chapter 9
DESCRIPTION
Chapter 9. Capital Budgeting and Risk. Topics Covered. Company and Project Costs of Capital Measuring the Cost of Equity Capital Structure and COC Discount Rates for Intl. Projects Estimating Discount Rates Risk and DCF. Company Cost of Capital. - PowerPoint PPT PresentationTRANSCRIPT
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Chapter 9
Capital Budgeting and Risk
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Topics Covered
Company and Project Costs of Capital Measuring the Cost of Equity Capital Structure and COC Discount Rates for Intl. Projects Estimating Discount Rates Risk and DCF
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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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Company Cost of Capital
10%nologyknown tech t,improvemenCost
COC)(Company 15%business existing ofExpansion
20%products New
30% ventureseSpeculativ
RateDiscount Category
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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
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Measuring Betas
The SML shows the relationship between return and risk
CAPM uses Beta as a proxy for risk Other 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 – Aug 88- Jan 95
Market return (%)
Dell return (%
)R2 = .11
B = 1.62
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Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Dell return (%
)R2 = .27
B = 2.02
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Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
GM
return (%)R2 = .13
B = 0.80
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Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
GM
return (%)R2 = .25
B = 1.00
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Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
Exxon M
obil return (%)
R2 = .28
B = 0.52
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Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Exxon M
obil return (%)
R2 = .16
B = 0.42
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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 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
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
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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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Union Pacific Corp.
Requity = Return on Stock
= 15%
Rdebt = YTM on bonds
= 7.5 %
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Union Pacific Corp.
.17.50PortfolioIndustry
.21.40PacificUnion
.26.52SouthernNorfolk
.24.46tionTransporta CSX
.20.64Northern Burlington
Error Standard.Beta
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Union Pacific Corp.
Example
100 valueFirmAssets Total
70ueEquity val
30Debt value100Assets
%75.12%157030
70%5.7
7030
30
assets
equitydebtassets
R
requitydebt
equityr
equitydebt
debtR
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International Risk
0.77.302.58Venezuela
1.39.482.91Thailand
0.81.421.93Poland
0.55.183.11Egypt
Betatcoefficien
nCorrelatioRatio
Source: The Brattle Group, Inc.
Ratio - Ratio of standard deviations, country index vs. S&P composite index
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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
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
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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?
%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
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?
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Risk,DCF and CEQ
ExampleProject 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
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Risk,DCF and CEQ
ExampleProject 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.
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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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Risk,DCF and CEQ
ExampleProject 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
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Risk,DCF and CEQ
ExampleProject 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