6.3 Risk, Cost of Capital, and Capital Budgeting

Risk, cost of capital, and capital budgeting are crucial concepts in corporate finance. They help firms decide which projects to invest in and how to finance them. Understanding these ideas is key to making smart financial choices that boost a company's value.

This section dives into how companies figure out their cost of capital and use it in decision-making. We'll look at different ways to calculate cost of capital, how it affects project choices, and methods for dealing with risk in investments.

Cost of Capital and its Components

Defining Cost of Capital

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• Cost of capital represents the minimum return a company must earn on investments to satisfy investors and maintain market value
• Opportunity cost plays a significant role determining the return foregone by choosing one investment over another
• Serves as a benchmark for evaluating potential investments and making financial decisions
• Reflects the overall risk of the company's operations and financial structure

Components of Cost of Capital

• Cost of equity estimated using models (Capital Asset Pricing Model, Dividend Growth Model)
• Cost of debt based on interest rate of company's debt, adjusted for tax benefits due to interest deductibility
• Cost of preferred stock calculated as preferred dividend divided by current market price of preferred stock
• Each component weighted according to its proportion in the company's capital structure

Estimating Cost of Equity

• Capital Asset Pricing Model (CAPM) formula: $E(R_i) = R_f + \beta_i(E(R_m) - R_f)$
  • E(Ri) expected return on security
  • Rf risk-free rate (typically U.S. Treasury bonds)
  • βi beta of the security
  • E(Rm) expected return of the market
• Dividend Growth Model formula: $k_e = \frac{D_1}{P_0} + g$
  • ke cost of equity
  • D1 expected dividend in the next period
  • P0 current stock price
  • g expected dividend growth rate

Calculating Weighted Average Cost of Capital

WACC Formula and Components

• WACC formula: $WACC = (E/V × R_e) + (D/V × R_d × (1-T)) + (P/V × R_p)$
• E, D, P represent market values of equity, debt, preferred stock
• V total market value of firm (E + D + P)
• Re, Rd, Rp costs of equity, debt, preferred stock
• T tax rate included to account for tax shield provided by interest payments on debt
• Market values used instead of book values to reflect current economic conditions

Practical Considerations in WACC Calculation

• WACC must be periodically recalculated as market conditions and firm's capital structure change
• Reflects firm's overall financing mix and costs of individual financing sources
• Challenges in estimating components (beta for non-public companies, market risk premium)
• Importance of using consistent time frames for all components (e.g., using current market values with forward-looking cost estimates)

WACC in Different Capital Structures

• Impact of changing debt-to-equity ratios on WACC
• Optimal capital structure minimizes WACC and maximizes firm value
• Trade-off between tax benefits of debt and increased financial risk
• Example: Company A with 60% equity, 40% debt vs. Company B with 80% equity, 20% debt

Cost of Capital for Budgeting

Application in Capital Budgeting Decisions

• Cost of capital serves as hurdle rate or discount rate in capital budgeting
• Used to discount future cash flows to present value in Net Present Value (NPV) analysis
• In Internal Rate of Return (IRR) analysis, projects accepted if IRR exceeds cost of capital
• Helps rank mutually exclusive projects, higher NPVs indicate more value creation
• Ensures projects generate returns exceeding firm's financing costs and create shareholder value

Adjusting Cost of Capital for Project Risk

• Adjustments necessary for projects with different risk profiles than company's average risk
• Risk-adjusted discount rates: increase discount rate for higher-risk projects
• Certainty equivalent method: adjust cash flows for risk, then discount at risk-free rate
• Example: Tech startup using higher discount rate for new product development vs. established product line

Capital Rationing and Cost of Capital

• Limited capital budget requires prioritizing projects based on NPV and cost of capital
• Profitability index (PI) used to rank projects when capital is constrained
• PI calculated as present value of future cash flows divided by initial investment
• Projects with highest PI selected until budget is exhausted

Risk and Project Valuation

Types of Risk in Capital Budgeting

• Systematic risk affects all investments in market, accounted for in cost of capital through beta in CAPM
• Project-specific risks require adjustments to discount rate or use of risk-adjusted cash flows
• Operational risk related to company's business processes and systems
• Financial risk stemming from company's capital structure and financial obligations

Risk Analysis Techniques

• Sensitivity analysis assesses how changes in key variables affect project outcomes
• Scenario analysis evaluates project performance under different sets of assumptions (best-case, worst-case, most likely)
• Monte Carlo simulation models multiple risk factors simultaneously, generates probability distribution of outcomes
• Decision trees map out potential outcomes and their probabilities, useful for sequential decision-making

Real Options and Risk Management

• Real options analysis incorporates value of managerial flexibility in responding to changing conditions
• Types of real options (expansion, abandonment, delay, flexible production)
• Option to expand valuable in high-growth industries (tech startups)
• Option to abandon important in capital-intensive industries (oil exploration)
• Real options can significantly impact project valuation in high-risk environments