Hurdle rates for projects 04/23/07 Ch. 8

Project definition Project – any proposal that will result in the use of a firm’s resources extension of business, acquisitions, new lines, etc. The risks (to equity holders and debt holders) for projects should be determined by project-specific characteristics Project cash flows are defined by: Length of project, Initial and subsequent investments required, and Cash inflows generated by the project

Categorizing projects Project’s influence on other projects Project continuum Prerequisite Complimentary Independent Mutually Exclusive | | | | Cost-reducing or revenue-generating

Why not use firm’s cost of equity or capital to evaluate all projects? This will result in an over-investment in risky projects and an under-investment in safe projects. Ex., Ford has a cost of capital of 10% and is considering entering the software development industry. The rate of return it expects to earn on projects it undertakes is 13%. Should these projects be accepted?

Sources of equity risk for projects Equity risk for projects – actual project cash flows are different from what was expected. Type of risk: Causes: Project CF estimation errors Project-specific factors change Competitive Competitors’ actions affect project Industry Industry-specific factors change (all companies in industry affected) These include technology, legal, commodity risks International Political changes Currency expectation changes Market Changes in interest rate, inflation or economy

How can risk be reduced /eliminated, i.e., diversified away? By the firm: By undertaking a number of projects (project risk) By acquiring competitors (competitive risk) Legal issues? By acquiring companies in different industries (industry risk) Synergies? By investing in projects globally (international risk) May not be completely diversifiable By the investor: By holding a globally diversified portfolio, investors will be able to eliminate all by the market risk (and possibly some of the international risk)

Which risks should be included for project evaluation? Determining the types of risks that should be included on a specific company’s projects requires identifying the marginal investor in that company. The marginal investor can be identified as the type of investor that holds and trades significant portions of equity in the firm We can categorize this marginal investor as : an insider (founder or managers) who is an individual with significant equity holdings, individual investors with small equity holdings, or institutional investors.

Which risks should be included for project evaluation? We can determine the marginal investor by examining the top percentage holdings of the different types of investors of the firm, If the marginal investor is an insider, we may consider using a total risk measure. If the marginal investor is an institutional or individual investor, for our purposes, we can assume that they are fairly well diversified.

Estimating project cost of equity Single line business, homogenous projects Firm operates just one line of business and the projects adopted by the firm have the same level of risk Use firm’s beta (from a regression or bottom-up approach) to determine cost of equity The advantage of this approach is that it does not require risk estimation prior to each project evaluation

Estimating project cost of equity Multiple line business, homogeneous projects within each line OR new line In this case, the risk profile of the business is different across its business lines (new line) but adopted projects within a particular line have similar risk We must determine a separate cost of equity for the business line in which the project is Use bottom-up approach to estimating beta

Estimating project cost of equity Bottom-up beta estimation for multiple line companies (Pure Play Approach): Identify the business in which the division or project operates Find companies that are primarily involved in this business Compute a weighted-average unlevered beta for these companies Adjust for financial leverage Use weighted-average comparable firm’s financial leverage if divisional / project leverage is not specified.

Estimating project cost of debt Assessing default risk (and thus the cost of debt) for individual projects is usually very difficult as projects seldom borrow on their own. The method used to determine the appropriate cost of debt and the financing mix to be used to evaluate the project is based on: Size of project relative to the firm Cash flow characteristics of the project Whether the project is a stand-alone project

Project cost of debt / financing mix Project characteristics Cost of Debt Debt Ratio Small/CFs are similar to firm’s CFs Firm’s cost of debt Firm’s debt ratio Large/ CFs are different from firm’s CFs Comparable firm cost of debt Average debt ratio of comparable firms OR firm’s debt ratio Stand-alone projects* Cost of debt for project (can be based on synthetic ratings) Debt ratio for project *Projects that raise their own funds

Project cost of capital Estimate an appropriate cost of equity Estimate an appropriate cost of debt Calculate the weighted average cost of capital based on your estimates and an appropriate debt and equity mix

Accounting for project risk Adjust the cost of capital Adjust cash flows – in practice this is primarily done subjectively Problems with the latter approach Adjustment can vary depending on who is doing the analysis Risks that are diversifiable may be adjusted for There may be double adjustment of risks if the cost of capital is also adjusted. Risk adjustment techniques used: Subjective adjustment - 48% Cost of capital adjustment – 29% No adjustment – 14%

Chapter 8 sections NOT covered Certainty equivalents Coefficient of Variation