Lecture 9 Capital Budgeting and Risk Managerial Finance FINA 6335 Ronald F. Singer

9-2 Topics Covered  Measuring Betas  Capital Structure and COC  Discount Rates for Intl. Projects  Estimating Discount Rates  Risk and DCF

9-3 Company Cost of Capital  A firm’s value can be stated as the sum of the value of its various assets.

9-4 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

9-5 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.

9-6 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) Hewlett-Packard return (%) R 2 =.53 B = 1.35

9-7 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) Hewlett-Packard return (%) R 2 =.49 B = 1.33

9-8 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) Hewlett-Packard return (%) R 2 =.45 B = 1.70

9-9 Measuring Betas Hewlett Packard Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) Hewlett-Packard return (%) R 2 =.35 B = 1.69

9-10 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 78 - Dec 82 Market return (%) A T & T (%) R 2 =.28 B = 0.21

9-11 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 83 - Dec 87 Market return (%) R 2 =.23 B = 0.64 A T & T (%)

9-12 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 88 - Dec 92 Market return (%) R 2 =.28 B = 0.90 A T & T (%)

9-13 Measuring Betas A T & T Beta Slope determined from 60 months of prices and plotting the line of best fit. Price data - Jan 93 - Dec 97 Market return (%) R 2 =..17 B =.90 A T & T (%)

9-14 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)

Capital Budgeting & Risk Modify CAPM (account for proper risk) Use COC unique to project, rather than Company COC Take into account Capital Structure

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.

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. 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

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

9-19 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

9-20 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

9-21 Pinnacle West Corp. R equity = r f + B ( r m - r f ) = (.08) =.0858 or 8.6% R debt = YTM on bonds = 6.9 %

9-22 Pinnacle West Corp.

9-23 Pinnacle West Corp.

9-24 International Risk Source: The Brattle Group, Inc.  Ratio - Ratio of standard deviations, country index vs. S&P composite index

9-25 Unbiased Forecast  Given three outcomes and their related probabilities and cash flows we can determine an unbiased forecast of cash flows.

9-26 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)

9-27 Asset Betas

9-28 Asset Betas

9-29 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?

9-30 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?

9-31 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 ) = (8) = 12 % r = r f + B(r m – r f ) = (8) = 12 %

9-32 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 ) = (8) = 12 % r = r f + B(r m – r f ) = (8) = 12 %

9-33 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?

9-34 Risk,DCF and CEQ Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.

9-35 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

9-36 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?

9-37 Risk,DCF and CEQ  The prior example leads to a generic certainty equivalent formula.