1. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-1 Chapter 12 Risk, Return, and Capital Budgeting

2. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-2 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.

3. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-3 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.

4. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-4 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?

5. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-5 Answer  Part 1. Cost of equity financing. The appropriate discount rate for projects of Wingmar is.04+.085(2)=.21.  Part 2. The NPV of the project is 4.2278533.  Take the project.

6. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-6 Chapter 12 Risk, Return, and Capital Budgeting  Determinants of the Cost of Equity Capital  Estimation of Beta  Financial leverage.

7. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-7 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

8. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-8 Cyclicality  Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.

9. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-9 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.

10. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-10 Beta Estimation  Problems  Betas may vary over time.  The sample size may be inadequate.  Solutions  More sophisticated statistical techniques.

11. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-11 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.

12. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-12 Financial leverage means debt  Equity beta for the firm’s shares.  Debt beta for the firm’s debt.  Asset beta for the physical firm.

13. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-13 The physical firm (the asset) is a portfolio  S = market value of equity (stock)  B = “ “ “ debt (bonds)  A = “ “ “ asset (firm)  Portfolio weights are

14. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-14 Beta of the (physical) firm  Beta of a portfolio is the weighted sum of the betas of the components.

15. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-15 Normally  Stock is risky  Debt is less risky  Asset is in between.

16. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-16 Weighted Average Cost of Capital

17. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-17 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

18. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-18 Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price -30-20-10 0+10+20+30 Days before (-) and after (+) announcement Efficient market response to “good news” Overreaction to “good news” with reversion Delayed response to “good news”

19. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-19 Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Days before (+) and after (-) announcement –30–20 –100+10 +20 +30 Efficient-market response to new information Delayed response Overreaction and reversion

20. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-20 Sets of Information relevant to a stock Past prices Publicly available information All information

21. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-21 Three Forms of Market Efficient Hypothesis  Weak  Prices reflect information in past prices  Random Walk  Semi-strong  Prices reflect publicly available information  Strong  Prices reflect all information

22. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-22 Implications for Corporate Financial Managers  Can financial managers “fool” investors?  Can financial managers “time” security sales?  Are there price pressure effects?

23. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-23 Some anomalies  Monday effects  Weekend effects  January effects  Small firm effects  Pre acquisition run-ups

24. Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 Corporate Finance Fifth Edition Ross Jaffe Westerfield.. 12-24 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.