Transcript No Slide Title

Principles of Corporate Finance
Brealey and Myers

Sixth Edition
Capital Budgeting and Risk
Slides by
Matthew Will
Irwin/McGraw Hill
Chapter 9
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9- 2
Topics Covered
 Measuring Betas
 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.
Firm value  PV(AB)  PV(A)  PV(B)
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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
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Project Beta
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9- 5
Measuring Betas
 The SML shows the relationship between
return and risk.
 CAPM uses Beta as a proxy for risk.
 Beta is the slope of the SML, using CAPM
terminology.
 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
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 78 - Dec 82
R2 = .53
B = 1.35
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 83 - Dec 87
R2 = .49
B = 1.33
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 88 - Dec 92
R2 = .45
B = 1.70
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 9
Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 93 - Dec 97
R2 = .35
B = 1.69
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 10
Measuring Betas
A T & T Beta
Price data - Jan 78 - Dec 82
A T & T (%)
R2 = .28
B = 0.21
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 11
Measuring Betas
A T & T Beta
Price data - Jan 83 - Dec 87
A T & T (%)
R2 = .23
B = 0.64
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 12
Measuring Betas
A T & T Beta
Price data - Jan 88 - Dec 92
A T & T (%)
R2 = .28
B = 0.90
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 13
Measuring Betas
A T & T Beta
Price data - Jan 93 - Dec 97
A T & T (%)
R2 = ..17
B = .90
Slope determined from 60 months of
prices and plotting the line of best
fit.
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Market return (%)
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9- 14
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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Capital Budgeting & Risk
Modify CAPM
(account for proper risk)
• Use COC unique to project,
rather than Company COC
• Take into account Capital Structure
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Company Cost of Capital
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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
9- 17
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
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Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
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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)
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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 )
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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 )
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IMPORTANT
E, D, and V are
all market values
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Capital Structure & COC
Expected Returns and Betas prior to refinancing
20
Expected
return (%)
Requity=15
Rassets=12.2
Rrdebt=8
0
0
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0.2
0.8
Bdebt
Bassets
1.2
Bequity
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9- 25
Pinnacle West Corp.
Requity = rf + B ( rm - rf )
= .045 + .51(.08) = .0858 or 8.6%
Rdebt = YTM on bonds
= 6.9 %
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Pinnacle West Corp.
Beta
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Standard. Error
Boston Electric
.60
.19
Central HUdson
.30
.18
Consolidat ed Edison
.65
.20
DTE Energy
.56
.17
Eastern Utilities Assoc .66
.19
GPU Inc
.65
.18
NE Electric System
.35
.19
OGE Energy
.39
.15
PECO Energy
.70
.23
Pinnacle West Corp
.43
.21
PP & LResources
.37
.21
Portfolio Average
.51
.15
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9- 27
Pinnacle West Corp.
COC  rassets
D
E
 rdebt  requity
V
V
 .35(.08)  .65(.10)
 .093 or 9.3%
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International Risk
 Ratio
Correlatio n
Beta
Argentina
3.52
coefficien t
.416
Brazil
3.80
.160
.62
Kazakhstan
2.36
.147
.35
Taiwan
3.80
.120
.47
1.46
Source: The Brattle Group, Inc.
 Ratio - Ratio of standard deviations, country index vs. S&P composite index
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Unbiased Forecast
 Given three outcomes and their related
probabilities and cash flows we can determine
an unbiased forecast of cash flows.
Possible
cash flow
1.2
Probabilit y
.25
Prob weighted
Unbiased
cash flow
.3
forecast
1.0
.50
.5
0.8
.25
.2
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$1.0 million
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9- 30
Asset Betas
Cash flow = revenue - fixed cost - variable cost
PV(asset) = PV(revenue) - PV(fixed cost) - PV(variable cost)
or
PV(revenue) = PV(fixed cost) + PV(variable cost) + PV(asset)
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Asset Betas
B revenue
PV(fixed cost)
 Bfixed cost

PV(revenue )
PV(variabl e cost)
PV(asset)
 B variable cost
 Basset
PV(revenue )
PV(revenue )
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Asset Betas
Basset  B revenue
PV(revenue ) - PV(variabl e cost)
PV(asset)
 PV(fixed cost) 
 B revenue 1 

PV(asset)


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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?
r  rf  B( rm  rf )
 6  .75(8)
 12%
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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?
Project A
r  rf  B( rm  rf )
 6  .75(8)
 12%
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Year
Cash Flow
PV @ 12%
1
100
89.3
2
100
79.7
3
100
71.2
Total PV
240.2
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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?
Project A
Year
Cash Flow
PV @ 12%
1
100
89.3
2
100
79.7
3
100
71.2
Total PV
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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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?
Project B
Project A
Year
Cash Flow
PV @ 6%
1
94.6
89.3
Year
Cash Flow
PV @ 12%
1
100
89.3
2
100
79.7
2
89.6
79.7
3
100
71.2
3
84.8
71.2
Total PV
240.2
Total PV
240.2
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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?.. Now assume that the cash flows change,
but are RISK FREE. What is the new PV?
Project B
Project A
Year
Cash Flow
PV @ 12%
Year
Cash Flow
PV @ 6%
1
100
89.3
1
94.6
89.3
2
100
79.7
2
89.6
79.7
3
100
71.2
3
84.8
71.2
Total PV
240.2
Total PV
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?.. 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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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
Year 2 
100
 89.6
2
1.054
100
Year 3 
 84.8
3
1.054
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Risk,DCF and CEQ
 The prior example leads to a generic certainty
equivalent formula.
Ct
CEQt
PV 

t
t
(1  r )
(1  rf )
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