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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 2
McGraw-Hill/Irwin
Topics Covered
Company and Project Costs of CapitalMeasuring the Cost of EquitySetting Discount Rates w/o BetaCertainty EquivalentsDiscount Rates for International Projects
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 3
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 4
McGraw-Hill/Irwin
Company Cost of Capital
10%nologyknown tech t,improvemenCost
COC)(Company 15%business existing ofExpansion
20%products New
30%Ventures eSpeculativ
RateDiscount Category
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 5
McGraw-Hill/Irwin
Company Cost of Capital
A company’s cost of capital can be compared to the CAPM required return
Required
return
Project Beta1.26
Company Cost of Capital
13
5.5
0
SML
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 6
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 7
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 8
McGraw-Hill/Irwin
Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data: Dec 97 - Apr 04
Market return (%)
Dell return (%
)R2 = .27
B = 1.61
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 9
McGraw-Hill/Irwin
Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Market return (%)
GM
return (%)R2 = .07
B = 0.72
Price data: May 91- Nov 97
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 10
McGraw-Hill/Irwin
Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Market return (%)
GM
return (%)R2 = .29
B = 1.21
Price data: Dec 97 - Apr 04
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 11
McGraw-Hill/Irwin
Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Market return (%)
Exxon M
obil return (%)
R2 = .23
B = 0.57
Price data: May 91- Nov 97
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 12
McGraw-Hill/Irwin
Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Market return (%)
Exxon M
obil return (%)
R2 = .18
B = 0.51
Price data: Dec 97 - Apr 04
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 13
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 14
McGraw-Hill/Irwin
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)
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 15
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 16
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 17
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 18
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 19
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 20
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 21
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 22
McGraw-Hill/Irwin
Risk,DCF and CEQ
tf
tt
t
r
CEQ
r
CPV
)1()1(
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 23
McGraw-Hill/Irwin
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?
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 24
McGraw-Hill/Irwin
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?
%12
)8(75.6
)(
fmf rrBrr
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 25
McGraw-Hill/Irwin
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?
%12
)8(75.6
)(
fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 26
McGraw-Hill/Irwin
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?
%12
)8(75.6
)(
fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Now assume that the cash flows change, but are RISK FREE. What is the new PV?
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 27
McGraw-Hill/Irwin
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
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 28
McGraw-Hill/Irwin
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
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 29
McGraw-Hill/Irwin
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 30
McGraw-Hill/Irwin
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?
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
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 31
McGraw-Hill/Irwin
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?
8.84054.1
100 3Year
6.89054.1
100 2Year
6.94054.1
100 1Year
3
2
Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved
9- 32
McGraw-Hill/Irwin
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