm ,but WACC assumes the D/D+E ratio(target debt ratio) will remain constant in the futureWACCTo estimate WACC, we needThe required return on equityThe required return on debtThe intended capital structural (optimal weight)Cost of equity : The Capital Asset Pricing ModelThe CAPM is not t

9、he only model to estimate rate of return for risky asset, other models include APT, but CAPM is the most widely used model(70%)ExampleSuppose Alpha Air Freight is an all-equity firm with a beta of 1.21, further suppose the market risk premium is 9.5%, and the risk-free rate is 5%. Compute the cost o

10、f equity From CAPM, Inputs Required to Use the CAPM The current risk-free rate.The expected market risk premium (the premium expected for investing in risky assets over the riskless asset).The beta of the asset being analyzed. The Bottom Line on Riskfree RatesUsing a long-term government rate as the

11、 riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true valueFor short term analysis, it is entirely appropriate to use a short-term government security rate as the riskfree rate.10-year treasury bond yieldcountry199819992000averageU.S.5.3%5.6%6%5

12、.6%Japan1.3%1.7%1.7%1.6%China4.9%3.2%3.4%3.8%U.K.5.4%5.4%5.4%5.4%Asia new industrial countries12.2%7%5.9%8.3%Measurement of the Risk PremiumThe risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate.This is a forward-looking rate

13、of return investors are to be received if the invest on market portfolio today, it is actually unobservable Estimating Risk Premiums in PracticeEstimate the implied premium from historical data,assuming that return is independent drawing from some distribution. The problem is that return on market p

14、ortfolio would not be expected to have constant meanBut we can assume that the market risk premium, has a constant mean over timeThe Historical Premium ApproachThis is the default approach used by most to arrive at the premium to use in the model.In most cases, this approach does the following:It de

15、fines a time period for the estimation (1962-Present.).It calculates average returns on a stock index during the period.It calculates average returns on a riskless security over the period.It calculates the difference between the two and uses it as a premium looking forward.Why implied risk premium

16、differMany practitioners use the Ibbotson data base and estimate historical premiums. There are three reasons for why the premium estimated may differ:1. How far back you go 2. Whether you use T.Bill or T.Bond rates ( during period 1926-1993,the arithmetic average of risk premium when riskfree rate

17、is T-bill is 8.6%, and 7.2% when riskfree rate is T-bill rate3. Whether you use arithmetic or geometric means (there is significant difference between AA and GA, during period 1926-1993, AA on S&P 500 index is 7.2%, GA is 5.2% when riskfree rate is measured by T-bond)The estimated market premium by

18、major U.S. investment banksEstimated risk premiumStern Stewart4%JP Morgan5%Kidder Peabody4.8%Value Line5%Market risk premium in China using historical approachThe average market risk premium in China using historical data is about 7.3%.year10-year yieldIndex returnRisk premium199315.3%6.8%-8.4%19941

19、3.5%-22.3%-35.8%199513.9%-14.3%-28.2%199610.6%65.1%54.6%19979.3%30.2%20.9%19984.9%-4%-8.9%19993.2%19.2%16%20003.4%51.7%48.4%Estimation of betaBy definition, beta is If we regress the market return with individual stock return, The regression coefficient is exactly (cov(ri,rm)/var(rm), soBeta can als

20、o be obtained from regression Estimating BetaThe standard procedure for estimating betas is to regress stock returns (Rj) against market returns (Rm):Rj = a + b Rmwhere a is the intercept and b is the slope of the regression. The slope of the regression corresponds to the beta of the stock, and meas

21、ures the riskiness of the stock. Using an industry betaThe estimated beta comes with measurement errorAlso, sometimes explanatory power is too low (poor R-square problem)One way to reduce these errors is using average industrial betaUsing Industry betaAdobe Systems Inc1.51BMC Software Inc0.96Cadence

22、 Design0.98Cerner Corp1.87Citrix Systems Inc1.29Comshare Inc1.22Informix Corp2.09Int.Lottery&Totalizator Sys.Inc3.34Microsoft Corp1.11Oracle Corp1.63Symantec Corp1.82Veritas Software1.94average1.65Using Industry betaAssuming risk free rate is 6%,market risk premium is 9.5%, consider the cost of equi

23、ty of Cadence Design,If we use historical beta, the cost of equity is 6%+0.98*9.5%=15.31%If we use industry beta, the cost of equity is 6%+1.65*9.5%=21.67%Very big difference Determinants of BetaBusiness RiskCyclicity of RevenuesOperating LeverageFinancial RiskFinancial LeverageCyclicality of Revenu

24、esHighly cyclical stocks have high betas.Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle.Transportation firms and utilities are less dependent upon the business cycle.Note that cyclicality is not the same as variabilitystocks with high standard devia

25、tions need not have high betas.Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops”, but their revenues are not especially dependent upon the business cycle.Operating LeverageThe degree of operating leverage measures how sensitive a firm (or project) i

26、s to its fixed costs. Operating leverage increases as fixed costs rise and variable costs fall.Operating leverage magnifies the effect of cyclicity on beta.The degree of operating leverage is given by:DOL = EBITD SalesSalesD EBITOperating leverageConsider two technology, technology has fixed cost of

27、 $1000/year, and variable cost of $8 per unit; technology B has fixed cost of $2000/year and variable cost of $6 per unit, compare their EBIT sensitivity to changes of salesOperating LeverageVolume$Fixed costsTotal costs EBIT VolumeOperating leverage increases as fixed costs rise and variable costs

28、fall.Fixed costsTotal costsFinancial Leverage and BetaFinancial leverage is the sensitivity of a firms fixed costs of financing.The relationship between the betas of the firms debt, equity, and assets is given by:Financial leverage always increases the equity beta relative to the asset beta.bAsset =

29、 Debt + EquityDebt bDebt + Debt + EquityEquity bEquityFinancial Leverage and Beta: ExampleAssuming a zero beta for debt, following relation holds for equity beta and asset betaConsider Grand Sport, Inc., which is currently all-equity and has a beta of 0.90.The firm has decided to lever up to D/E as

30、1:1bEquity = 2 0.90 = 1.80From Cost of Equity to Cost of CapitalThe cost of capital is a composite cost to the firm of raising financing to fund its projects. In addition to equity, firms can raise capital from debt.What Is Debt?Debt generally has the following characteristics:Commitment to make fix

31、ed payments in the futureThe fixed payments are tax deductibleFailure to make the payments can lead to either bankruptcy or loss of control of the firm to the party to whom payments are due.As a consequence, debt should includeAny interest-bearing liability, whether short-term or long-term.Any lease

32、 obligation, whether operating or capital.Estimating the Cost of DebtIf the firm has bonds outstanding, and the bonds are traded, the yield to maturity on a long-term, straight (no special features) bond can be used as the interest rate.If the firm is rated, use the rating and a typical default spre

33、ad on bonds with that rating to estimate the cost of debt.If the firm is not rated, and it has recently borrowed long term from a bank, use the interest rate on the borrowing orestimate a synthetic rating for the company, and use the synthetic rating to arrive at a default spread and a cost of debt.

34、Estimating Weight Average Cost of CapitalEquityCost of Equity = 5% + 0.40 (5.5%) =7.20%Market Value of Equity = $32.10 billionEquity/(Debt+Equity ) =81.0%DebtAfter-tax Cost of debt = 6% (1-.35) =3.9%Market Value of Debt =$7.54 billionDebt/(Debt +Equity) =19.0%Cost of Capital = 7.20% (0.81) + 3.9% (0.19) = 6.57%Average cost of capital in ChinaFollowing is the average estimated cost of capital for 521 Chinese public companies yearInflation rateCost of debtCost of equityCo