BUSI 530 Week 5 Discussion Board Forum 3 Example

Discussion Board Forum 3: Risk, Return and the Cost of Capital

BUSI 530 Managerial Finance, Discussion Board Forum 3 Thread and Replies

Thread by [Student Name]

The forum prompt, the two classmates and the company in the thread are composites standing in for the course's own prompt; the figures in the worked example are the writer's, and the textbook and research cited are real.

Thread

No figure in corporate finance gets quoted more often than WACC, and it is easy to treat it as the hurdle rate for everything a company does. Brealey et al. (2018) are careful to say otherwise. The company cost of capital is the right discount rate only for projects that have the same risk as the company's existing business. A project's true cost of capital is the return investors could earn on other investments of the same risk, whoever undertakes it.

Consider a regulated electric utility with an asset beta of 0.6. With a risk-free rate of 4 percent and a market risk premium of 8 percent, the capital asset pricing model gives an asset return of about 8.8 percent, and after the tax saving on its debt the company's WACC comes to roughly 8 percent. Now suppose the utility considers building a merchant power plant that sells electricity at market prices. Independent power producers that specialize in that business have asset betas closer to 1.2, which implies a required return of about 13.6 percent before financing benefits and roughly 12 percent after. A plant expected to return 10 percent passes the utility's hurdle and destroys value.

This shortcut is common. Graham and Harvey (2001) surveyed 392 CFOs. Roughly 74 percent said the CAPM was their usual method for the cost of equity, yet a surprising number judged new investments by the risk of the firm as a whole rather than the risk of the project. Krüger et al. (2015) tested the consequences in conglomerates. Divisions riskier than the firm's core business invested more, and safer divisions less, just as a single hurdle rate would predict, and acquirers buying riskier targets earned lower announcement returns.

A single discount rate quietly moves capital from a firm's safest businesses to its riskiest ones. The textbook's remedy is practical: estimate the project's beta from companies that specialize in its line of business and discount at that rate, even if the estimate is imperfect.

Reply to Kendra

Kendra, your thread explained the difference between unique risk and market risk well, and your chart of portfolio volatility falling as stocks are added made the idea concrete. I want to question the common rule you mentioned, that about 10 stocks are enough to diversify. Statman (1987) compared the reduction in risk from adding stocks with the extra transaction costs of holding them and concluded that a portfolio of randomly picked stocks is not well diversified until it holds at least 30 names for a borrowing investor, or 40 for a lending one. The volatility curve flattens, but not as early as the rule suggests, and the remaining unique risk is risk the market does not pay investors to bear. For most individuals today, a low-cost index fund solves the problem at once, holding hundreds of companies for a small annual fee. Familiarity also works against diversification, since people tend to buy companies they know from work or shopping, which often means one industry or region. Does that change your advice to the beginning investor in your example, who planned to buy a dozen stocks she knew well?

Reply to Andre

Andre, your use of the historical risk premium on U.S. stocks to set the market risk premium in your CAPM example was exactly the approach Brealey et al. (2018) describe, and you were right to note that the estimate depends on the period chosen. There is a deeper puzzle behind that number. Mehra and Prescott (1985) showed that the historical premium of stocks over safe assets was far larger than standard economic models of investors' attitudes to risk could explain; reasonable levels of risk aversion predicted a premium of well under 1 percent, compared with about 6 percent in the data. Economists still debate whether the past premium was partly good luck, a reward for risks that happened not to materialize in the United States during the twentieth century, or compensation for disasters that investors feared but did not see. If it was, a forward-looking premium would be lower than history suggests. Would you lower your 8 percent estimate, or do you think the historical average is still the best guide we have?

References

Brealey, R. A., Myers, S. C., & Marcus, A. J. (2018). Fundamentals of corporate finance (9th ed.). McGraw-Hill Education.

Graham, J. R., & Harvey, C. R. (2001). The theory and practice of corporate finance: Evidence from the field. Journal of Financial Economics, 60(2-3), 187-243. https://doi.org/10.1016/S0304-405X(01)00044-7

Krüger, P., Landier, A., & Thesmar, D. (2015). The WACC fallacy: The real effects of using a unique discount rate. The Journal of Finance, 70(3), 1253-1285. https://doi.org/10.1111/jofi.12250

Mehra, R., & Prescott, E. C. (1985). The equity premium: A puzzle. Journal of Monetary Economics, 15(2), 145-161. https://doi.org/10.1016/0304-3932(85)90061-3

Statman, M. (1987). How many stocks make a diversified portfolio? Journal of Financial and Quantitative Analysis, 22(3), 353-363. https://doi.org/10.2307/2330969