Estimating Hurdle Rates

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Estimating Hurdle Rates
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Cost of Capital

• 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

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• 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 firms
  assets

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

• If use cost of capital as hurdle rate and
• IRR gt hurdle rate (NPV gt0)
• Take project since expected to earn more than
• it will cost to finance
• IRR lt hurdle rate (NPV lt 0)
• Reject project as expected to earn less than it
• would cost to finance

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Estimating Cost of Capital
Three sources of capital
Internal Funds
New Issues of equity
Equity
Debt
Preferred equity
Firm
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• 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 projects cost of capital
• We will look at how to do that later.

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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

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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 firms regular line
  of business (scale enhancing), assumed that
  project has same debt capacity as the firm
  overall
• May not be true for projects that involve
  expanding into new businesses (see Project Cost
  of Capital later)

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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 wrongcalculate 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

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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

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Convertible Debt

• Process
• use the yield on firms 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

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Convertible Debt

• Example
• 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 firms convertible bonds mature in 10 years,
  carry a 5 coupon (paid semi-annually), and have
  a book value of 75 million
• What is firms cost of capital?

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Project Cost of Capital

• What of a project is not scale enhancing?
• Not same as normal business of firm
• Inappropriate to use firms WACC as discount rate
• Have to estimate the projects cost of capital
  that takes into account the projects level of
  risk (which is different from the firms)

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Project Cost of Capital

• Three main issues in coming up with the project
  cost of capital
• How to get cost of equity?
• How to get cost of debt?
• What weights to use for debt and equity?
• (Note we are ignoring preferred here for
  simplicity)

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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

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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
• ßL levered beta beta including effect of
  leverage
• ßU 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

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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 firms 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

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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 firms D and E weights
• If the project is large enough to affect firms
  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

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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 Govt 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.

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• Firm is considering entering a new line of
  business, selling electronics in its stores
• Three electronic retailing companies have the
  following information

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• What is the project's cost of capital if
• The project is very small relative to the firm
  and will not affect its debt capacity or default
  risk?
• The project is quite large and could have a
  significant effect on the firms risk and debt
  capacity?