Solutions to Chapter 9 Questions: Risk and the Cost of Capital

1. Company cost of capital

Question: Suppose a firm uses its company cost of capital to evaluate all projects. Will it
underestimate or overestimate the value of high-risk projects?

Answer:
Using a single company-wide cost of capital for all projects ignores the risk profile of
individual projects. High-risk projects typically have a higher cost of capital, reflecting their
greater risk. If the company uses a lower, company-wide cost of capital, it will overestimate
the value of high-risk projects, as it underestimates the discount rate needed to properly
account for their risk.

2. WACC Calculation
Given:
- Debt financing = 40%
- Interest rate on debt (Rd) = 10%
- Equity financing = 60%
- Beta of stock (β) = 0.5
- Market risk premium (Rm - Rf) = 8%
- Tax rate = 35%

Solution:
1. Cost of equity (Re):
Use the CAPM formula:

Re = Rf + β ⋅ (Rm - Rf)

Assuming Rf = 0:
Re = 0 + 0.5 ⋅ 8% = 4%

2. After-tax cost of debt (Rd(1 - T)):

Rd(1 - T) = 10% ⋅ (1 - 0.35) = 6.5%

3. WACC:

WACC = (Equity Weight ⋅ Re) + (Debt Weight ⋅ Rd(1 - T))

WACC = (0.6 ⋅ 4%) + (0.4 ⋅ 6.5%)

WACC = 2.4% + 2.6% = 5%
Answer: The company’s after-tax WACC is 5%.

3. Measuring risk
Question: What proportion of Dow Chemical’s returns was explained by market
movements? What proportion of risk was diversifiable? How does the diversifiable risk
show up in the plot? What is the range of possible errors in the estimated beta?

Answer:
- The proportion of returns explained by market movements can be inferred from the
regression’s R², which measures the variation in returns explained by the market.
- Diversifiable risk is the portion of risk not explained by market factors (1 - R²).
- In the plot, diversifiable risk shows up as residuals (deviations from the regression line).
- Errors in beta arise from statistical uncertainty in the regression, indicated by the
confidence intervals around the beta estimate.

4. Definitions
a. Cost of debt: The effective interest rate a company pays on its debt, adjusted for the tax
shield.
b. Cost of equity: The return required by equity investors, often estimated using the CAPM.
c. After-tax WACC: The weighted average cost of capital, factoring in the tax shield on debt.
d. Equity beta: A measure of a stock’s sensitivity to market movements.
e. Asset beta: Reflects business risk without the impact of leverage.
f. Pure-play comparable: A firm in a similar industry used to estimate a project’s beta.
g. Certainty equivalent: A risk-adjusted value of future cash flows that makes the decision-
maker indifferent to risk.

5. Asset Betas
Given:
- Debt financing = 50%
- Debt beta = 0.15
- Equity beta = 1.25

Formula:
β_asset = (Equity Weight ⋅ β_equity) + (Debt Weight ⋅ β_debt)

Solution:
β_asset = (0.5 ⋅ 1.25) + (0.5 ⋅ 0.15)
β_asset = 0.625 + 0.075 = 0.7

Answer: The company’s asset beta is 0.7.

6. Diversifiable risk
Question: What does “diversifiable” mean in this context? How should diversifiable risks be
accounted for in project valuation?

Answer:
- Diversifiable risk refers to the portion of total risk that can be eliminated by holding a
diversified portfolio. It is unique to a specific project or company.
- In project valuation, diversifiable risk should not affect valuation, as it is not priced by the
market. Only systematic (non-diversifiable) risk impacts the cost of equity and valuation.

7. Fudge factors
Question: Explain why setting a 15% discount rate instead of 8% does not offset optimistic
biases.

Answer:
Setting an arbitrarily high discount rate penalizes all projects, including potentially good
ones. It does not directly address the optimistic biases of project sponsors, which should
instead be managed through accurate forecasting and evaluation practices.

8. Asset Betas (Continuation)

a. Fixed salary vs. commission-based salesforce:
- Answer: The salesforce paid by commission (Project B) has a higher beta, as their income
directly depends on company revenues, making the project more sensitive to market risks.

b. First-class airline vs. breakfast cereals:

- Answer: The first-class airline (Project C) has a higher beta due to its high sensitivity to
economic cycles, unlike breakfast cereals, which are consumer staples with stable demand.

9. True/False
a. False: The company-wide cost of capital ignores the specific risk profile of individual
projects.
b.False: Distant cash flows are not necessarily riskier than near-term cash flows. Risk
depends on the project's specific nature and systematic risk, not just the time horizon.

c. True: Fudge factors over-penalize long-term projects by inflating their discount rates.

10. Certainty Equivalents

Given:
- Forecasted cash flows: Year 1 = $110; Year 2 = $121
- Risk-free rate (Rf) = 5%; Market risk premium = 10%; β = 0.5

Steps:
1. Risk-adjusted discount rate (Ra):
Ra = Rf + β ⋅ (Rm - Rf)
Ra = 5% + 0.5 ⋅ 10% = 10%
2. Certainty-equivalent cash flows:
- Year 1: CE = $110 / (1.1) = $100
- Year 2: CE = $121 / (1.21) = $100

3. Ratios:
- Year 1: CE / Expected = $100 / $110 = 0.909
- Year 2: CE / Expected = $100 / $121 = 0.826

Answers:
- a. PV = $100 + $100 = $200
- b. CE cash flows: Year 1 = $100; Year 2 = $100
- c. Ratios: Year 1 = 0.909; Year 2 = 0.826

Solutions to Challenge Questions 23 and 24

23. Beta of Costs

Question: Suppose you are valuing a future stream of high-risk (high-beta) cash outflows.
High risk means a high discount rate. But the higher the discount rate, the less the present
value. This seems to say that the higher the risk of cash outflows, the less you should worry
about them! Can that be right? Should the sign of the cash flow affect the appropriate
discount rate? Explain.

Answer:
1. Higher Discount Rates and Present Value:
- It is correct that a higher discount rate decreases the present value of cash flows. For
cash outflows, this would appear to reduce the perceived cost of future liabilities, seemingly
minimizing their impact. However, this interpretation is misleading because the discount
rate reflects risk-adjusted opportunity cost. The higher the risk, the higher the discount rate
used to calculate present value.
2. Sign of Cash Flow and Discount Rate:
- The sign of the cash flow does not change the discount rate. The discount rate is
determined by the risk associated with the cash flow, not whether it is an inflow or outflow.
For high-risk outflows, the same high discount rate should be applied as it would for high-
risk inflows.
3. Logical Fallacy in Ignoring High-Risk Outflows:
- While a high discount rate reduces the present value of high-risk cash outflows, ignoring
such outflows can lead to underestimating future liabilities. The proper approach is to
account for the risk-adjusted present value accurately, not to dismiss the importance of the
outflows.
4. Conclusion:
- The risk (and corresponding discount rate) must reflect the underlying uncertainty of the
cash flow, regardless of whether it is positive or negative. Therefore, the higher the risk of
the cash flow, the higher the discount rate, ensuring that the value appropriately reflects its
uncertainty. Ignoring high-risk outflows by relying solely on the discounted present value is
incorrect.

24. Fudge Factors

Given: An oil company executive is considering investing $10 million in one or both of two
wells. Well 1 is expected to produce oil worth $3 million a year for 10 years; well 2 is
expected to produce $2 million for 15 years. These are real (inflation-adjusted) cash flows.
The beta for producing wells is 0.9. The market risk premium is 8%, the nominal risk-free
interest rate is 6%, and expected inflation is 4%. The two wells are intended to develop a
previously discovered oil field. Unfortunately, there is still a 20% chance of a dry hole in
each case. A dry hole means zero cash flows and a complete loss of the $10 million
investment. Ignore taxes and make further assumptions as necessary.

a. What is the correct real discount rate for cash flows from developed wells?
Answer:
1. Calculate the nominal cost of equity (Re):
Re = Rf + β ⋅ (Rm - Rf)
Re = 6% + 0.9 ⋅ 8% = 13.2%
2. Convert to the real cost of equity (re):
Using the Fisher equation:
re = (1 + Re) / (1 + Inflation) - 1
re = (1.132 / 1.04) - 1 = 8.85%
The correct real discount rate is 8.85%.

b. The oil company executive proposes to add 20 percentage points to the real discount rate
to offset the risk of a dry hole. Calculate the NPV of each well with this adjusted discount rate.
Answer:
1. Adjusted real discount rate: 8.85% + 20% = 28.85%
2. NPV for Well 1:
PV = $3M ⋅ [1 - (1 / (1 + 0.2885)^10)] / 0.2885 = $9.15M
NPV = $9.15M - $10M = -$0.85M
3. NPV for Well 2:
PV = $2M ⋅ [1 - (1 / (1 + 0.2885)^15)] / 0.2885 = $6.39M
NPV = $6.39M - $10M = -$3.61M
NPVs with the adjusted discount rate:
Well 1: -$0.85M
Well 2: -$3.61M

c. What do you say the NPVs of the two wells are?

Answer:
Using the original real discount rate (8.85%) and incorporating the 20% chance of failure
(dry hole):
1. Well 1 expected cash flows: $3M ⋅ 80% = $2.4M/year
NPV = $2.4M ⋅ [1 - (1 / (1 + 0.0885)^10)] / 0.0885 - $10M = $5.4M
2. Well 2 expected cash flows: $2M ⋅ 80% = $1.6M/year
NPV = $1.6M ⋅ [1 - (1 / (1 + 0.0885)^15)] / 0.0885 - $10M = $2.17M
NPVs with proper adjustment:
Well 1: $5.4M
Well 2: $2.17M

d. Is there any single fudge factor that could yield the correct NPV for both wells?
Answer:
No, a single fudge factor cannot yield the correct NPV for both wells. Adding a fixed
percentage to the discount rate disproportionately penalizes long-term cash flows (Well 2)
compared to shorter-term cash flows (Well 1). The probability of a dry hole should be
incorporated directly into the expected cash flows, as demonstrated in part (c), rather than
using an arbitrary adjustment to the discount rate.