chapter 9 principles of corporate finance eighth edition capital budgeting and risk slides by...

Chapter 9

Principles of

Corporate FinanceEighth Edition

Capital Budgeting and Risk

Slides by

Matthew Will

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved

McGraw-Hill/Irwin


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Topics Covered

Company and Project Costs of CapitalMeasuring the Cost of EquitySetting Discount Rates w/o BetaCertainty EquivalentsDiscount Rates for International Projects


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Company Cost of Capital

A firm’s value can be stated as the sum of the value of its various assets

PV(B)PV(A)PV(AB) valueFirm


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10%nologyknown tech t,improvemenCost

COC)(Company 15%business existing ofExpansion

20%products New

30%Ventures eSpeculativ

RateDiscount Category


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A company’s cost of capital can be compared to the CAPM required return

Required

return

Project Beta1.26


13

5.5

0

SML


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Measuring Betas

The SML shows the relationship between return and risk

CAPM uses Beta as a proxy for riskOther methods can be employed to

determine the slope of the SML and thus Beta

Regression analysis can be used to find Beta


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Measuring Betas

Dell Computer

Slope determined from plotting the line of best fit.

Price data: May 91- Nov 97

Market return (%)

Dell return (%

)R2 = .10

B = 1.87


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Measuring Betas

Dell Computer


Price data: Dec 97 - Apr 04

Market return (%)

Dell return (%

)R2 = .27

B = 1.61


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Measuring Betas

General Motors


Market return (%)

GM

return (%)R2 = .07

B = 0.72



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Measuring Betas

General Motors


Market return (%)

GM

return (%)R2 = .29

B = 1.21



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Measuring Betas

Exxon Mobil


Market return (%)

Exxon M

obil return (%)

R2 = .23

B = 0.57



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Measuring Betas

Exxon Mobil


Market return (%)

Exxon M

obil return (%)

R2 = .18

B = 0.51



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Estimated Betas

Beta equity

Standard Error

Burlington Northern & Santa Fe 0.53 0.2

CSX Transportation 0.58 0.23Norfolk Southern 0.47 0.28

Union Pacific Corp 0.47 0.19Industry portfolio 0.49 0.18


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Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER

10 (High betas) 35 69

9 18 54

8 16 45

7 13 41

6 14 39

5 14 42

4 13 40

3 16 45

2 21 61

1 (Low betas) 40 62

Source: Sharpe and Cooper (1972)


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Company Cost of Capitalsimple approach

Company Cost of Capital (COC) is based on the average beta of the assets

The average Beta of the assets is based on the % of funds in each asset


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Company Cost of Capital (COC) is based on the average beta of the assets

The average Beta of the assets is based on the % of funds in each asset

Example1/3 New Ventures B=2.01/3 Expand existing business B=1.31/3 Plant efficiency B=0.6

AVG B of assets = 1.3

Company Cost of Capitalsimple approach


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Capital Structure - the mix of debt & equity within a company

Expand CAPM to include CS

R = rf + B ( rm - rf )becomes

Requity = rf + B ( rm - rf )

Capital Structure


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Capital Structure & COC

COC = rportfolio = rassets

rassets = WACC = rdebt (D) + requity (E)

(V) (V)

Bassets = Bdebt (D) + Bequity (E)

(V) (V)

requity = rf + Bequity ( rm - rf )

IMPORTANT

E, D, and V are all market values


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0

20

0 0,2 0,8 1,2

Capital Structure & COC

Expected return (%)

Bdebt Bassets Bequity

Rrdebt=8

Rassets=12.2

Requity=15

Expected Returns and Betas prior to refinancing


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Asset Betas

)PV(revenue

PV(asset)B

)PV(revenue

cost) ePV(variablB

)PV(revenue

cost) PV(fixedBB

assetcost variable

cost fixedrevenue

)PV(revenue

PV(asset)B

)PV(revenue

cost) ePV(variablB

)PV(revenue

cost) PV(fixedBB

assetcost variable

cost fixedrevenue


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Asset Betas

PV(asset)

cost) PV(fixed1B

PV(asset)

cost) ePV(variabl-)PV(revenueBB

revenue

revenueasset

PV(asset)

cost) PV(fixed1B

PV(asset)

cost) ePV(variabl-)PV(revenueBB

revenue

revenueasset


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Risk,DCF and CEQ

tf

tt

t

r

CEQ

r

CPV

)1()1(


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Risk,DCF and CEQ

Example

Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?


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Risk,DCF and CEQ

Example


%12

)8(75.6

)(

fmf rrBrr


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Risk,DCF and CEQ

Example


%12

)8(75.6

)(

fmf rrBrr

240.2 PVTotal

71.21003

79.71002

89.31001

12% @ PV FlowCashYear

AProject


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Risk,DCF and CEQ

Example


%12

)8(75.6

)(

fmf rrBrr

240.2 PVTotal

71.21003

79.71002

89.31001


AProject

Now assume that the cash flows change, but are RISK FREE. What is the new PV?


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Risk,DCF and CEQExample

Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

240.2 PVTotal

71.284.83

79.789.62

89.394.61


Project B

240.2 PVTotal

71.21003

79.71002

89.31001


AProject


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240.2 PVTotal

71.284.83

79.789.62

89.394.61


Project B

240.2 PVTotal

71.21003

79.71002

89.31001


AProject

Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.


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Risk,DCF and CEQ

Example

Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? DEDUCTION FOR RISK

15.284.81003

10.489.61002

5.494.61001riskfor

DeductionCEQFlowCash Year


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The difference between the 100 and the certainty equivalent (94.6) is 5.4%…this % can be considered the annual premium on a risky cash flow

flow cash equivalentcertainty 054.1

flow cashRisky


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8.84054.1

100 3Year

6.89054.1

100 2Year

6.94054.1

100 1Year

3

2


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International Risk

Source: The Brattle Group, Inc.

Ratio - Ratio of standard deviations, country index vs. S&P composite index

Ratio of Standard Deviations Correlation Coefficient Beta

Brazil 6.29 0.134 0.84Egypt 5.67 0.104 0.59India 6.1 0.173 1.05

Indonesia 7.29 0.176 1.28Mexioco 3.92 0.131 0.51Poland 3.21 0.264 0.85

Thailand 6.32 0.276 1.74South Africa 4.04 0.211 0.85

chapter 9 principles of corporate finance eighth edition capital budgeting and risk slides by...

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