|Es= rf + Bs(Emkt - rf)|
rf = the risk-free rate
Bs = the beta of the investment
Emkt = the expected return of the market
Es = the expected return of the investment
When a new product line for Newco is considered, the project's beta is 1.5. Assuming the risk-free rate is 4% and the expected return on the market is 12%, compute the cost of equity for the new product line.
Cost of equity = rf + Bs(Emkt - rf) = 4% + 1.5(12% - 4%) = 16%
The project's required return on retained earnings is thus 16% and should be used in our calculation of WACC.
In risk analysis, estimating the beta of a project is quite important. But like many estimations, it can be difficult to determine.
The two most widely used methods of estimating beta are:
1. Pure-Play Method
When using the pure-play method, a company seeks out companies with a product line that is similar to the line for which the company is trying to estimate the beta. Once these companies are found, the company would then take an average of those betas to determine its project beta.
Suppose Newco would like to add beer to its existing product line of soda. Newco is quite familiar with the beta of making soda given its history. However, determining the beta for beer is not as intuitive for Newco as it has never produced it.
Thus, to determine the beta of the new beer project, Newco can take the average beta of other beer makers, such as Anheuser Busch and Coors.
2. Accounting-Beta Method
When using the accounting-beta method, a company would run a regression using the company's return on assets (ROA) against the ROA for market benchmark, such as the S&P 500. The accounting beta is the slope coefficient of the regression.
The typical procedure for developing a risk-adjusted discount rate is as follows:
1. A company first begins with its cost of capital for the firm.
2. The cost of capital then must be adjusted for the riskiness of the project, by adjusting the company's cost of capital either up or down depending on the risk of the project relative to the firm.
For projects that are riskier, the company's WACC would be adjusted higher and if the project is less risky, the company's WACC is adjusted lower. The main issue in this procedure is that it is subjective.
Essentially, capital rationing is the process of allocating the company's capital among projects to maximize shareholder return.
When making decisions to invest in positive net-present-value (NPV) projects, companies continue to invest until their marginal returns equal their marginal cost of capital. There are times, however, when a company may not have capital to do this. As such, a company must ration its capital among the best combination of projects with the highest total NPV.
Factors that Influence a Company's Capital-Structure Decision
Managing WealthLearn how to properly use this measure that can help you meet your criteria for risk.
Managing WealthBeta says something about price risk, but how much does it say about fundamental risk factors? Find out here.
Managing WealthWe explain two methods for calculating the beta of a private company.
MarketsWe compare the Beta values obtained from financial sources. Also, how to compute Beta using Excel.
Managing WealthLearn how the bet against beta strategy is used by a large hedge fund to profit from a pricing anomaly in the stock market caused by high stock prices.
Managing WealthThe security market line graphs the systematic risk versus return of the whole market at a certain time, and shows all risky marketable securities.
Managing WealthBeta is a useful tool for calculating risk, but the formulas provided online aren't specific to you. Learn how to make your own.
MarketsExamine the theoretical and statistical relationship between beta and volatility to identify three factors that limit beta's explanatory value.
InvestingFind out why smart beta strategies might not be the best bet, and discover 3 reasons why you should think twice before using them to allocate stocks.
InvestingWeighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality.