11: Risk and Capital Budgetingthe NPV of any project that this company might undertake, its managers can use the required return
on equity, often called the cost of equity, as the discount rate. If the company uses the cost of equity as
its discount rate then, by definition, any project with a positive NPV will generate returns that exceed
shareholders’ required returns.
To quantify shareholders’ return expectations, managers look to the market. Recall from Chapter 7
that, according to the CAPM, the expected or required return on any security equals the risk-free rate plus
the security’s beta multiplied by the expected market risk premium:Eq. 11.1 E(ri) = rf + βi (E(rm) – rf)
Managers can estimate the return that shareholders require if they know: (1) their company’s equity
beta; (2) the risk-free rate; and (3) the expected market risk premium. Research has shown that most
managers use the CAPM to compute their company’s cost of equity this way.
The empirical evidence on risk adjustment choices by financial managers is not deep, depending
on one international survey published in 2001, a European survey from 2004 and a Canadian survey
published in 2009. However, the evidence from these surveys does indicate that nearly 60% of managers
stated that they would almost always use company-wide discount rates to evaluate projects with different
risk characteristics, while a much smaller fraction in the mid-30% range adopted a risk-matched discount
rate. When risk factors are allowed for, they tended to be interest-rate risk, size of the project, inflation
risk and foreign exchange risk. Few managers adjusted for book-to-market ratios, financial distress, or
momentum risk factors, which have been suggested by academic research.exampleAustral Carbonlite manufactures bicycle frames
that are both extremely strong and very light. The
company finances its operations 100% with equity,
and is now evaluating a proposal to build a new
manufacturing facility that will enable it to double its
output within three years. Because Austral Carbonlite
(Carbonlite, for short) sells a luxury good, its fortunes
are sensitive to macroeconomic conditions; its shares
have a beta of 1.5. Carbonlite’s financial managers
observe that the current interest rate on risk-free
government bonds is 5%, and they expect that the
return on the overall share market will be about
11% per year in the future. Given this information,Carbonlite should calculate the NPV of the expansion
proposal using a discount rate of 14%:Er(())=5%+1.511%–5%
=14%To reiterate, Carbonlite should use its cost of equity
capital, 14%, to discount cash flows because we have
assumed both that the company has no debt on its
balance sheet and that undertaking any of Carbonlite’s
investment proposals will not alter the company’s risk.
If either assumption is invalid, then the cost of equity
may not be the appropriate discount rate.In the preceding example, Austral Carbonlite’s share beta is 1.5 because sales of premium bicycle
frames are highly correlated with the overall economy. Therefore, Carbonlite’s investment in new capacity
is riskier than an investment in new capacity by some other company producing a product whose sales
are relatively insensitive to economic conditions. For example, managers of a food-processing company
might apply a lower discount rate to an expansion project than Carbonlite’s managers, because the shares
of a food processor have a lower beta. The general lesson is that the same type of capital investment
project (such as capacity expansion, equipment replacement or new product development) may require
different discount rates in different industries. The level of systematic (non-diversifiable) risk varies from
one industry to another; so, too, should the discount rate used in capital budgeting analysis.LO11.1
When you look at company
annual reports, can you find
references to the cost of capital
used by the companies? Why
might companies be reluctant
to state explicitly such a cost?thinking cap
question