finance

Project vs Firm Risk and the
Impact of Leverage

The SML and WACC
§ Consider 100% equity financed firm
§ Beta = 1
E/V = 1!
D/V = 0!
§ WACC =?

E
D
WACC = × RE + × RD × (1 − TC ) = RE
V
V
WACC = Cost of equity from CAPM

[

]

WACC = RE = R f + β × E [RM ] − R f = E [RM ]
Beta =1!

2

SML and WACC
SML

Expected
Return
WACC = E[RM]

Rf

[

R f + β × E [RM ] − R f

]

β=1

Beta
3

Accept Projects Y and/or Z?
Expected
Return
IRRz
WACC = E[RM]
IRRY

SML

Z
Y

Rf

β=1

Beta
4

Accept Projects Y and/or Z?
E[R]

SML

E[RZ]

Z

WACC = E[RM]

Y

E[RY]
Rf

βY

β=1

βZ

Beta
5

Accept Projects Y and/or Z?
E[R]

SML
Incorrect

Z

WACC = E[RM]

acceptance
Incorrect
rejection

Y

Rf

β=1

Beta
6

Project Y
§ IRR of Project Y is lower than WACC
§ Project Y would be rejected based on
WACC
§ BUT: Project Y is less risky than firm as a whole § Its return is higher than the expected return from CAPM (it is above the SML)
§ Accept Project Y
7

Project Z
§ IRR of Project Z is higher than WACC
§ Project Z would be accepted based on
WACC
§ BUT: Project Z is more risky than firm as a whole § Its return is lower than the expected return from CAPM (it is below the SML)
§ Reject Project Z
8

Solutions to the problem
§ Pure play (opposite of conglomerate)
§ Use WACC of “pure play” companies in the same industry (a pure play company operates in a single industry only: for example,
Blackberry maker Research in Motion is a pure play in smart phones and related software)

§ Subjective
§ Adjust firm’s WACC to reflect the riskiness of the project relative to riskiness of the firm
9

Finding Comparable Pure Play
§ Often difficult to find comparable pure play companies § Honda enters aircraft business
§ Honda Motors Beta:
§ Embraer
Source: Google Finance

0.96
1.65

10

Systematic vs.