Transcript No Slide Title

Principles of
Corporate
Finance
Chapter 9
Capital Budgeting and Risk
Seventh Edition
Richard A. Brealey
Stewart C. Myers
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
9- 2
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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Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
9- 3
Company Cost of Capital
 A firm’s value can be stated as the sum of the
value of its various assets
Firm value  PV(AB)  PV(A)  PV(B)
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9- 4
Company Cost of Capital
Category
Discount Rate
Speculative ventures
30%
New products
20%
Expansionof existingbusiness
15% (CompanyCOC)
Cost improvemen
t, known technology
10%
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9- 5
Company Cost of Capital
 A company’s cost of capital can be compared
to the CAPM required return
SML
Required
return
13
Company Cost
of Capital
5.5
0
1.26
McGraw Hill/Irwin
Project Beta
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9- 6
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
Dell return (%)
Price data – Aug 88- Jan 95
R2 = .11
B = 1.62
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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9- 8
Measuring Betas
Dell Computer
Dell return (%)
Price data – Feb 95 – Jul 01
R2 = .27
B = 2.02
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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Measuring Betas
General Motors
GM return (%)
Price data – Aug 88- Jan 95
R2 = .13
B = 0.80
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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9- 10
Measuring Betas
General Motors
GM return (%)
Price data – Feb 95 – Jul 01
R2 = .25
B = 1.00
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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9- 11
Measuring Betas
Exxon Mobil
Exxon Mobil return (%)
Price data – Aug 88- Jan 95
R2 = .28
B = 0.52
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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Measuring Betas
Exxon Mobil
Exxon Mobil return (%)
Price data – Feb 95 – Jul 01
R2 = .16
B = 0.42
Slope determined from plotting the
line of best fit.
McGraw Hill/Irwin
Market return (%)
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9- 13
Beta Stability
RISK
CLASS
% IN SAME
CLASS 5
YEARS LATER
% WITHIN ONE
CLASS 5
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 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
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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
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Capital Structure
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 )
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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 )
McGraw Hill/Irwin
IMPORTANT
E, D, and V are
all market values
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9- 18
Capital Structure & COC
Expected Returns and Betas prior to refinancing
Expected
return (%)
20
Requity=15
Rassets=12.2
Rrdebt=8
0
0
McGraw Hill/Irwin
0.2
0.8
Bdebt
Bassets
1.2
Bequity
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9- 19
Union Pacific Corp.
Requity = Return on Stock
= 15%
Rdebt = YTM on bonds
= 7.5 %
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Union Pacific Corp.
Beta Standard.Error
McGraw Hill/Irwin
BurlingtonNorthern .64
CSX T ransporta
tion .46
.20
.24
NorfolkSouthern
.52
.26
Union P acific
IndustryP ortfolio
.40
.50
.21
.17
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9- 21
Union Pacific Corp.
Example
Assets
100
T otalAssets
Rassets
Rassets
McGraw Hill/Irwin
Debt value
Equity value
30
70
Firm value
100
debt
equity

rdebt 
requity
debt  equity
debt  equity
30
70

7.5% 
15%  12.75%
30  70
30  70
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9- 22
International Risk
Correlation
 Ratio
Beta
coefficient
Egypt
3.11
.18
0.55
Poland
1.93
.42
0.81
T hailand
2.91
.48
1.39
Venezuela
2.58
.30
0.77
Source: The Brattle Group, Inc.
 Ratio - Ratio of standard deviations, country index vs. S&P composite
index
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9- 23
Brevenue
Asset Betas
PV(fixedcost)
 Bfixed cost

PV(revenue)
PV(variable cost)
PV(asset)
 Bvariablecost
 Basset
PV(revenue)
PV(revenue)
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Asset Betas
Basset  B revenue
P V(revenue) - P V(variable cost )
P V(asset )
 P V(fixedcost )
 B revenue 1 

P
V(asset
)


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9- 25
Risk,DCF and CEQ
Ct
CEQt
PV 

t
t
(1  r )
(1  rf )
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9- 26
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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9- 27
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?
r  rf  B( rm  rf )
 6  .75(8)
 12%
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9- 28
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?
P rojectA
Year Cash Flow P V @ 12%
r  rf  B( rm  rf )
 6  .75(8)
 12%
McGraw Hill/Irwin
1
100
89.3
2
3
100
100
79.7
71.2
T otalP V
240.2
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9- 29
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?
P rojectA
Year Cash Flow P V @ 12%
1
100
89.3
2
3
100
100
79.7
71.2
T otalP V
240.2
r  rf  B( rm  rf )
Now assume that the cash
flows change, but are
RISK FREE. What is the
new PV?
 6  .75(8)
 12%
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9- 30
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?
P rojectA
Year Cash Flow P V @ 12%
1
100
89.3
2
3
100
100
79.7
71.2
T otalP V
240.2
McGraw Hill/Irwin
P roject B
Year Cash Flow P V @ 6%
1
94.6
89.3
2
3
89.6
84.8
79.7
71.2
T otalP V
240.2
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9- 31
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?
P rojectA
Year Cash Flow P V @ 12%
P roject B
Year Cash Flow P V @ 6%
1
100
89.3
1
94.6
89.3
2
3
100
100
79.7
71.2
2
3
89.6
84.8
79.7
71.2
T otalP V
240.2
T otalP V
240.2
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
Year Cash Flow CEQ
McGraw Hill/Irwin
Deduction
1
2
100
100
94.6
89.6
for risk
5.4
10.4
3
100
84.8
15.2
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9- 33
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
Risky cash flow
 certainty equivalent cash flow
1.054
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9- 34
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?
100
Year 1 
 94.6
1.054
100
Year 2 
 89.6
2
1.054
Year 3 
McGraw Hill/Irwin
100
 84.8
3
1.054
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