Topic 6: WACC

Question 0

Security Market Line graph is…
Project beta = ?

Compare project beta for project with debt and project without debt. Which is higher.

Answer 0

Graph of cost of equity (the most variable input) vs the security beta

Project beta = sum of operating risk and financing risk.

• no debt project: beta reflects operating (business) risk)
• project with debt: beta will be higher and reflect impact of financial risk

Question 1

CAPM: Key implications (2)

1. Project’s systematic risk is incorporated into the discount rate via ?
2. Project specific risk (non systematic) should be incorporated into ?

Answer 1

1. Project’s systematic risk is incorporated into the discount rate via CAPM
2. Project specific risk (non systematic) should be incorporated into expected cash flows

Question 2

2 steps to ensure cost of equity matches the operating risk and financial risk status of project or business

Answer 2

1. FInd companies that match operating risk of our project / business (“pureplays”). Calculate their beta
2. Adjust this beta to reflect financing risk of our project

Question 3

Asset Beta

Answer 3

1. Asset beta describes systematic operating risk.
2. The extent to which a project’s operating risk is correlated with the market
3. Operating risk describes the component of total risk due to a firm’s assets.

Question 4

Adjust for different financial structures
Financial risk = ?
Impact on equity holders = ?

Answer 4

Financial risk = effect of debt finance on firm’s operations

• increases variability of rate of return of equity holders
• increases financial risk carried by equity
• increases rate of return required by equity

Question 5

Equity Beta

Answer 5

• beta for shares
• incorporates operating & financial risk
• AKA leveraged beta or company beta

Question 6

Asset beta

Answer 6

• risk of firm if it were all equity financed
• AKA unlevered beta
• for all equity firm; asset beta and equity beta are the same

Question 7

Debt beta

Answer 7

• cost of the debt of the entity. Can be implied by CAPM

Question 8

Market and Beta: segmented vs not segmented (integrated) in global markets

Answer 8

MARKET

• if segmented, then international investing created diversification and foreign projects may therefore have lower cost of eq
• if markets are integrated (global); all of company’s investments will have a lower cost of equity than that estimated using domestic market index

BETA

• segmented mkt: calc beta of foreign investment vs home index. Beta of intl project could be low, adding diversification benefits
• integrated mkt: measure beta relative to global index. Beta depends on size of global linkages betw country & project

Question 9

Premium for FX Risk

Premium for Political Risk

Answer 9

Premium for FX Risk
- if use fwd rates to convert CFs to base currency when valuing foreign project; no need to add premium for FX risk

Premium for Political Risk

• eg investments in EM.
• ** little financial logic to this ***
• better to adjust CFs for political risk - improved transparency; focus on political risk highlights tax law & restrictions that affect CFs; political risk prob declines as project and mkt mature - a premium n discount rate causes exponential adjustment.

Question 10

Incorrect decisions can be made when overall cost of capital is used to evaluate a project when risk differs to that of the firm.

2 critical parameters:

Answer 10

1. beta for the project
2. target cap structure

Use comps to estimate

Question 11

steps to est project cost of capital

Answer 11

1. find comparable companies
2. remove effect of financing to get asset beta
3. estimate asset beta
4. be careful of betas from other countries - diff currency; diff mkt index
5. est tgt cap structure for project
6. choose valuation method (WACC, APV, FTE)
7. estimate discount rates

Question 12

Discount rates:

• WACC:
• APV (or MM WACC)
• FTE:

Answer 12

• WACC: derive eq beta, then CAPM to get cost of equity, then use WACC formula
• APV (or MM WACC): use asset beta to determine ungeared cost of eq using CAPM and value debt benefits separately
• FTE: calc eq beta then use CAPM to derive est cost of eq, then calc geared CFs for valuing eq