Chapter 12 Risk, Return, and Capital Budgeting

Review Item  Yahoo is considering building a cafeteria for its employees.  At a high discount rate appropriate to Yahoo’s risk, the NPV of the cafeteria is negative.  At a low discount rate appropriate to a Wendy’s, the NPV of the cafeteria is positive.  Should Yahoo build the cafeteria?  Explain briefly.

Answer  Build the cafeteria.  The project is safe like a Wendy’s, not risky like an internet service.  NPV is market value.  The market it not deceived but sees the project for the safe investment that it is.

Example of beta and NPV  Wingmar Inc. has a beta of 2.  The Market risk premium is 8.5%  The risk-free rate is 4%.  Wingmar has a project with cash flows -100, 60, 80.  The project is typical of Wingmar’s core business.  Should the project be undertaken?

Answer  Part 1. Cost of equity financing. The appropriate discount rate for projects of Wingmar is (2)=.21.  Part 2. The NPV of the project is  Take the project.

Chapter 12 Risk, Return, and Capital Budgeting  Determinants of the Cost of Equity Capital  Estimation of Beta  Financial leverage.

The Cost of Equity  E(r s ) = R F +  s x [E(R M ) - R F ]  Business risk 1: Cyclicality of revenues  Business risk 2: Operating leverage.  Financial Leverage

Cyclicality  Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.

Operating leverage  Fixed cost of debt service, leases, employment contracts versus variable costs.  High operating leverage means high fixed costs. MRI labs.  Low leverage, low fixed cost. Fast food, services.  EBIT = earnings before interest and taxes. Assume depreciation = loss of market value.  EBITDA = earnings before interest, taxes, depreciation, or amortization, i.e., nearly cash flow.

Beta Estimation  Problems  Betas may vary over time.  The sample size may be inadequate.  Solutions  More sophisticated statistical techniques.

Beta Estimation  Problem: Beta for a firm is overly influenced by random factors peculiar to the firm.  Solution: Look at average beta estimates of several comparable firms in the industry.  Problem: Firms have financial leverage, which shouldn’t matter in NPV.  Solution: Adjust as follows.

Financial leverage means debt  Equity beta for the firm’s shares.  Debt beta for the firm’s debt.  Asset beta for the physical firm.

The asset is equivalent to a portfolio  S = market value of equity (stock)  B = “ “ “ debt (bonds)  A = “ “ “ asset (firm)  Portfolio weights are

Beta of the asset (the physical firm)  Beta of a portfolio is the weighted sum of the betas of the components.

Normally  Stock is risky  Debt is less risky  Asset is in between.

Weighted Average Cost of Capital

Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets  13.1 Can Financing Decisions Create Value?  13.2 A Description of Efficient Capital Markets  13.3 The Different Types of Efficiency

Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Days before (-) and after (+) announcement Efficient market response to “good news” Overreaction to “good news” with reversion Delayed response to “good news”

Sets of Information relevant to a stock Past prices Publicly available information All information

Forms of the Efficient Market Hypothesis  Weak  Prices reflect information in past prices  Random Walk  Semi-strong  Prices reflect publicly available information  Strong  Prices reflect all information

Implications for Corporate Financial Managers  Can financial managers “fool” investors?  Can financial managers “time” security sales?  Are there price pressure effects?

Some anomalies  Monday effects  Weekend effects  January effects  Small firm effects  Pre acquisition run-ups

Some explanations  Closing positions over the weekend.  ditto  Tax timing, annual reporting, data mining.  Trading with better informed quasi-insiders.  Information leaking out bit by bit.