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Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.

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Presentation on theme: "Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk."— Presentation transcript:

1 Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk

2 9- 2 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Topics Covered  Company and Project Costs of Capital  Measuring the Cost of Equity  Capital Structure and COC  Discount Rates for Intl. Projects  Estimating Discount Rates  Risk and DCF

3 9- 3 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Company Cost of Capital  A firm’s value can be stated as the sum of the value of its various assets

4 9- 4 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Company Cost of Capital

5 9- 5 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

6 9- 6 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

7 9- 7 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas Dell Computer Slope determined from plotting the line of best fit. Price data – Aug 88- Jan 95 Market return (%) Dell return (%) R 2 =.11 B = 1.62

8 9- 8 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas Dell Computer Slope determined from plotting the line of best fit. Price data – Feb 95 – Jul 01 Market return (%) Dell return (%) R 2 =.27 B = 2.02

9 9- 9 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas General Motors Slope determined from plotting the line of best fit. Price data – Aug 88- Jan 95 Market return (%) GM return (%) R 2 =.13 B = 0.80

10 9- 10 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas General Motors Slope determined from plotting the line of best fit. Price data – Feb 95 – Jul 01 Market return (%) GM return (%) R 2 =.25 B = 1.00

11 9- 11 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas Exxon Mobil Slope determined from plotting the line of best fit. Price data – Aug 88- Jan 95 Market return (%) Exxon Mobil return (%) R 2 =.28 B = 0.52

12 9- 12 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Measuring Betas Exxon Mobil Slope determined from plotting the line of best fit. Price data – Feb 95 – Jul 01 Market return (%) Exxon Mobil return (%) R 2 =.16 B = 0.42

13 9- 13 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Beta Stability % IN SAME % WITHIN ONE RISK CLASS 5 CLASS 5 CLASS YEARS LATER YEARS LATER 10 (High betas) 35 69 9 18 54 8 16 45 7 13 41 6 14 39 5 14 42 4 13 40 3 16 45 2 21 61 1 (Low betas) 40 62 Source: Sharpe and Cooper (1972)

14 9- 14 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

15 9- 15 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

16 9- 16 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

17 9- 17 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

18 9- 18 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

19 9- 19 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Union Pacific Corp. R equity = Return on Stock = 15% R debt = YTM on bonds = 7.5 %

20 9- 20 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Union Pacific Corp.

21 9- 21 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Union Pacific Corp. Example

22 9- 22 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved International Risk Source: The Brattle Group, Inc.  Ratio - Ratio of standard deviations, country index vs. S&P composite index

23 9- 23 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Asset Betas

24 9- 24 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Asset Betas

25 9- 25 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Risk,DCF and CEQ

26 9- 26 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

27 9- 27 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

28 9- 28 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

29 9- 29 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

30 9- 30 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

31 9- 31 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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.

32 9- 32 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

33 9- 33 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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

34 9- 34 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved 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?

35 9- 35 McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved Preparation for Next Class  Please read:  BM Chapter 10, P259-284

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