Estimating Hurdle Rates

Cost of Capital

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• To evaluate project, need estimates of cashflows, and also estimate of an appropriate hurdle rate (r).

• Hurdle rate must reflect risk• riskier project = higher hurdle rate

• consider a scale enhancing project• potential project which is similar to the existing assets of the firm• risk of project should be similar to risk of firm• the cost of capital of the firm is an appropriate hurdle rate• cost of capital is based on riskiness of firm’s assets

• Cost of capital = average cost of raising money for the firm

• If use cost of capital as hurdle rate and:• IRR > hurdle rate (NPV >0)

Take project since expected to earn more than it will cost to finance

• IRR < hurdle rate (NPV < 0)Reject project as expected to earn less than it would cost to finance

Estimating Cost of CapitalThree sources of capital:

Firm

Preferred equity

EquityDebt

Internal Funds

New Issues of equity

• cost of capital is based on the cost of each source of capital and how much the firm uses each one

Cost of Capital = (% of firm financed with debt) x (cost of debt) + (% of firm financed with equity) x (cost of equity) + (% of firm financed with preferred equity) x (cost of preferred)

Important Note: only an appropriate hurdle rate if the project is of same risk as overall firm.

What if the project is a new business line for the firm?• Have to estimate the project’s cost of capital • We will look at how to do that later.

Issues in Estimating Cost of Capital

• The weights on each type of capital should be based on market values

• If firm has target D/E ratio, should use that to calculate weights

• Problem: debt is often not traded or very thinly traded• No market price available to calculate weight• Sometimes use book value as a proxy

– Only good estimate of interest rates have not changed much

• Also, no yield to maturity available for cost of debt• Could use average yield on firms with same bond rating

Issues in Estimating Cost of Capital

• The actual manner in which a project is financed is irrelevant

• Weights should be based upon how project affects debt capacity of the firm

• For a project that is in the firm’s regular line of business (scale enhancing), assumed that project has same debt capacity as the firm overall

» May not be true for project’s that involve expanding into new businesses (see “Project Cost of Capital” later)

Issues in Estimating Cost of Capital• Cost of equity:

– Different methods to estimate• CAPM, Dividend Growth Model, others

– Problem: results are very sensitive to estimates used on the models

• Sometimes, a group of comparable firms is used• firms in similar business (“comps”)• E.g. you are worried that estimate of beta for CAPM is

wrong…calculate beta for several other similar firms and use average as beta for your company

» By averaging across firms, reduces errors in estimate» Problem: assumes that the comps are truly the same

as your firm

Another Issue: Convertible Debt

• Have looked at weighting debt/equity/preferred to get WACC

• What about convertible debt?• Hybrid security• In between debt and equity• How to take account of it in cost of capital?

• Part of the market value of the convertible debt must be assigned to debt and part assigned to equity

Convertible Debt

Process:– use the yield on firm’s regular debt to calculate what

the market value of convertible debt would be if it were straight debt (i.e. not convertible)

– Add this amount to market of value of debt for firm in WACC calculation

– Remainder of market value of convertible is added to market value of equity for firm

Convertible DebtExample:• You have already determined that a firm has a cost of

equity of 12%, a cost of debt before-tax of 6% and a tax rate of 35%

• Firm also has:– Common shares with market value = $500 million– Bonds outstanding with market value = $300 million– Convertible bonds outstanding with market value =

$100 million

• The firm’s convertible bonds mature in 10 years, carry a 5% coupon (paid semi-annually), and have a book value of $75 million

• What is firm’s cost of capital?

Project Cost of Capital

• What of a project is not scale enhancing?• Not same as normal business of firm

• Inappropriate to use firm’s WACC as discount rate

• Have to estimate the project’s cost of capital that takes into account the project’s level of risk (which is different from the firm’s)

Project Cost of Capital

Three main issues in coming up with the project cost of capital:

1. How to get cost of equity?

2. How to get cost of debt?

3. What weights to use for debt and equity?

(Note: we are ignoring preferred here for simplicity)

Project Cost of Equity

• Common to use “pure play” approach (a.k.a. using “comparables”)

• Find other firms that operate in the same business as the project you are evaluating

• They should be “pure play” firms: operate only in that business

• These firms are your “comparables”

• Assume using CAPM:• Get beta for each comparable firm• Use these to estimate beta for the project

Project Cost of Equity• However, know beta is affected by amount of leverage a

firm has (e.g. debt increases risk) and comparable firms may have different leverage than the project in your firm will have

• Must control for this using the formula:

• βL= levered beta = beta including effect of leverage

• βU = unlevered beta = “asset beta” = beta if the firm had no leverage

• D, E, T are market value of debt and equity, and tax rate, respectively

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Project Cost of Equity

• Comparable firm betas are “delevered” using their D/E ratio to get underlying unlevered beta

• Average unlevered beta across comparable firms = estimate of unlevered beta of project

• “re-lever” the beta by applying formula again, this time with the D/E appropriate for the project

• (see notes later on appropriate D and E values of project)

• The resulting beta represents the same business risk as comparable firms but with D/E of project

• Use in CAPM to get project cost of equity

Project Cost of Debt

• Depends on how project will affect default risk of overall firm

• If project is relatively small and will not affect default risk of firm → use firm’s cost of debt

• If project is big and may affect overall firm risk → need to estimate cost of debt for project itself

• Typical to use average cost of debt for comparable firms

Weights on Debt and Equity for Project

• Based on how the project would affect the debt capacity of the firm

• Not the same as how the project is actually financed

• If the project is relatively small, often assumed that it will not meaningfully affect debt capacity

– Use firm’s D and E weights

• If the project is large enough to affect firm’s debt capacity, need to estimate how those types of assets could be financed

– Use D and E weights from comparable firms– Note: in this case, you would use the comparable

firms’ D/E ratios to “re-lever” the beta for cost of equity purposes

Project Cost of Capital Example

• A firm is currently in the grocery business• It has already calculated the following information:

• Cost of debt = 6.5% before tax• Beta of stock = 0.75 (i.e. levered beta)• D/E ratio using market values = 0.6• Tax rate = 35%

• Also know that the yield on long term Gov’t of Canada bonds is 5%, and risk premium on the market is 4.5%

• To finance the project, the firm will borrow all of the required capital.

• Firm is considering entering a new line of business, selling electronics in its stores

• Three electronic retailing companies have the following information:

Comparable Firm

Beta of stock

D/E using market values

Cost of Debt

Tax rate

A 1.2 0.4 7.5% 30%

B 1.35 0.3 8% 30%

C 1.15 0.37 7.75% 30%

• What is the project's cost of capital if:

1. The project is very small relative to the firm and will not affect its debt capacity or default risk?

2. The project is quite large and could have a significant effect on the firm’s risk and debt capacity?