Chapter 9 Principles of Corporate Finance Eighth Edition Capital Budgeting and Risk Slides by Matthew Will, adopted by Craig Mayberry Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Week 6 Seminar Chapters 9 and 10

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 2 McGraw-Hill/Irwin Company Cost of Capital  A firm’s value can be stated as the sum of the value of its various assets

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 3 McGraw-Hill/Irwin Company Cost of Capital  A company’s cost of capital can be compared to the CAPM required return Required return Project Beta 1.26 Company Cost of Capital SML

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 4 McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 5 McGraw-Hill/Irwin Measuring Betas Dell Computer Slope determined from plotting the line of best fit. Price data: Dec 97 - Apr 04 Market return (%) Dell return (%) R 2 =.27 B = 1.61

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 6 McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 7 McGraw-Hill/Irwin 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 Company Cost of Capital simple approach

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 8 McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 9 McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Asset Betas

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Asset Betas

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Risk,DCF and CEQ

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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 = X / (1.06)^2 = 79.7 X (1.06^2)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 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?

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Chapter 10 Principles of Corporate Finance Eighth Edition A Project is Not A Black Box Slides by Matthew Will Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin How To Handle Uncertainty Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued Possible Outcomes

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Break Even Analysis  Point at which the NPV=0 is the break even point  Otobai Motors has a breakeven point of 85,000 units sold. Sales, 000’s PV (Yen) Billions Break even NPV=0 PV Inflows PV Outflows

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Monte Carlo Simulation  Step 1: Modeling the Project  Step 2: Specifying Probabilities  Step 3: Simulate the Cash Flows Modeling Process

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Monte Carlo Simulation

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes.  Decision trees help companies determine their Options by showing the various choices and outcomes.  The Option to avoid a loss or produce extra profit has value.  The ability to create an Option thus has value that can be bought or sold.

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) (.6) (.4) +100(.6) (.4) -550 NPV= NPV= * or NPV= NPV= NPV= NPV= Turboprop Piston

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Chapter 9 Practice Problem

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Chapter 9 Practice Problem- Solution