Project Management and Evaluation

Following:
Benninga, Simon. 2011. Principles of Finance with Excel, 2nd ed. Oxford University Press:
New York
Benninga, Simon. 2014. Financial modeling. 4th ed., MIT Press: Cambridge (MA)
Benninga, Simon. 2000. Financial modeling. 2nd ed., MIT Press: Cambridge (MA)

Chapter 4
Choosing a discount rate /
Calculating the Cost of Capital
 Reminder: Why do you need a
discount rate?

 In the NPV criterion, you discount by the discount rate

 In the IRR criterion, you compare the IRR to the discount rate

Either way: YOU NEED THE RISK-ADJUSTED DISCOUNT RATE!

2
 Discounting basics
The numerator of the NPV
is the cash flows--these can
be either riskless or risky.

Cash flow1 Cash flow 2 Cash flow 3

NPV = Cost today + + + ...
(1 + discount rate ) (1 + discount rate ) 2 (1 + discount rate ) 3

The denominator of the NPV

is the discount rate. The
more risky the numerator, the
higher the discount rate.

Discounting: Numerator vs Denominator

Numerator: The anticipated (expected) future cash flow
Denominator: Discount rate appropriate to the risk of
the numerator (“RADR”=Risk-Adjusted Discount Rate”)
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Discount rate basics
If cash flow numerator is riskless
Discount rate = risk-free rate, rf
If cash flow numerator is risky
Discount rate > risk-free rate
Discount rate = rf + risk premium

4
Example 1: Savings to CD
You have $10,000 in your bank
savings account, paying 4% annually.
The bank offers you a $10,000, two-
year, certificate of deposit (CD) paying
5% annually.
What’s the NPV of pulling the money
out of the savings and putting it into
the CD?

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Example 1: Use rf = 4% as
discount rate
A B C
1 BANK CD
2 Savings account interest rate 4.00%
3 CD rate 5.00%
4
CD
5 Year cash flows
6 0 -10,000.00
7 1 500.00
8 2 10,500.00
9
10 NPV 188.61 <-- =B6+NPV(B2,B7:B8)

4% is the appropriate discount rate—it corresponds

to the riskiness of the cash flows.

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Example 2: Evelyn Wyer Lipstick
franchise
You have money in the bank earning
4%.
You are offered an Evelyn Wyer
Lipstick franchise:
Pay $1,000 today, get an Evelyn Wyer
cart to sell lipstick in the mall
After one year, anticipated payback is
$1,500

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 Evelyn Wyer: What’s the
discount rate?
A B C
EVELYN WYER LIPSTICK 4% is NOT the
1 FRANCHISE appropriate discount
Franchise rate!!!
2 Year cash flows  4% is for a risk-free
3 0 -1,000
4 1 1,500
investment
5  Evelyn Wyer is risky!
6 Discount rate? 4% <-- ???
7 NPV 442 <-- =B3+B4/(1+B6)
8 IRR 50% <-- =IRR(B3:B4)
What’s the appropriate rate? Depends on the risk!!

We discuss two models for determining the appropriate rate:

 Gordon dividend model
 Weighted average cost of capital (WACC)
Another model
 Security market line (SML)

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The “Funding Cost” concept
The funding cost is the cost of raising
the money needed for an investment.
The funding cost is often the
appropriate candidate to use as the
discount rate.
The funding cost identifies the cost of
the funds used and uses this cost to
discount the future investment cash
flows.
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When to use funding cost as
discount rate
Ask: “What would an investor charge
to put money into this project?”
Example 1: Take money out of
savings account to put into CD
Investor would charge 4% (the return on
the savings account)
Example 2: $1,000 to set up an
Evelyn Wyer lipstick franchise
Investor would demand higher return than
4% because of risk
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Weighted average cost of capital
(WACC)
The funding cost for many corporate
projects
How are corporations funded?
Equity:
Funds provided by shareholders
Cost of equity: rE
Debt:
Funds provided by lenders
Cost of debt = borrowing rate net of corporate
taxes: rD*(1-TC)

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WACC formula

12
rE as the cost of equity
rE is the return demanded (or
expected) by shareholders
rE increases as the riskiness of the
shareholder returns increases
The after-corporate-tax cost of equity
is rE . [Note that equity payouts are not
an expense for corporate tax
purposes.]

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(1-TC)*rD as the cost of debt
 rDis the rate charged by lenders to
company
When lenders perceive that the
company has higher risk, they
demand a larger rD
The after-corporate-tax cost of of debt
is (1-TC )*rD

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rE > (1-TC )*rD !
Equity is riskier than debt
On an after-corporate-tax basis: the
cost of equity will be greater than the
cost of debt

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WACC example
 United Transport Inc. has 3 million shares
outstanding; the current market price per
share is $10. The company thinks its
shareholders want an annual return on their
investment of 20%; this 20% return is the
company’s cost of equity rE.
 The company has also borrowed $10
million from its banks at a rate of 8%; this is
the company’s cost of debt, rD. United
Transport has a tax rate of TC = 40%.5

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United Transport (continued)

A B C
1 UNITED TRANSPORT--WACC
2 Number of shares 3,000,000
3 Market price per share 10
4
5 E, market value of equity 30,000,000 <-- =B3*B2
6 D, market value of debt 10,000,000
7
8 rE, cost of equity 20%
9 rD, cost of debt 8%
10 TC, firm's tax rate 40%
11
WACC, weighted average cost of capital:
12 WACC=rE*E/(E+D)+rD*(1-TC)*D/(E+D) 16.20% <-- =B8*B5/(B5+B6)+B9*(1-B10)*B6/(B5+B6)
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United Transport:
Where did rE = 20% come from?
How did United Transport come to the
conclusion that its shareholders want
a 20% return? This is the question in
the computation of the WACC, and we
will spend a lot of this chapter
discussing the answer.
So be patient!

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When is the WACC an
appropriate discount rate?
Use WACC when the riskiness is
appropriate.
Example 1: White Water Rafting
Wants to purchase a new raft
Risk of purchase approximately same as
riskiness of White Water Rafting
 Use WACC to discount cash flows
from new raft

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Example2: Gorgeous Fountain Water
Company
Wants to buy competitor
Competitor’s cash flow risk ≈ as GF cash
flow risk
 Use WACC to discount cash flows
from takeover target

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When not to use WACC
Example 3: Delicious Licorice (DL)
wants to buy a regional cellphone
operator
Entirely different risks!
Valuation of takeover target’s cash flows
should be at rate appropriate to takeover
target’s risk
DON’T USE DL’S WACC to value the
cellphone takeover.

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WACC is the appropriate rate to
use when the riskiness of the
cash flows under consideration
is approximately equal to the
riskiness of the company’s
current cash flows.

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Determining the WACC
components
Reminder:
E D
WACC = rE + (1 − TC ) rD
E+D E+D
E=market value of equity
= #shares * current market
price/share
D=market value of debt
(but often use book value of debt)
TC = Corporate tax rate
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 rD= Cost of debt = Corporate
borrowing rate
rE = Cost of equity
In this chapter we determine rE using
the Gordon dividend model (see
below)

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Computing the WACC for UPS
Usedata from Yahoo
Have to compute 5 parameters:
E = value of equity
D = Value of debt
rD = cost of debt
TC = the corporate tax rate
rE = cost of equity

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Basic WACC Template

A B C
1 COMPUTING THE WACC FOR UPS
2 E
3 D
4 rD
5 TC
6 rE
7
8 WACC #DIV/0! <-- =B6*B2/(B2+B3)+B4*(1-B5)*B3/(B2+B3)

We will fill this template in the next slides.

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UPS value of equity, E
Current stock price * number of
shares

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 UPS debt D

NOTES:
 Debt for WACC should be net debt: Debt minus Cash
 Debt for WACC should be market value of debt, but this is pretty
hopeless—standard to replace market value with book value
 Upshot: UPS Debt = 10.26 – 4.01 = 6.25 B

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Template update

A B C
1 COMPUTING THE WACC FOR UPS
2 E 66.88 <-- Billion $, from Yahoo Key Statistics for UPS
3 D 6.25 <-- Book value of debt minus cash
4 TC
5 rD
6 rE
7
8 WACC 0 <-- =B6*B2/(B2+B3)+B5*(1-B4)*B3/(B2+B3)

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Computing rD

A B C D
1 COMPUTING rD for UPS
2 31-Dec-09 31-Dec-08
3 Cash and cash equivalents 1,542,000 507,000
4 Long term debt 8,668,000 7,797,000
5 Net debt 7,126,000 7,290,000 <-- =C4-C3
6 Interest expense 445,000
7 rD 6.17% <-- =B6/AVERAGE(B5:C5)

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 Computing TC for UPS
A B C D
1 COMPUTING TC FOR UPS
2 31-Dec-09 31-Dec-08
3 Income before tax 3,366,000 5,015,000
4 Income tax expense 1,214,000 2,012,000
5 TC 36.07% 40.12% <-- =C4/C3

31
Template update

A B C
1 COMPUTING THE WACC FOR UPS
2 E 66.88 <-- Billion $, from Yahoo Key Statistics for UPS
3 D 6.25 <-- Book value of debt minus cash
4 rD 6.17%
5 TC 36.07%
6 rE
7
8 WACC 0.34% <-- =B6*B2/(B2+B3)+B4*(1-B5)*B3/(B2+B3)

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Computing rE for UPS
Use Gordon dividend model
Div0 (1 + g )
rE = +g
P0

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 UPS dividend history, Yahoo
A B
11 Date Dividend
12 24-Nov-99 0.30
13 24-Feb-00 0.17
14 25-May-00 0.17
15 24-Aug-00 0.17
16 22-Nov-00 0.17
17 22-Feb-01 0.19
18 25-May-01 0.19
19 24-Aug-01 0.19
20 23-Nov-01 0.19
21 25-Feb-02 0.19
22 23-May-02 0.19
23 22-Aug-02 0.19
24 21-Nov-02 0.19
25 20-Feb-03 0.21
26 15-May-03 0.21
27 21-Aug-03 0.25
28 20-Nov-03 0.25
29 19-Feb-04 0.28
30 13-May-04 0.28
31 19-Aug-04 0.28
32 24-Nov-04 0.28
33 17-Feb-05 0.33
34 12-May-05 0.33
35 18-Aug-05 0.33
36 23-Nov-05 0.33
37 16-Feb-06 0.38
38 11-May-06 0.38
39 17-Aug-06 0.38
40 22-Nov-06 0.38
41 15-Feb-07 0.42
42 17-May-07 0.42
43 6-Sep-07 0.42
44 15-Nov-07 0.42
45 7-Feb-08 0.45
46 15-May-08 0.45
47 21-Aug-08 0.45
48 13-Nov-08 0.45
49 19-Feb-09 0.45
50 14-May-09 0.45
51 20-Aug-09 0.45
52 12-Nov-09 0.45
53 11-Feb-10 0.47
54 13-May-10 0.47
55 12-Aug-10 0.47
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 Applying the Gordon model
A B C D E F G
1 COMPUTING COST OF EQUITY rD for UPS
2 Current UPS stock price P0 67.71
Contains formula
3 Current annual dividend 1.88 <-- =B55*4
=(B55/B35)^(1/20)-1
4 Growth rate of dividends
5 Whole period 1.03% 4.17% <-- =(1+B5)^4-1
6 Last 5 years 1.78% 7.33% <-- =(1+B6)^4-1
r
7 E cost of equity
, 10.31% <-- =B3*(1+C6)/B2+C6

NOTES:
 The dividend growth rate g depends on the period chosen
 We’ve chosen the last 5 years … but you could choose other time
frames
 Critical question: What is the future anticipated dividend growth
rate?
 Note that dividends are quarterly. We have derived the quarterly
growth rate and then annualized.
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WACC template, UPS
A B C
1 COMPUTING THE WACC FOR UPS
2 E 66.88 <-- Billion $, from Yahoo Key Statistics for UPS
3 D 6.25 <-- Book value of debt minus cash
<-- Interest from income statement, average net
r 6.17%
4 D debt over last two years
5 TC 36.07% <-- From income statement
6 rE 10.31% <-- Using Gordon model
7
8 WACC 9.77% <-- =B6*B2/(B2+B3)+B4*(1-B5)*B3/(B2+B3)

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Five problems in WACC
determination
FROM EASIEST TO HARDEST
Determine market value of equity E
Determine market value of debt D
Determine corporate tax rate TC
Find cost of debt rD
Find cost of equity rE

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A note before we begin
The illustrations in this Powerpoint
concentrate on individual firms
BUT: You should use industry data
(average of firms in industry) to
determine the WACC for a specific
firm.
On the other hand—often there is no
industry
Hard to find comparables
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 Asset beta approach to WACC

Could use Asset Beta

E D
βAsset = βE + βD (1−TC )
E+ D E+ D
where
βE =equity beta
βD = debt beta
E = marketvalue of the firm' s equity
D= marketvalue of the firm' s debt
TC = firm' s corporate tax rate
WACC = rf +βAsset E( rM ) −rf 
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Problems with asset beta

How is debt beta βD

determined?
In practice: most
professors seem to use
either βD=0.2 or βD=0
(without much justification)

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βD in principle

Suppose you knew the expected

return on debt, E(rD). Then

E( rD ) =rf +βD E( rM ) −rf 

E( rD ) −rf
βD =
E( rM ) −rf

Problem: How do we determine E(rD)?

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A note on terminology
In finance “cost” often means “rate of
return”
Thus: other names for cost of equity
 Required rate of equity return
 Expected rate of equity return (used in
CAPM)
 Opportunity cost
 Discount rate for equity cash flows
Inall cases: the rate of return
expected by a firm’s shareholders
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Back to five problems:
Finding market value of equity, E
E: number of shares * market price
per share

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