1. 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

2. 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

3. 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 13 5.5 0 SML

4. 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

5. 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

6. 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

7. 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

8. 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

9. 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

10. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 10 McGraw-Hill/Irwin Asset Betas

11. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 11 McGraw-Hill/Irwin Asset Betas

12. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 12 McGraw-Hill/Irwin Risk,DCF and CEQ

13. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 13 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?

14. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 14 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?

15. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 15 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?

16. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 16 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?

17. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 17 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?

18. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 18 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. 79.7 = X / (1.06)^2 = 79.7 X (1.06^2)

19. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 19 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

20. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 20 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

21. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 21 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?

22. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 22 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

23. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 23 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.

24. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 24 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.

25. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 25 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV= 3.43 billion Yen

26. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 26 McGraw-Hill/Irwin Sensitivity Analysis Example - continued Possible Outcomes

27. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 27 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Calculations for Optimistic Market Size Scenario NPV= +5.7 bil yen

28. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 28 McGraw-Hill/Irwin Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

29. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 29 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 400 200 19.6 85 200 Break even NPV=0 PV Inflows PV Outflows

30. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 30 McGraw-Hill/Irwin Monte Carlo Simulation  Step 1: Modeling the Project  Step 2: Specifying Probabilities  Step 3: Simulate the Cash Flows Modeling Process

31. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 31 McGraw-Hill/Irwin Monte Carlo Simulation

32. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 32 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.

33. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 33 McGraw-Hill/Irwin Decision Trees NPV=0 Don’t test Test (Invest $200,000) Success Failure Pursue project NPV=$2million Stop project NPV=0

34. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 34 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) 812 456 660 364 148 +150(.6) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

35. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 35 McGraw-Hill/Irwin Chapter 9 Practice Problem

36. Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved 9- 36 McGraw-Hill/Irwin Chapter 9 Practice Problem- Solution