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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,9-,34,McGraw Hill/Irwin,Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved,Principles of Corporate Finance,Seventh Edition,Richard A. Brealey,Stewart C. Myers,Slides by,Matthew Will,Chapter 9,McGraw Hill/Irwin,Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved,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,A firms value can be stated as the sum of the value of its various assets,Company Cost of Capital,Company Cost of Capital,A companys cost of capital can be compared to the CAPM required return,Required,return,Project Beta,1.26,Company Cost of Capital,13,5.5,0,SML,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,Measuring Betas,Dell Computer,Slope determined from plotting the line of best fit.,Price data Aug 88- Jan 95,Market return (%),Dell return (%),R,2,= .11,B = 1.62,Measuring Betas,Dell Computer,Slope determined from plotting the line of best fit.,Price data Feb 95 Jul 01,Market return (%),Dell return (%),R,2,= .27,B = 2.02,Measuring Betas,General Motors,Slope determined from plotting the line of best fit.,Price data Aug 88- Jan 95,Market return (%),GM return (%),R,2,= .13,B = 0.80,Measuring Betas,General Motors,Slope determined from plotting the line of best fit.,Price data Feb 95 Jul 01,Market return (%),GM return (%),R,2,= .25,B = 1.00,Measuring Betas,Exxon Mobil,Slope determined from plotting the line of best fit.,Price data Aug 88- Jan 95,Market return (%),Exxon Mobil return (%),R,2,= .28,B = 0.52,Measuring Betas,Exxon Mobil,Slope determined from plotting the line of best fit.,Price data Feb 95 Jul 01,Market return (%),Exxon Mobil return (%),R,2,= .16,B = 0.42,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),Company Cost of Capital,simple 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,Company Cost of Capital,simple 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,Example,1/3 New Ventures B=2.0,1/3 Expand existing business B=1.3,1/3 Plant efficiency B=0.6,AVG B of assets = 1.3,Capital Structure - the mix of debt & equity within a company,Expand CAPM to include CS,R = r,f,+ B ( r,m,- r,f,),becomes,R,equity,= r,f,+ B ( r,m,- r,f,),Capital Structure,Capital Structure & COC,COC,=,r,portfolio,= r,assets,r,assets,= WACC = r,debt,(D) + r,equity,(E),(V) (V),B,assets,= B,debt,(D) + B,equity,(E),(V) (V),r,equity,= r,f,+ B,equity,( r,m,- r,f,),IMPORTANT,E, D, and V are all market values,Capital Structure & COC,Expected return (%),B,debt,B,assets,B,equity,R,rdebt,=8,R,assets,=12.2,R,equity,=15,Expected Returns and Betas prior to refinancing,Union Pacific Corp.,R,equity,= Return on Stock,= 15%,R,debt,= YTM on bonds,= 7.5 %,Union Pacific Corp.,Union Pacific Corp.,Example,International Risk,Source: The Brattle Group, Inc.,s,Ratio,- Ratio of standard deviations, country index vs. S&P composite index,Asset Betas,Asset Betas,Risk,DCF and CEQ,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?,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?,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?,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?,Now assume that the cash flows change, but are RISK FREE. What is the new PV?,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?.,Now assume that the cash flows change, but are RISK FREE. What is the new PV?,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?.,Now assume that the cash flows change, but are RISK FREE. What is the new PV?,Since the 94.6 is risk free, we call it a,Certainty Equivalent,of the 100.,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,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?. 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,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?. Now assume that the cash flows change, but are RISK FREE. What is the new PV?,
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