Lecture 9 Capital Budgeting and Risk

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Lecture 9Capital Budgeting and Risk

• Managerial Finance
• FINA 6335
• Ronald F. Singer

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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 firms value can be stated as the sum of the
  value of its various assets.

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Company Cost of Capital

• A companys cost of capital can be compared to
  the CAPM required return.

13 5.5 0
SML
Required return
Company Cost of Capital
Project Beta
1.26
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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
Price data - Jan 78 - Dec 82
R2 .53 B 1.35
Hewlett-Packard return ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
Hewlett Packard Beta
Price data - Jan 83 - Dec 87
R2 .49 B 1.33
Hewlett-Packard return ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
Hewlett Packard Beta
Price data - Jan 88 - Dec 92
R2 .45 B 1.70
Hewlett-Packard return ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
Hewlett Packard Beta
Price data - Jan 93 - Dec 97
R2 .35 B 1.69
Hewlett-Packard return ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
A T T Beta
Price data - Jan 78 - Dec 82
R2 .28 B 0.21
A T T ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
A T T Beta
Price data - Jan 83 - Dec 87
R2 .23 B 0.64
A T T ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
A T T Beta
Price data - Jan 88 - Dec 92
R2 .28 B 0.90
A T T ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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Measuring Betas
A T T Beta
Price data - Jan 93 - Dec 97
R2 ..17 B .90
A T T ()
Slope determined from 60 months of prices and
plotting the line of best fit.
Market return ()
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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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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 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.
• Example
• 1/3 New Ventures B2.0
• 1/3 Expand existing business B1.3
• 1/3 Plant efficiency B0.6
• 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)
IMPORTANT E, D, and V are all market values
requity rf Bequity ( rm - rf )
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Capital Structure COC
Expected Returns and Betas prior to refinancing
Expected return ()
Requity15
Rassets12.2
Rrdebt8
Bdebt
Bassets
Bequity
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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.
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Pinnacle West Corp.
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International Risk
Source The Brattle Group, Inc. s Ratio - Ratio
of standard deviations, country index vs. SP
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.

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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
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Asset Betas
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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?

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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 r f B(r m r f) 6 0.75 (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?
r r f B(r m r f) 6 0.75 (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?

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Risk,DCF and CEQ
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 5.4this can be
  considered the annual premium on a risky cash flow

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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?

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Risk,DCF and CEQ

• The prior example leads to a generic certainty
  equivalent formula.