Title: Corporate
Finance, 10th Edition Author: Stephen A. Ross,
Randolph W. Westerfield, and Jeffrey Jaffe
For five
points, a posting will thoughtfully consider and respond to the question, using
sound argumentation and clear prose. It will contain virtually no grammatical
errors or typos. Not only will such a post engage with the ongoing conversation
in a rhetorically suitable fashion, it will foster further discussion on the
topic, perhaps exploring new lines of argument or different perspectives. The
five-point post isn’t just a response; it’s proof that you are facilitating
learning both for yourself and your fellow students. (no more than 3 pages) add
at least 2 referencesCost of Capital and Efficient Capital Markets !!!!!!!
• What are the sources of funds for a
corporation and what are the costs of those components of funds?
• How a corporation can reduce its cost
of capital? Is the flotation cost optimal and what is the role of investment
banks in our firms financing?
• What is the difference between
Investment-Saving schedule and WACC-Investment opportunities schedule?
• Do you think that the financial
markets are efficient?
• Can we predict the prices of an asset
or they follow random walks?
• Do you know any evidence about market
inefficiencies?
Please respond to at least one other student’s
post by the end of the week !!!chap013.pptchap014.pptChapter 13
Risk, Cost of Capital, and Valuation
McGraw-Hill/Irwin
Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
Know how to determine a firm’s cost of equity
capital
Understand the impact of beta in determining
the firm’s cost of equity capital
Know how to determine the firm’s overall cost
of capital
Understand the impact of flotation costs on
capital budgeting
13-1
Chapter Outline
13.1
13.2
13.3
13.4
13.5
13.6
13.7
13.8
13.9
13.10
13.11
The Cost of Equity Capital
Estimating the Cost of Equity Capital with the CAPM
Estimation of Beta
Determinants of Beta
The Dividend Discount Model Approach
Cost of Capital for Divisions and Projects
Cost of Fixed Income Securities
The Weighted Average Cost of Capital
Valuation with RWACC
Estimating Eastman Chemical’s Cost of Capital
Flotation Costs and the Weighted Average Cost of Capital
13-2
Where Do We Stand?
Earlier chapters on capital budgeting
focused on the appropriate size and
timing of cash flows.
This chapter discusses the appropriate
discount rate when cash flows are risky.
13-3
13.1 The Cost of Equity Capital
Firm with
excess cash
Pay cash dividend
Shareholder
invests in
financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment
Invest in project
Shareholder’s
Terminal
Value
Because 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.
13-4
The Cost of Equity Capital
From the firm’s perspective, the expected
return is the Cost of Equity Capital:
R s = RF + β ( R M − RF )
• To estimate a firm’s cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
2. The market risk premium, R M
− RF
Cov( Ri , RM ) σ i , M
= 2
3. The company beta, βi =
Var ( RM )
σM
13-5
Example
Suppose the stock of Stansfield Enterprises, a
publisher of PowerPoint presentations, has a beta
of 1.5. The firm is 100% equity financed.
Assume a risk-free rate of 3% and a market risk
premium of 7%.
What is the appropriate discount rate for an
expansion of this firm?
R s = RF + β ( R M − RF )
R s = 3% + 1.5 7%
R s = 13.5%
13-6
Example
Suppose Stansfield Enterprises is evaluating the following
independent projects. Each costs $100 and lasts one year.
Project
Project b
A
IRR
NPV at
13.5%
1.5
Project’s
Estimated Cash
Flows Next
Year
$125
25%
$10.13
B
1.5
$113.5
13.5%
$0
C
1.5
$105
5%
-$7.49
13-7
IRR
Project
Using the SML
Good
A
project
30%
B
5%
C
SML
Bad project
Firm’s risk (beta)
2.5
An all-equity firm should accept projects whose IRRs
exceed the cost of equity capital and reject projects
whose IRRs fall short of the cost of capital.
13-8
The Risk-Free Rate
Treasury securities are close proxies for the risk-free
rate.
The CAPM is a period model. However, projects are
long-lived. So, average period (short-term) rates
need to be used.
The historic premium of long-term (20-year) rates
over short-term rates for government securities is
2%.
So, the risk-free rate to be used in the CAPM could
be estimated as 2% below the prevailing rate on 20year treasury securities.
13-9
Market Risk Premium
Method 1: Use historical data
Method 2: Use the Dividend Discount Model
Rs
◼
D
=
+g
1
P
Market data and analyst forecasts can be used to
implement the DDM approach on a market-wide
basis
13-10
13.3 Estimation of Beta
Market Portfolio – Portfolio of all assets in the
economy. In practice, a broad stock market
index, such as the S&P 500, is used to represent
the market.
Beta – Sensitivity of a stock’s return to the return
on the market portfolio.
13-11
Estimation of Beta
•
Problems
Cov( Ri , RM )
β=
Var ( RM )
1. Betas may vary over time.
2. The sample size may be inadequate.
3. Betas are influenced by changing financial leverage and business risk.
•
Solutions
– Problems 1 and 2 can be moderated by more sophisticated statistical
techniques.
– Problem 3 can be lessened by adjusting for changes in business and
financial risk.
– Look at average beta estimates of comparable firms in the industry.
13-12
Stability of Beta
Most analysts argue that betas are generally
stable for firms remaining in the same
industry.
That is not to say that a firm’s beta cannot
change.
◼
◼
◼
◼
Changes in product line
Changes in technology
Deregulation
Changes in financial leverage
13-13
Using an Industry Beta
It is frequently argued that one can better estimate a
firm’s beta by involving the whole industry.
If you believe that the operations of the firm are
similar to the operations of the rest of the industry,
you should use the industry beta.
If you believe that the operations of the firm are
fundamentally different from the operations of the
rest of the industry, you should use the firm’s beta.
Do not forget about adjustments for financial
leverage.
13-14
13.4 Determinants of Beta
Business Risk
◼
◼
Cyclicality of Revenues
Operating Leverage
Financial Risk
◼
Financial Leverage
13-15
Cyclicality of Revenues
Highly cyclical stocks have higher betas.
◼
◼
Empirical evidence suggests that retailers and
automotive firms fluctuate with the business cycle.
Transportation firms and utilities are less dependent on
the business cycle.
Note that cyclicality is not the same as
variability—stocks with high standard deviations
need not have high betas.
◼
Movie studios have revenues that are variable,
depending upon whether they produce “hits” or “flops,”
but their revenues may not be especially dependent
upon the business cycle.
13-16
Operating Leverage
The degree of operating leverage measures how
sensitive a firm (or project) is to its fixed costs.
Operating leverage increases as fixed costs rise
and variable costs fall.
Operating leverage magnifies the effect of
cyclicality on beta.
The degree of operating leverage is given by:
DOL =
Sales
D EBIT
×
EBIT
D Sales
13-17
Operating Leverage
$
Total
costs
Fixed costs
D EBIT
D Sales
Fixed costs
Sales
Operating leverage increases as fixed costs rise
and variable costs fall.
13-18
Financial Leverage and Beta
Operating leverage refers to the sensitivity to the
firm’s fixed costs of production.
Financial leverage is the sensitivity to a firm’s
fixed costs of financing.
The relationship between the betas of the firm’s
debt, equity, and assets is given by:
bAsset =
•
Debt
Equity
× bDebt +
× bEquity
Debt + Equity
Debt + Equity
Financial leverage always increases the equity beta
relative to the asset beta.
13-19
Example
Consider Grand Sport, Inc., which is currently all-equity
financed and has a beta of 0.90.
The firm has decided to lever up to a capital structure of
1 part debt to 1 part equity.
Since the firm will remain in the same industry, its asset
beta should remain 0.90.
However, assuming a zero beta for its debt, its equity
beta would become twice as large:
bAsset = 0.90 =
1
× bEquity
1+1
bEquity = 2 × 0.90 = 1.80
13-20
13.5 Dividend Discount Model
Rs =
D +g
1
P
The DDM is an alternative to the CAPM for
calculating a firm’s cost of equity.
The DDM and CAPM are internally consistent, but
academics generally favor the CAPM and companies
seem to use the CAPM more consistently.
◼
The CAPM explicitly adjusts for risk and it can be used on
companies that do not pay dividends.
13-21
Project IRR
Capital Budgeting & Project Risk
The SML can tell us why:
SML
Incorrectly accepted
negative NPV projects
RF + β FIRM ( R M − RF )
Hurdle
rate
rf
bFIRM
Incorrectly rejected
positive NPV projects
Firm’s risk (beta)
A firm that uses one discount rate for all projects may over time
increase the risk of the firm while decreasing its value.
13-22
Capital Budgeting & Project Risk
Suppose the Conglomerate Company has a cost of capital, based on
the CAPM, of 17%. The risk-free rate is 4%, the market risk
premium is 10%, and the firm’s beta is 1.3.17% = 4% + 1.3 × 10%
This is a breakdown of the company’s investment projects:
1/3 Automotive Retailer b = 2.0
1/3 Computer Hard Drive Manufacturer b = 1.3
1/3 Electric Utility b = 0.6
average b of assets = 1.3
When evaluating a new electrical generation investment,
which cost of capital should be used?
13-23
Capital Budgeting & Project Risk
Project IRR
SML
24%
17%
10%
Investments in hard
drives or auto retailing
should have higher
discount rates.
Project’s risk (b)
0.6
1.3
2.0
R = 4% + 0.6×(14% – 4% ) = 10%
10% reflects the opportunity cost of capital on an investment
in electrical generation, given the unique risk of the project.
13-24
Cost of Debt
Interest rate required on new debt
issuance (i.e., yield to maturity on
outstanding debt)
Adjust for the tax deductibility of
interest expense
13-25
Cost of Preferred Stock
Preferred stock is a perpetuity, so its
price is equal to the coupon paid divided
by the current required return.
Rearranging, the cost of preferred stock
is:
◼
RP = C / PV
13-26
13.8 The Weighted Average Cost of
Capital
The Weighted Average Cost of Capital is given by:
RWACC =
Equity
Debt
× REquity +
× RDebt ×(1 – TC)
Equity + Debt
Equity + Debt
S
B
RWACC =
× RS +
× RB ×(1 – TC)
S+B
S+B
• Because interest expense is tax-deductible, we
multiply the last term by (1 – TC).
13-27
Firm Valuation
The value of the firm is the present value
of expected future (distributable) cash
flow discounted at the WACC
To find equity value, subtract the value
of the debt from the firm value
13-28
Example: International Paper
First, we estimate the cost of equity and
the cost of debt.
◼
We estimate an equity beta to estimate the
cost of equity.
◼
We can often estimate the cost of debt by
observing the YTM of the firm’s debt.
Second, we determine the WACC by
weighting these two costs appropriately.
13-29
Example: International Paper
The industry average beta is 0.82, the
risk free rate is 3%, and the market risk
premium is 8.4%.
Thus, the cost of equity capital is:
RS = RF + bi × ( RM – RF)
= 3% + 0.82×8.4%
= 9.89%
13-30
Example: International Paper
The yield on the company’s debt is 8%,
and the firm has a 37% marginal tax rate.
The debt to value ratio is 32%
S
B
RWACC =
× RS +
× RB ×(1 – TC)
S+B
S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
= 8.34%
8.34% is International’s cost of capital. It should be used to
discount any project where one believes that the project’s risk
is equal to the risk of the firm as a whole and the project has
the same leverage as the firm as a whole.
13-31
13.11 Flotation Costs
Flotation costs represent the expenses incurred upon the
issue, or float, of new bonds or stocks.
These are incremental cash flows of the project, which
typically reduce the NPV since they increase the initial
project cost (i.e., CF0).
Amount Raised = Necessary Proceeds / (1-% flotation cost)
The % flotation cost is a weighted average based on the
average cost of issuance for each funding source and the
firm’s target capital structure:
fA = (E/V)* fE + (D/V)* fD
13-32
Quick Quiz
How do we determine the cost of equity
capital?
How can we estimate a firm or project beta?
How does leverage affect beta?
How do we determine the weighted average
cost of capital?
How do flotation costs affect the capital
budgeting process?
13-33
Chapter 14
Efficient Capital Markets and Behavioral
Challenges
McGraw-Hill/Irwin
Copyright © 2013 by the McGraw-Hill Companies, Inc. All rights reserved.
Key Concepts and Skills
Understand the importance of capital market
efficiency
Be able to define the forms of efficiency
Know the various empirical tests of market
efficiency
Understand the implications of efficiency for
corporate finance managers
14-1
Chapter Outline
14.1 Can Financing Decisions Create Value?
14.2 A Description of Efficient Capital Markets
14.3 The Different Types of Efficiency
14.4 The Evidence
14.5 The Behavioral Challenge to Market Efficiency
14.6 Empirical Challenges to Market Efficiency
14.7 Reviewing the Differences
14.8 Implications for Corporate Finance
14-2
14.1 Can Financing Decisions Create Value?
Earlier parts of the book show how to evaluate
investment projects according to the NPV criterion.
The next few chapters concern financing decisions,
such as:
◼
◼
◼
How much debt and equity to sell
When to sell debt and equity
When (or if) to pay dividends
We can use NPV to evaluate financing decisions.
14-3
Creating Value through Financing
1.
Fool Investors
•
2.
Reduce Costs or Increase Subsidies
•
3.
Empirical evidence suggests that it is hard to fool
investors consistently.
Certain forms of financing have tax advantages or
carry other subsidies.
Create a New Security
•
•
Sometimes a firm can find a previously-unsatisfied
clientele and issue new securities at favorable prices.
In the long-run, this value creation is relatively small.
14-4
14.2 A Description of Efficient Capital Markets
An efficient capital market is one in which stock
prices fully reflect available information.
The EMH has implications for investors and firms.
◼
Since information is reflected in security prices
quickly, knowing information when it is released does
an investor little good.
◼
Firms should expect to receive the fair value for
securities that they sell. Firms cannot profit from
fooling investors in an efficient market.
14-5
Foundations of Market Efficiency
Investor Rationality
Independence of events
Arbitrage
14-6
Stock Price Reactions
Stock
Price
Overreaction to “good
news” with reversion
Delayed
response to
“good news”
Efficient market
response to “good news”
-30
-20
-10
0
+10
+20
+30
Days before (-) and
after (+) announcement
14-7
Stock Price Reactions
Stock
Price
Efficient market
response to “bad news”
-30
-20
-10
Overreaction to “bad
news” with reversion
Delayed
response to
“bad news”
0
+10
+20
+30
Days before (-) and
after (+) announcement
14-8
14.3 The Different Types of Efficiency
Weak Form
◼
Semistrong Form
◼
Security prices reflect all historical information
Security prices reflect all publicly available
information
Strong Form
◼
Security prices reflect all information—public
and private
14-9
Weak Form Market Efficiency
Security prices reflect all information
found in past prices and volume.
If the weak form of market efficiency
holds, then technical analysis is of no
value.
Since stock prices only respond to new
information, which by definition arrives
randomly, stock prices are said to follow a
random walk.
14-10
Stock Price
Why Technical Analysis Fails
Investor behavior tends to eliminate any profit
opportunity associated with stock price patterns.
Sell
Sell
Buy
Buy
If it were possible to make
big money simply by
finding “the pattern” in the
stock price movements,
everyone would do it, and
the profits would be
competed away.
Time
14-11
Semistrong Form Market Efficiency
Security prices reflect all publicly
available information.
Publicly available information includes:
◼
Historical price and volume information
◼
Published accounting statements
◼
Information found in annual reports
14-12
Strong Form Market Efficiency
Security prices reflect all information—
public and private.
Strong form efficiency incorporates
weak and semistrong form efficiency.
Strong form efficiency says that
anything pertinent to the stock and
known to at least one investor is already
incorporated into the security’s price.
14-13
Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices
14-14
What the EMH Does and Does NOT Say
Investors can throw darts to select stocks.
◼
◼
This is almost, but not quite, true.
An investor must still decide how risky a portfolio he
wants based on risk aversion and expected return.
Prices are random or uncaused.
◼
◼
◼
Prices reflect information.
The price CHANGE is driven by new information,
which by definition arrives randomly.
Therefore, financial managers cannot “time” stock and
bond sales.
14-15
14.4 The Evidence
The record on the EMH is extensive, and, in large
measure, it is reassuring to advocates of the
efficiency of markets.
Studies fall into three broad categories:
1.
Are changes in stock prices random? Are there
profitable “trading rules?”
2.
Event studies: does the market quickly and accurately
respond to new information?
3.
The record of professionally managed investment
firms.
14-16
Are Changes in Stock Prices Random?
Can we really tell?
◼
◼
A matter of degree
◼
Many psychologists and statisticians believe that most
people want to see patterns even when faced with pure
randomness.
People claiming to see patterns in stock price
movements are probably seeing optical illusions.
Even if we can spot patterns, we need to have returns
that beat our transactions costs.
Random stock price changes support weak form
efficiency.
14-17
What Pattern Do You See?
Randomly Selected Numbers
1
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
1
3
5
7
9
11
13
15
17
19
21
23
25
14-18
Event Studies
❑
Event Studies are one type of test of the semistrong
form of market efficiency.
✓
❑
❑
Recall, this form of the EMH implies that prices should
reflect all publicly available information.
To test this, event studies examine prices and returns
over time—particularly around the arrival of new
information.
Test for evidence of underreaction, overreaction,
early reaction, or delayed reaction around the event.
14-19
Event Studies
Returns are adjusted to determine if they are
abnormal by taking into account what the rest of the
market did that day.
The Abnormal Return on a given stock for a
particular day can be calculated by subtracting the
market’s return on the same day (RM) from the actual
return (R) on the stock for that day:
AR= R – RM
The abnormal return can be calculated using the
Market Model approach:
AR= R – (a + bRM)
14-20
Cumulative abnormal returns
(%)
Event Studies: Dividend Omissions
Cumulative Abnormal Returns for Companies Announcing
Dividend Omissions
1
0.146 0.108
-8
-6
0.032
-4
-0.72
0
-0.244
-2 -0.483 0
-1
2
-2
-3
-3.619
-4
-5
4
6
8
Efficient market
response to “bad news”
-4.563-4.747-4.685-4.49
-4.898
-5.015
-5.183
-5.411
-6
Days relative to announcement of dividend omission
14-21
Event Study Results
Over the years, event study methodology has been
applied to a large number of events including:
◼
◼
◼
◼
◼
Dividend increases and decreases
Earnings announcements
Mergers
Capital Spending
New Issues of Stock
The studies generally support the view that the
market is semistrong form efficient.
Studies suggest that markets may even have some
foresight into the future, i.e., news tends to leak out
in advance of public announcements.
14-22
The Record of Mutual Funds
If the market is semistrong form efficient,
then no matter what publicly available
information mutual fund managers rely on to
pick stocks, their average returns should be
the same as those of the average investor in
the market as a whole.
We can test efficiency by comparing the
performance of professionally managed
mutual funds with the performance of a
market index.
14-23
The Record of Mutual Funds
All funds
Smallcompany
growth
Otheraggressive
growth
-2.13%
Growth
Income
-0.39%
-2.17%
Growth and Maximum
income
capital gains
Sector
-1.06%
-0.51%
-2.29%
-5.41%
-8.45%
Taken from Lubos Pastor and Robert F. Stambaugh, “Mutual Fund Performance and Seemingly Unrelated Assets,” Journal
of Financial Exonomics, 63 (2002).
14-24
The Strong Form of the EMH
One group of studies of strong form
market efficiency investigates insider
trading.
A number of studies support the view
that insider trading is abnormally
profitable.
Thus, strong form efficiency does not
seem to be substantiated by the evidence.
14-25
14.5 The Behavioral Challenge
Rationality
◼
◼
People are not always rational.
Many investors fail to diversify, trade too much,
and seem to try to maximize taxes by selling
winners and holding losers.
14-26
The Behavioral Challenge
Independent Deviations from Rationality
◼
Psychologists argue that people deviate from
rationality in predictable ways:
Representativeness: drawing conclusions from too
little data
◼
This can lead to bubbles in security prices.
Conservativism: people are too slow in adjusting their
beliefs to new information.
◼
Security prices seem to respond too slowly to earnings
surprises.
14-27
The Behavioral Challenge
Arbitrage
◼
◼
◼
Suppose that your superior, rational, analysis shows that
company ABC is overpriced.
Arbitrage would suggest that you should short the shares.
After the rest of the investors come to their senses, you
make money because you were smart enough to “sell high
and buy low.”
But what if the rest of the investment community
does not come to their senses in time for you to
cover your short position?
◼
This makes arbitrage risky.
14-28
14.6 Empirical Challenges
Limits to Arbitrage
◼
Earnings Surprises
◼
◼
Stock prices adjust slowly to earnings announcements.
Behavioralists claim that investors exhibit conservatism.
Size
◼
“Markets can stay irrational longer than you can stay
insolvent.” John Maynard Keynes
Small cap stocks seem to outperform large cap stocks.
Value versus Growth
◼
High book value-to-stock price stocks and/or high E/P
stocks outperform growth stocks.
14-29
Empirical Challenges
Crashes
◼
◼
On October 19, 1987, the stock market dropped
between 20 and 25 percent on a Monday
following a weekend during which little
surprising news was released.
A drop of this magnitude for no apparent reason
is inconsistent with market efficiency.
Bubbles
◼
Consider the tech stock bubble of the late 1990s.
14-30
14.7 Reviewing the Differences
Financial Economists have sorted themselves
into three camps:
1.
2.
3.
Market efficiency
Behavioral finance
Those that admit that they do not know
This is perhaps the most contentious area in
the field.
14-31
14.8 Implications for Corporate Finance
If information is reflected in security prices quickly,
investors should only expect to obtain a normal rate of
return.
◼
Awareness of information when it is released does an
investor little good. The price adjusts before the investor has
time to act on it.
Firms should expect to receive the fair value for
securities that they sell.
◼
Fair means that the price they receive for the securities they
issue is the present value.
◼
Thus, valuable financing opportunities that arise from fooling
investors are unavailable in efficient markets.
14-32
Implications for Corporate Finance
The EMH has three implications for corporate
finance:
1.
2.
3.
The price of a company’s stock cannot be affected by a
change in accounting.
Financial managers cannot “time” issues of stocks and
bonds using publicly available information.
A firm can sell as many shares of stocks or bonds as it
desires without depressing prices.
There is conflicting empirical evidence on all three
points.
14-33
Why Doesn’t Everybody Believe?
There are optical illusions, mirages, and apparent
patterns in charts of stock market returns.
The truth is less interesting.
There is some evidence against market efficiency:
◼
◼
◼
Seasonality
Small versus large stocks
Value versus growth stocks
The tests of market efficiency are weak.
14-34
Quick Quiz
Define capital market efficiency.
What are the three forms of efficiency?
What does the evidence say regarding
the efficiency of capital markets?
What are the implications for corporate
finance managers?
14-35
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