Chapter 9 Principles of Corporate Finance Eighth Edition Capital Budgeting and Risk 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 9- 2 McGraw-Hill/Irwin Topics Covered  Company and Project Costs of Capital  Measuring the Cost of Equity  Setting Discount Rates w/o Beta  Certainty Equivalents  Discount Rates for International Projects

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 3 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- 4 McGraw-Hill/Irwin Company Cost of Capital

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 5 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- 6 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- 7 McGraw-Hill/Irwin Measuring Betas Dell Computer Slope determined from plotting the line of best fit. Price data: May 91- Nov 97 Market return (%) Dell return (%) R 2 =.10 B = 1.87

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 8 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- 9 McGraw-Hill/Irwin Measuring Betas General Motors Slope determined from plotting the line of best fit. Market return (%) GM return (%) R 2 =.07 B = 0.72 Price data: May 91- Nov 97

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Measuring Betas General Motors Slope determined from plotting the line of best fit. Market return (%) GM return (%) R 2 =.29 B = 1.21 Price data: Dec 97 - Apr 04

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Measuring Betas Exxon Mobil Slope determined from plotting the line of best fit. Market return (%) Exxon Mobil return (%) R 2 =.23 B = 0.57 Price data: May 91- Nov 97

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Measuring Betas Exxon Mobil Slope determined from plotting the line of best fit. Market return (%) Exxon Mobil return (%) R 2 =.18 B = 0.51 Price data: Dec 97 - Apr 04

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

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER 10 (High betas) (Low betas) Source: Sharpe and Cooper (1972)

Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 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 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 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 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 Capital Structure & COC Expected return (%) B debt B assets B equity R rdebt =8 R assets =12.2 R equity =15 Expected Returns and Betas prior to refinancing

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 100.

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 International Risk Source: The Brattle Group, Inc.  Ratio - Ratio of standard deviations, country index vs. S&P composite index