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1 Corcovado Pharmaceuticals
Corcovado Pharmaceuticals cost of debt is 7%. The risk-free rate of interest is 3%. The expected return
on the market portfolio is 8%. After effective taxes, Corcovados effective tax rate is 25%. Its optimal
capital structure is 60% debt and 40% equity.
a. If Corcovados beta is estimated at 1.1, what is its weighted average cost of capital?
b. If Corcovados beta is estimated at 0.8, significantly lower because of the continuing profit prospects
in the global energy sector, what is its weighted average cost of capital?
Assumptions
Corcovado's beta
Cost of debt, before tax
Risk-free rate of interest
Corporate income tax rate
General return on market portfolio
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V
a.
Values
1.10
7.000%
3.000%
25.000%
8.000%
b.
Values
0.80
7.000%
3.000%
25.000%
8.000%
60%
40%
60%
40%
5.250%
5.250%
8.500%
7.000%
WACC
WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]
6.550%
5.950%
a. To raise $120,000,000
First $40,000,000
Second $40,000,000
Third $40,000,000
Values
40%
50%
50%
$ 120,000,000
Cost of
Domestic
Equity
12%
18%
22%
Debt Market
European
European
Domestic
b. To raise $60,000,000
First $40,000,000
Additional $20,000,000
Weighted average cost
Cost of
Domestic
Debt
8%
12%
16%
Debt Cost
6.00%
10.00%
16.00%
Cost of
European
Equity
14%
16%
24%
Equity Market
Domestic
European
Domestic
10.67%
(equal weights)
Debt Market
European
European
Debt Cost
6.00%
10.00%
7.33%
(2/3 & 1/3 weights)
Equity Market
Domestic
European
Cost of
European
Debt
6%
10%
18%
Equity Cost
Incremental
WACC
12.00%
16.00%
22.00%
7.80%
11.00%
15.80%
16.67%
(equal weights)
11.53%
Equity Cost
Incremental
WACC
12.00%
16.00%
7.80%
11.00%
13.33%
(2/3 & 1/3 weights)
8.87%
International
ICAPM
0.85
3.60%
4.40%
8.00%
35%
8.00%
30%
70%
30%
70%
9.270%
7.340%
5.200%
5.200%
8.049%
6.6980%
Assumptions
Trident's beta,
Risk-free rate of interest, krf
Company credit risk premium
Cost of debt, before tax, kd
Corporate income tax rate, t
General return on market portfolio, km
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V
c. 5.00%
d. 4.00%
Assumptions
Trident's beta,
Risk-free rate of interest, krf
Company credit risk premium
Cost of debt, before tax, kd
Corporate income tax rate, t
Equity risk premium
General return on market portfolio, km
Optimal capital structure:
Proportion of debt, D/V
Proportion of equity, E/V
30%
70%
12.400%
10.800%
5.460%
5.460%
10.318%
9.198%
CAPM
ICAPM
a. 8.00%
10.318%
9.198%
b. 7.00%
9.583%
8.603%
c. 5.00%
8.113%
7.413%
d. 4.00%
7.378%
6.818%
krf
kd
km
t
D/V
E/V
3.0%
7.5%
9.0%
35.0%
35%
65%
3.0%
7.8%
12.0%
35.0%
40%
60%
Estimated beta
= ( jm x j ) / ( m )
1.20
1.16
ke
10.200%
13.432%
kd (1-t)
4.875%
5.070%
WACC
8.336%
10.087%
Assumptions
Total sales
Company's beta
Company credit rating
Risk-free rate of interest
Market risk premium
Weighted average cost of debt
Corporate tax rate
Debt to total capital ratio
Equity to total capital ratio
International sales as % of total sales
Symbol
Sales
S&P
krf
km-krf
kd
t
D/V
E/V
Symbol
Cost of equity
ke = krf + (km - krf)
Cost of debt, after-tax
Weighted average cost of capital
WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)
Comparables
Company A
Company B
$10.5 billion
$45 billion
0.83
0.68
AA
A
4.5%
4.5%
5.5%
5.5%
6.885%
7.125%
48.0%
48.0%
34%
41%
66%
59%
11%
34%
Cargill
$113 billion
0.90
AA
4.5%
5.5%
6.820%
48.0%
28%
72%
54%
Company A
Company B
Cargill
ke
9.065%
8.240%
9.450%
kd ( 1 - t )
3.580%
3.705%
3.546%
WACC
7.200%
6.381%
7.797%
Once the data is organized, the absence of a beta for Cargill is the obvious data deficiency.
A series of observations is then helpful:
1. Note that beta and credit ratings do not necessarily parallel one another
2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost
3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas
4. Cargill's sales are twice that of the next largest firm
5. Cargill's sales are significantly more internationally diversified than either of the other two companies; the question
is whether this is a positive or negative factor for the estimation of Cargill's cost of equity?
If we take the approach that the beta for Cargill has to pick up all the incremental information, the beta would then fall
between say 0.80 and 1.00. If the higher degree of international sales was interpreted as increasing risk, beta would
be on the higher end; yet being a commodity firm in the current market, its beta would rarely surpass 1.0. A value of
0.90 is shown here giving a WACC of 7.797%. A series of sensitivities would find a WACC between 7.1% and 7.9%.
1995
23.20%
53.10%
0.972
16.0%
1996
10.00%
27.10%
1.039
28.0%
1997
4.80%
24.70%
1.117
30.2%
1998
1.00%
29.20%
1.207
33.5%
1999
10.50%
30.70%
1.700
151.9%
All three are on the right track. It is mostly a matter of finding the linkages beween their individual arguments.
1. Theoretically, Curly is correct in that CAPM assumes that all equity returns are over and above risk-free rates. These are of course,
expected returns, and are the investor's expectations or requirements going INTO the investment.
2. Mo is also correct in arguing that regardless of what investors may EXPECT, the results are often quite different, sometimes disappointing.
Theoretically, when the investment does not yield at least the expected return, the investor should indeed liquidate their position. However,
in reality, many investors for a variety of reasons (tax implications, investment horizon, etc.), may stay in the investment and just complain
about the past and hope about the future.
3. Larry also is on the right track arguing that actual market returns will often result in less than various interest or debt instruments. One of
the more helpful arguments here is that equity returns and interest returns arise from very different economic and financial processes. Most
interest rate charges are stated and contracted for up front, and represent lenders' perception of an adequate risk-adjusted return over the
expected rate of inflation for the coming period. Equity returns, however, are that mystical process of equity markets in which the many
different motives of equity investors combine to move markets in sometimes mysterious ways, independent of interest rates, inflation rates,
or any other fundamental money price.
Mean
9.90%
32.96%
120.7%
51.92%
Senior management at Genedak-Hogan is actively debating the implications of diversification on its cost of equity. Although both
parties agree that the companys returns will be less correlated with the reference market return in the future, the financial advisors
believe that the market will assess an additional 3.0% risk premium for "going international" to the basic CAPM cost of equity.
Calculate Genedak-Hogan's cost of equity before and after international diversification of its operations, with and without the
hypothetical additional risk premium, and comment on the discussion.
Before
After
Assumptions
Symbol
Diversification
Diversification
Correlation between G-H and the market
jm
0.88
0.76
Standard deviation of G-H's returns
j
28.0%
26.0%
Standard deviation of market's returns
m
18.0%
18.0%
Risk-free rate of interest
krf
3.0%
3.0%
Additional equity risk premium for internationalization
RPM
0.0%
3.0%
Estimate of G-H's cost of debt in US market
kd
7.2%
7.0%
Market risk premium
km-krf
5.5%
5.5%
Corporate tax rate
t
35.0%
35.0%
Proportion of debt
D/V
38%
32%
Proportion of equity
E/V
62%
68%
Estimating Costs of Capital
Estimated beta
= ( jm x j ) / ( m )
1.37
1.10
ke
10.529%
9.038%
ke + RPM
10.529%
12.038%
This may be a case in which everyone is correct. When G-H's beta is recalculated, it falls in value as a result of
the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost of
equity, which is cheaper at 9.038% (previous cost of equity was 10.529%).
If, however, the market was to add an additional risk premium to the firm's cost of equity as a result of internationally
diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity would
indeed be higher, 12.038% compared to the before value of 10.529%.
Assumptions
Correlation between G-H and the market
Standard deviation of G-H's returns
Standard deviation of market's returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of G-H's cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
jm
j
m
krf
RPM
kd
km-krf
t
D/V
E/V
Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
35.0%
32%
68%
Before
Diversification
After
Diversification
Estimated beta
= ( jm x j ) / ( m )
1.37
1.10
ke
10.529%
9.038%
ke + RPM
10.529%
12.038%
4.680%
4.550%
8.306%
7.602%
8.306%
9.642%
kd (1-t)
WACC
WACC*
There are a number of different factors at work here. First, as a result of international diversification, the firm's access to debt
has improved, resulting in a lower cost of debt capital. This is not fully appreciated, however, as the firm has chosen to
reduce its overall use of debt post-diversification (common among MNEs).
The firm's WACC does indeed drop for the standardized case. If, however, the market assesses an additional equity risk
premium of 3.0%, the benefits are swamped by the higher required return on equity by the market.
Assumptions
Correlation between G-H and the market
Standard deviation of G-H's returns
Standard deviation of market's returns
Risk-free rate of interest
Additional equity risk premium for internationalization
Estimate of G-H's cost of debt in US market
Market risk premium
Corporate tax rate
Proportion of debt
Proportion of equity
Symbol
jm
j
m
krf
RPM
kd
km-krf
t
D/V
E/V
Before
Diversification
0.88
28.0%
18.0%
3.0%
0.0%
7.2%
5.5%
35.0%
38%
62%
After
Diversification
0.76
26.0%
18.0%
3.0%
3.0%
7.0%
5.5%
32.0%
32%
68%
Before
Diversification
After
Diversification
Estimated beta
= ( jm x j ) / ( m )
1.37
1.10
ke
10.529%
9.038%
ke + RPM
10.529%
12.038%
4.680%
4.760%
8.306%
7.669%
8.306%
9.709%
kd (1-t)
WACC
WACC*
The reduction in the effective tax rate obviously affects WACC through the cost of debt. This does have substantial
benefits in the company's WACC -- as long as additional equity risk premiums are not assessed. Then, even the lower
effective tax rate does not offset the higher equity costs associated with the international risk premium.