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Welcome back as we discuss some topics with regards to estimation of cost of capital in this lesson,
we examine what Project Bater is.
How to estimate it and how to use it.
Let's get rolling.
Recall, in an earlier lesson, we learned that one of the limitations of the NPV or IRR method is the
assumption that the project under consideration has the same level of risk as the firm's existing projects.
This is because when we calculate the WAC see of the firm, all the component costs are due to the firm's
existing projects.
So if we use this HCC to evaluate a new project, the implicit assumption is that this new project has
the same level of risk as the existing projects.
However, this may not be a reasonable assumption, as most of the times the project under consideration
is of a different risk level.
This implies that the firm's HCC is not suitable for evaluation of the project.
One way to factor in the difference in risk level is to estimate the project better, a project's beta
is a measure of the project's systematic risk on its own.
We've learned in the last lesson that under Cap Em, we can use a firm's bater to estimate its required
return on equity, which is the firm's cost of equity.
Likewise, we can use a projects better to estimate the cost of equity for a specific project.
So how do we estimate the beta of a project under consideration?
Obviously, there's no stock price to analyze, as the project has not even started.
One way is to make inferences from other publicly traded companies which are engaged in the business,
similar to the project under consideration.
For example, if Wal-Mart is looking to set up a fast food chain using the beta of its own stock to
estimate the cost of equity for the new project may not be suitable as it's based on the risk level
of its current hypermarket business.
Rather, McDonald's stock trades beta or the fast food industry average beta may be more appropriate.
In order for the estimation to be meaningful, the comparable business must be purely engaged in the
same business as the project under consideration.
Thus, using the beta of a conglomerate that is engaged in the same business as the project would be
inappropriate because it's better depends on its many different lines of business.
This is why this method is called the pure play method.
Another important consideration is that the degree of financial leverage can differ significantly between
firms and the beta of a firm is a function of it.
In general, the higher a firm's debt to equity ratio, the greater is, its better.
So if MacDonald's debt to equity ratio is 4.0 while Walmart is 0.8, we cannot just use McDonald's better
on Wal-Mart's capital structure.
We need to find what McDonald's baiter would be if it had the same degree of leverage as Walmart.
To do that, we first need to unleash the beta of the equity of the public listed company using this
formula.
What we get here is the beta of the asset without any borrowing.
Once we have this, the next step is to relieve a based on the capital structure of the company evaluating
the project, using this formula.
For easier reference, let's call this the subject company, and this the reference company from this
point on.
At first glance, this may look complicated.
However, once you see the pattern here, it's actually quite simple.
The first thing you should remember is this term, when you unleash of the beta of an equity T is the
marginal tax rate and D over E is the debt to equity ratio of the reference company.
And you divide the batter of the stock with this term.
When you relieve the beta of an asset, see is the marginal tax rate and deep poverty is the debt to
equity ratio of the subject company, and you multiply the beta of the asset with this term.
For example, if the beta of the publicly traded company stock is one point eight, its debt to equity
ratio is 4.0 and it's marginal tax rate is 35 percent.
The beta of the asset without leverage will be 0.5.
If the subject company has a debt to equity ratio of 0.8 and its marginal tax rate is 40 per cent,
the beta of the project will be 0.7 for.
Once we get the beta of the project, we can use this beta to estimate the cost of equity of the project.
And plug this in to find the ICC applicable to the project.
Let's work on an example.
Trinity Inc. is a US listed company that's considering building a power generation facility in India.
Ta-Da, Inc. is an India listed company whose only business is power generation in India.
Based on the given information estimate, the project beta for the power generation project that Trinity
is evaluating.
Pause the video now and work out your answer.
And we're back.
The main challenge for the pure play method is to determine which figures to use at which stage.
The first stage is to unleash a $2 stock baiter.
This has all to do with ta da.
So all the figures we use are from Ta DA Plug Ta DA Stock Beta, marginal tax rate and debt to equity
ratio to the formula.
And we get a deleverage beta of zero point six.
Take note that at this stage, we divide by the leverage factor, the next stage is to relieve the beta
to Trinity's capital structure.
So at this stage, we use Trinity's figures.
Plug Trinity's marginal tax rate and debt to equity ratio into the formula, and we get the project
baiter of 0.8 three.
Take note that at this stage we multiply the leverage factor.
To wrap up on Project Bater, let's discuss some of the challenges you should be aware of when estimating
the bater of a stock.
To estimate the beta of a stock, the volatility of the stock price is measured against the volatility
of a benchmark.
Beta is greater than one.
If the stock's volatility is higher than the benchmark and lower than one, if its volatility is lower.
The first challenge is that historical returns data are used, and as always, past patterns may not
be indicative of future patterns.
Besides, the estimates can be sensitive to the length, period and frequency of the data, but the
analyst uses the bater that you arrive at may be different than that of another analyst.
Another challenge is the choice of benchmark choosing an inappropriate benchmark can result in a beta
that's not meaningful.
Third, baiters are believed to revert towards one over time.
You may want to adjust your estimate of data for this tendency, meaning lowering the estimate if it's
greater than one and raising the estimate when it's lower than one.
Fourth voter may not fully capture the risk inherent in small firms.
You may want to adjust your estimate upward if you have reasons to believe the risk is higher for a
small firm.
On the same track, baiter may also not adequately capture country risk, supporting research has suggested
that beta does not adequately capture country risk for companies in developing countries.
In our next lesson, we continue discussing on more topics in cost of capital.
Take a break and see you at the next lesson.