Module 7: Capital Budgeting

with Risk
Professor Zhengyang Jiang
FINC-430/BUS INST-304
Recommended Readings and Problems

• Optional readings
– BD Chapters 10, 11, 12

• Optional textbook problems

– Chapter 10: 2, 7, 26, 35-37
– Chapter 11: 2, 5-7, 21, 47, 49
– Chapter 12: 2

2
Outline
• CAPM for capital budgeting
– Project beta vs. firm beta
– Calculating beta and discount rate using comparable companies
• Single Principle: The whole is the sum of the parts (Miller-
Modigliani)!
– Accounting for capital structure
– Firms with multiple divisions
– Firms with large cash holdings

3
CAPM in Practice

4
Example of Calculating a CAPM Discount Rate

• Let’s use GE and Apple as an example

• We need the inputs for the CAPM equation (the security
market line):
𝑬𝑬(𝒓𝒓𝒊𝒊 ) = 𝒓𝒓𝒇𝒇 + 𝜷𝜷𝒊𝒊 𝑬𝑬(𝒓𝒓𝒎𝒎 ) − 𝒓𝒓𝒇𝒇
– A risk free rate of return.
– The historical average of the returns on a market portfolio.
– Betas for each risky asset.

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Risk Free Rate

• The standard practice for 𝑟𝑟𝑓𝑓 is to use the current yield on

a US government bond.
– Why not use historical average return?
– What maturity should this bond have?

6
Current Treasury Yield Curve

7
Market Premium
• Use what historical period for the market excess return average?
– Often, the sample average from 1926 or 1950 to today is used.
– Why not 1999 to 2009?
• What market index?
– Value-weighted market index, e.g. S&P 500.
– Why not equal-weighted index?
• Putting these together, the standard market excess return premium
that is often used by analysts, and the one we will use, is around 5%.
– Estimates can range from 3-12%, depending on the sample, the index, and the
averaging approach

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Implied Equity Risk Premia from Damodaran

9
Determinants of the ERP

• Risk appetite
• Economic risk
• Information/Technology
• Liquidity
• Behavioral factors . . .

10
Security Market Line

• With these numbers, we can estimate the cost of capital

for any firm/project beta:

𝑬𝑬(𝒓𝒓𝒊𝒊 ) = 𝒓𝒓𝒇𝒇 + 𝜷𝜷𝒊𝒊 𝑬𝑬(𝒓𝒓𝒎𝒎 ) − 𝒓𝒓𝒇𝒇

= 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎 + 𝜷𝜷𝒊𝒊 (𝟎𝟎. 𝟎𝟎𝟎𝟎)

11
Example of Calculating a CAPM Discount Rate

12
Example of Calculating a CAPM Discount Rate

• GE’s equity beta is 1.23.

• Now use the CAPM equation:
𝑬𝑬(𝒓𝒓𝒊𝒊 ) = 𝒓𝒓𝒇𝒇 + 𝜷𝜷𝒊𝒊 𝑬𝑬(𝒓𝒓𝒎𝒎 ) − 𝒓𝒓𝒇𝒇
= 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎 + 𝜷𝜷𝑮𝑮𝑮𝑮 (𝟎𝟎. 𝟎𝟎𝟎𝟎)

𝑬𝑬(𝒓𝒓𝑮𝑮𝑮𝑮−𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬𝑬 ) = 𝟎𝟎. 𝟎𝟎𝟎𝟎𝟎𝟎𝟎𝟎 + 𝟏𝟏. 𝟐𝟐𝟐𝟐(𝟎𝟎. 𝟎𝟎𝟎𝟎�

= 𝟖𝟖. 𝟒𝟒%

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Comparison to the Implied Required Return
on Equity

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Calculation of the Shareholders’ Required Return

• According to the constant dividend growth model, the expected

return to the shareholders (𝑟𝑟𝐸𝐸 ), can be calculated in the following
way:
𝐷𝐷𝐷𝐷𝐷𝐷1
𝑟𝑟𝐸𝐸 = + 𝑔𝑔
𝑃𝑃0
• 𝑟𝑟𝐸𝐸 is composed of:

1. Current dividend yield – expected yield from dividends paid by the stock

2. Expected growth rate

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Example

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Example
• How can we use the constant dividend growth model to estimate
the return investors require on holding the stock of Intel?
We need to estimate next
year’s dividend

We need to estimate the

𝐷𝐷𝐷𝐷𝐷𝐷1 dividend growth rate
𝑟𝑟𝐸𝐸 = + 𝑔𝑔
𝑃𝑃0

The share price is known

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Dividend
0.8

0.7

0.6

0.5

USD
0.4

0.3

0.2

0.1

0
Jul-09 Apr-12 Dec-14 Sep-17 Jun-20 Mar-23

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Dividend Growth
3

2.5

2
USD

1.5

0.5

0
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
𝟏𝟏
𝟐𝟐.𝟕𝟕𝟕𝟕 𝟗𝟗
Average growth rate is 𝟏𝟏𝟏𝟏. 𝟑𝟑𝟑𝟑% = − 𝟏𝟏
𝟏𝟏.𝟏𝟏𝟏𝟏

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The Implied Required Return on Equity

• Average Dividend growth rate 10.36%

• Dividend per share for 2023 𝐷𝐷𝐷𝐷𝐷𝐷2023 =2.72 (estimated)

𝐷𝐷𝐷𝐷𝐷𝐷2024 2.72 × (1 + 10.36%)

𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑟𝑟𝐸𝐸 = + 𝑔𝑔 = + 10.36% = 11.21%
𝑃𝑃0 322.20

• MSFT beta is 0.9. Compare to

𝐸𝐸 𝑟𝑟𝑖𝑖 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 𝐸𝐸 𝑟𝑟𝑚𝑚 − 𝑟𝑟𝑓𝑓 = 2.28% + 𝛽𝛽𝑖𝑖 5% = 6.78%

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Discount Rates and Capital Structure

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Capital Structure and the Cost of Capital

• Most companies have both debt and equity.

• The cash flows from a firm are split between equity
holders and debt holders. So are the firm’s market
values:

Total Value (V) = Equity (E) + Debt (D)

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Principle: The whole is the sum of all parts
• Given its capital structure, a firm’s overall discount rate is:
𝑬𝑬 𝑫𝑫
𝑬𝑬(𝒓𝒓𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 ) = 𝑬𝑬(𝒓𝒓𝑬𝑬 ) + 𝑬𝑬(𝒓𝒓𝑫𝑫 )
𝑽𝑽 𝑽𝑽
– Also known as the expected return on a firm’s assets or the pre-
tax WACC (weighted average cost of capital).
• When valuing a company, this weighted average cost of
capital is used as the discount rate.
– This principle is also known as the Modigliani-Miller theorem.
– More on WACC and M-M in FIN 2.
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A Firm’s Beta

• It follows that a firm’s overall beta is:

𝑬𝑬 𝑫𝑫
𝜷𝜷𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 = 𝜷𝜷𝑬𝑬 + 𝜷𝜷𝑫𝑫
𝑽𝑽 𝑽𝑽

• This is also referred to as the asset beta, βA.

• It reflects the underlying risk of a company’s free cash
flows.
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An Example of Discount Rates and Capital
Structure
• Using the CAPM, what is the appropriate overall
opportunity cost of capital for GE?
– To answer this, we need:
• The market value for GE’s debt and equity.
• The beta of GE’s debt and equity.
• How do we get the debt beta?

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 Cost of Debt
• Look up yields on outstanding debt for existing company.
• Bond ratings and default probabilities.

• Bottom line: Because bonds are illiquid, estimating bond

betas is challenging. More on this in FIN 2.

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27
Capital Structure Cost of Capital Example

• From online sources, we can find that GE has

– Equity with market value $280 billion and a beta of 1.23.
– Debt with market value of $198 billion and a beta of 0.25.
• For the CAPM assume
– rf = 2.28%
– E(rm) − rf = 5%

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Example: Capital Structure and Cost of Capital

• To compute the cost of capital for 𝐺𝐺𝐺𝐺 we need to compute 𝐺𝐺𝐺𝐺’s overall firm
(asset) beta
𝐸𝐸 𝐷𝐷
𝛽𝛽𝐺𝐺𝐺𝐺−𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝛽𝛽𝐺𝐺𝐺𝐺−𝐸𝐸 + 𝛽𝛽𝐺𝐺𝐺𝐺−𝐷𝐷
𝑉𝑉 𝑉𝑉
$280 $198
= 1.23 + 0.25
$280+$198 $280+$198
= 59% 1.23 + 41% 0.25
= 0.82
• Using the CAPM formula,
𝐸𝐸 𝑟𝑟𝐺𝐺𝐺𝐺−𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐺𝐺𝐺𝐺−𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝐸𝐸 𝑟𝑟𝑚𝑚 − 𝑟𝑟𝑓𝑓
= 2.28% + 0.82 5%
= 6.4%

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Can Increasing a Firm’s Debt Decrease its Discount Rate?

• GE’s required return on assets is 6.4%.

• Its cost of debt is lower than its cost of equity:
𝐸𝐸(𝑟𝑟𝐺𝐺𝐺𝐺−𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 ) = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝐺𝐺𝐺𝐺−𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝐸𝐸(𝑟𝑟𝑚𝑚 ) − 𝑟𝑟𝑓𝑓
= 2.28% + 0.25 5%
= 3.5%
• Can GE lower its cost of funds by increasing the
percentage of the debt it has in its capital structure from
41% to 80%?

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Modigliani-Miller

• No. The increase in leverage will only raise the beta of

GE’s equity and will not change their overall beta:
𝐸𝐸 𝐷𝐷
0.82 = 𝛽𝛽𝐺𝐺𝐺𝐺−𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝛽𝛽𝐺𝐺𝐺𝐺−𝐸𝐸 + 𝛽𝛽𝐺𝐺𝐺𝐺−𝐷𝐷
𝑉𝑉 𝑉𝑉
= 20% 3.10 + 80% 0.25

• Unless GE’s underlying free cash flows change can GE’s

overall opportunity cost of capital change.

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The opportunity cost of capital reflects the risk of the
underlying free cash flows
The risk of firm’s underlying business
is passed to free cash flows.
Absent friction, how these cash flows are split should not
affect the risk of GE’s underlying business.

Returns to
GE’s Assets Share-holders

• Machines
• Factories
• Land Free
• Buildings Cash
• Cash Flows
• Bonds
• People
• Brand
Returns to
Bond- holders

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Estimating a Project’s Beta from Comparables

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Key Insight
• What determines the cost of capital for a risky project in the CAPM
world?
– The beta of the project!
– Not the standard deviation of the returns.
– Not (necessarily) the company’s overall beta
– Not the capital structure used to finance the project
• Firm Beta vs Project Beta:
– A high-beta project increases the overall beta of the firm’s cash flows.
– Using the firm beta will bias your financing decisions.
• Beta vs Standard Deviation
– Standard deviation also captures idiosyncratic/diversifiable risk, which is
irrelevant for cost of capital in the CAPM world.

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Comparables
• What if there are no publicly traded financial securities
from which to get betas?
– Use comparables approach
– Comparable in what dimension?

35
Example 1

• What is the estimate of the cost of capital for the airline

industry?

Debt-Value
Airline Equity β Debt β
Ratio
Southwest 1.13 0.00 0.13

SkyWest 1.69 0.15 0.51

Alaska Air 1.80 0.15 0.51

Mesa Air 3.27 0.30 0.78

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Example 1 Airline Equity β Debt β
Debt-Value
Ratio
Southwest 1.13 0.00 0.13

SkyWest 1.69 0.15 0.51

Alaska Air 1.80 0.15 0.51

Mesa Air 3.27 0.30 0.78

• β(asset_Southwest) = (1-13%)(1.13) + 13%*(0) = 0.983

• β(asset_SkyWest) = (1-51%)(1.69) + 51%*(.15) = 0.905
• β(asset_Alaska) = (1-51%)(1.80) + 51%*(.15) = 0.959
• β(asset_Mesa) = (1-78%)(3.27) + 78%*(.3) = 0.953

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Industry Betas

38
Example 2
• Pfizer is evaluating a proposal for a project that would
use genetic engineering methods to develop new drugs
for the treatment of tuberculosis.
• We need to evaluate the cost of capital for this project.

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Q1

• You identify two firms whose only projects are genetic engineering
projects equivalent in risk to the project you are analyzing. They are
Genentech (call this firm A) and Pluristem Therapeutics (firm B).
• Should Pfizer take the project?
Debt-Value
Firm Equity β Debt β
Ratio

A 1.2 0.2 35%

B 1.5 0.4 60%

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Q1 Firm Equity β Debt β
Debt-Value
Ratio

A 1.2 0.2 35%

B 1.5 0.4 60%

• β(firm A) = 65%(1.2) + (35%)(.2) = .85

• β(firm B) = 40%(1.5) + (60%)(.4) = .84
• Average β = 0.845
• E(r) = 2.28% + 0.845(5%) = 6.51%

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Q2
• Suppose you identify the following two purely equity financed firms C and D.
– Firm C has two divisions
• Division 1 is a genetic engineering division equivalent in risk to Pfizer’s new
project.
• Division 2 is a high-volume drug-production division, with very different risk
from genetic engineering.
• The market values of Divisions 1 and 2 are $100 million and $600 million,
respectively, and the equity beta of firm C is 1.5.
– Firm D is only a high-volume drug-production company equivalent in risk to Firm
C’s second division above.
• Firm D has an equity beta of 1.6.

42
Q2
• β(FirmC) = (Vgenetics/V) β(genetics) + (Vdrugs/V) β(drugs)
• 1.5 = 100/700 beta(genetics) + 600/700*1.6

• Therefore
• β(genetics) = 0.9
• E(r) = 2.28% + 0.9(5%) = 6.78%

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Firms with Large Cash Holdings

44
Firms With Large Cash Holdings
• What if a firm has a lot of cash – how do you find the risk of its business
operations?
• Suppose Apple has no debt and had equity capitalization of $500 B.
– Included in Apple’s assets are $150 B in cash and risk free securities
– Value of Apple’s operations is:
$500 B - $150 B = $350 B
• What discount rate should Apple use to evaluate its business
operations?
– Risk free rate is 2.28% and the expected excess return on the market is 5%.
– Apple’s equity beta is 1.52.

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Firms With Large Cash Holdings

• Again, the whole is the sum of all parts!

• Apple’s firm (asset) beta is equal to a weighted average of the betas of its
operations and its cash:
𝑽𝑽𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 𝑽𝑽𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪
𝜷𝜷𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨𝑨−𝑭𝑭𝑭𝑭𝑭𝑭𝑭𝑭 = 𝜷𝜷𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 + 𝜷𝜷𝑪𝑪𝑪𝑪𝑪𝑪𝑪𝑪
𝑽𝑽 𝑽𝑽

𝟏𝟏. 𝟓𝟓𝟓𝟓 = 𝟕𝟕𝟕𝟕𝟕 𝜷𝜷𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 + 𝟑𝟑𝟑𝟑𝟑 𝟎𝟎

𝜷𝜷𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶𝑶 = 𝟐𝟐. 𝟏𝟏𝟏𝟏

46
Wrap Up

47
Wrap Up: Valuation and the CAPM

• We can use the CAPM’s security market line to determine

appropriate discount rates to use in capital budgeting.
– What determines the cost of capital for a risky project under CAPM
is the beta of the project!
𝐸𝐸(𝑟𝑟𝑖𝑖 ) = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑖𝑖 𝐸𝐸(𝑟𝑟𝑀𝑀 ) − 𝑟𝑟𝑓𝑓
– Use a firm’s own debt and equity betas to determine the firm’s
asset beta.
– If the firm is not publicly traded, use comparable firms to derive
the discount rate.

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Equations

• A firm’s pre-tax weighted average cost of capital is

𝐸𝐸 𝐷𝐷
𝐸𝐸(𝑟𝑟𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 ) = � 𝐸𝐸(𝑟𝑟𝐸𝐸 ) + � 𝐸𝐸(𝑟𝑟𝐷𝐷 )
𝑉𝑉 𝑉𝑉

• A firm’s weighted average beta is

𝐸𝐸 𝐷𝐷
𝛽𝛽𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = � 𝛽𝛽𝐸𝐸 + � 𝛽𝛽𝐷𝐷
𝑉𝑉 𝑉𝑉

49
Next Step

• So far, we have been assuming that the capital structure

does not affect the firm’s cash flows
– The standard Modigliani-Miller assumption
• Possible ways this assumption fails
– Tax: interest expenses generate tax shield
– Bankruptcy: significant reorganization/dissolution event
that alters the firm’s organization structure
– The trade-off theory of capital structure

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