EFB210 Lecture Notes - Lecture 9: Risk-Free Interest Rate, Capital Asset Pricing Model, Cash Flow

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harlequingnat161

25 May 2018

School

QUT

Department

Economics and Finance

Course

EFB210

Professor

All

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Week 9 Finance 1 Lecture Notes

Weighted Average Cost of Capital (WACC)

Setting the discount rate

• Discount cash flows to present by using a discount rate that reflects the risk of cash

flows

o To date, the discount rate for the decision rule has been given

• Three approaches to setting the discount rate

1. Just set it! (Hurdle Rate)

o e.g. just use 10.00% or 15.00% or some other percent

o Justification – past experience or some comparable.

2. Use the CAPM directly

o CAPM of the project, which means you need a project β

▪ Do you know the covariance of the project and market returns?

▪ Could proxy (look for something similar), use experience or infer.

▪ Must be careful of capital structure

3. Weighted Average Cost of Capital (WACC)

o Assume that the project has the same risk as the existing operations of the

firm.

o Hee the fi’s uet ost of det (kd) and cost of equity (ke) reflect the

appropriate levels of return.

o Weight kd and ke according to capital structure.

CAPM

• Calculating the Discount Rate with CAPM:

• Example:

o The risk free rate,  

o The market return,  

o The project beta,  

o The risk adjusted discount rate is 11.2%

• Problem: a project beta is usually not available

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WACC

• Weighted Average Cost of Capital (WACC)

o Firms raise capital via debt and equity, and must pay for these funds

▪ explicitly via interest on debt

▪ implicitly via opportunity cost of equity

o WACC is the rate that an investment or project must return to meet the

euied etus of those that hae supplied the fi’s apital (det ad

equity).

o WACC is an average of costs from all sources of debt (kd) and equity (ke).

o It can be argued that the WACC is a rate that reflects the risk of the firm.

o If the pojet’s cash flows are such that they are more than sufficient to cover

the WACC then the project will have a positive NPV. Negative NPVs arise

when cash flows do not sufficiently cover the WACC.

o If the WACC does ot appopiately eflet the pojet’s isk, the NPV

calculated in the discounted cash flow analysis is wrong.

• No Taxes

• No taxes example:

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• With taxes

• With Taxes Example

WACC: Elements

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Document Summary

It can be argued that the wacc is a rate that reflects the risk of the firm. If the p(cid:396)oje(cid:272)t"s cash flows are such that they are more than sufficient to cover the wacc then the project will have a positive npv. Negative npvs arise when cash flows do not sufficiently cover the wacc. If the wacc does (cid:374)ot app(cid:396)op(cid:396)iately (cid:396)efle(cid:272)t the p(cid:396)oje(cid:272)t"s (cid:396)isk, the npv calculated in the discounted cash flow analysis is wrong: no taxes, no taxes example, with taxes, with taxes example. Wacc: elements: cost of equity, (cid:3032, dividend pricing formula. Capm) explicitly, but does so implicitly via the current share price 0: example, ra(cid:374)do(cid:373) co(cid:373)pa(cid:374)y"s, expected dividend is . 20 and dividends are expected to grow at. However, the rates from the models only coincide because it was assumed that the constant dividend growth rate was exceptionally high, 10. 20% p. a. That is, use: note that there are two approaches for solving after tax (cid:3031).

Related Questions

8.1 Is each of the following statements true or false? Explain your answers briefly.

a. Using the same risk-adjusted discount rate to discount all future cash flows ignores the fact that the more distant cash flows are often riskier than cash flows occurring sooner.

b. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm.

c. If you can borrow all of the money you need for a project at 6 percent, the cost of capital for this project is 6 percent.

d. The best way to estimate the cost of debt capital for a firm is to di- vide the interest expense on the income statement by the interest-bearing debt on the balance sheet.

e. One reliable estimate of a privately held firmâs equity beta is the average of the equity betas of several publicly held competitors.

Which of the following statements are true? Select 4 that apply. (4 points)

Discounted payback method of capital appraisal ignores cash flows beyond the discounted payback period.

The net present value is found by discounting all positive cash flows at the projectâs cost of capital.

The project is accepted if the IRR is less than the projectâs cost of capital.

The IRR is the discount rate which forces the present value of a projectâs future cash flows to equal the future value of its costs.

Firms often choose among mutually exclusive projects on the basis of the present value of future costs.

To use the CAPM approach in capital budgeting, we estimate the firmâs beta, multiply this by the market risk premium and add the firmâs risk premium to the risk-free rate to obtain the firmâs cost of retained earnings or cost of equity.

The best proxy for the risk-free rate is the yield on treasury bonds.

Floatation costs are generally material when looking at its effect on the after-tax cost of debt.

burgundygnat457

Use the following information to answer the next four questions.) Firms 1 â 7 operate in the industries shown. All seven firms are considering projects in the industries shown, to be financed using the same mix of debt and equity (B/V and S/V, respectively) as finances existing projects. The firmsâ stock betas are shown.

Corporation:	Firm 1	Firm 2	Firm 3	Firm 4	Firm 5	Firm 6	Firm 7
Current Business:	Industries 1 & 2	Industries 3 & 4	Industry 1	Industry 2	Industry 3	Industry 4	Industry 4
B/V S/V	0.0000 1.0000	0.2000 0.8000	0.0000 1.0000	0.0000 1.0000	0.1000 0.9000	0.3000 0.7000	0.0000 1.0000
Î²_S	0.9000	1.2420	0.6000	1.1000	0.8533	1.8857	1.5000
Project:	Industry 1	Industry 3	Industry 1	Industry 1	Industry 3	Industry 2	Industry 2
Notes:	T = 0.40 and R_B = 0.03 for all firms. The risk-free return is 1% per year. The market risk premium is 7% per year.

18. Which of the following statements is most accurate?

a. Firm 1âs stock beta lies between the asset betas of Firms 3 and 4.

b. Firm 1âs cost of equity (R_S) is the correct discount rate for its project.

c. Firm 1âs cost of equity for the project is 0.064 or 6.4%.

19. Which of the following statements is most accurate?

a. Firm 2âs weighted average cost of capital (WACC) is the correct discount rate for this project.

b. Firm 2 may rightly use Firm 5 as a proxy firm to find a discount rate for its project.

c. Firm 2 may rightly use Firm 5âs WACC as the discount rate for this project.

20. Which of the following statements is inaccurate?

a. Firms 3 and 4 may rightly use the same discount rate for their projects.

b. The discount rate for Firm 5âs project is 0.065 or 6.5%.

c. The rate of return Firm 5 stockholders require on existing projects is 0.061 or 6.1%.

21. Which of the following statements is most accurate?

a. Existing projects at Firms 6 and 7 have the same asset beta.

b. Stockholders at Firm 6 require a lower rate of return on the firmâs existing projects than stockholders at Firm 7 require on their firmâs existing projects.

c. Firms 6 and 7 are both pure-play firms undertaking expansion / replacement projects.

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EFB210 Lecture Notes - Lecture 9: Risk-Free Interest Rate, Capital Asset Pricing Model, Cash Flow

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