1. Last Study Topics Capital structure and COC Measuring the Cost of Equity

2. Today’s Study Topics Discount Rates for International Projects International Risk Asset Beta Risk, DCF and CEQ

3. DISCOUNT RATES FOR INTERNATIONAL PROJECTS Foreign Investments Are Not Always Riskier; Table 2 shows estimated betas for the Egyptian market and for markets in Poland, Thailand, and Venezuela. The standard deviations of returns in these markets were two or three times more than the U.S. market, but only Thailand had a beta greater than 1.

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

5. Continue The reason is low correlation. – For example, the standard deviation of the Egyptian market was 3.1 times that of the Standard and Poor’s index, but the correlation coefficient was only.18. – The beta was 3.1 x 0.18 =.55.

6. Understanding Table doesn’t prove that investment abroad is always safer than at home. But it should remind you always to distinguish between diversifiable and market risk. The opportunity cost of capital should depend on market risk.

7. DISCOUNT RATES FOR INTERNATIONAL PROJECTS Foreign Investment; Suppose that the Swiss pharmaceutical company, Roche, is considering an investment in a new plant near Basel in Switzerland. Since the project is risky, the company requires a higher return than the Swiss franc interest rate. – First measures the risk of the investment by estimating Roche’s beta and the beta of other Swiss pharmaceutical companies in that country.

8. Continue Beta of 1.1 and that the expected risk premium on the Swiss market index is 6%. Then Roche needs to discount the Swiss franc cash flows from its project at 1.1 x 6 = 6.6%. – calculates these betas relative to the Swiss market index. What if the project chooses to be in other country than Swiss? What would be the possible affect on the discount rate under this circumstances?

9. Understanding Risk cannot be considered in isolation; it depends on the other securities in the investor’s portfolio. Beta measures risk relative to the investor’s portfolio. For example, you can now buy funds that specialize in investment in emerging capital markets such as Vietnam, Peru, or Hungary.

10. Continue As investors increase their holdings of overseas stocks, it becomes less appropriate to measure risk relative to the domestic market and more important to measure the risk of any investment relative to the portfolios that they actually hold.

11. SETTING DISCOUNT RATES WHEN YOU CAN’T CALCULATE BETA What should a manager do if the asset has no such convenient price record? What if the proposed investment is not close enough to business as usual to justify using a company cost of capital? – These cases clearly call for judgment.

12. Continue For managers making that kind of judgment, we offer two pieces of advice. – 1. Avoid fudge factors. Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment. Adjust cash-flow forecasts first.

13. Example Project Z will produce just one cash flow, forecasted at $1 million at year 1. It is regarded as average risk, suitable for discounting at a 10% company cost of capital. – P.V = = $909,100

14. Continue The most likely outcome is $1 million, But you also see some chance that project Z will generate zero cash flow next year. Also, new worry is the ‘Technology’. – There is some discount rate (10% plus a fudge factor) that will give the right value, but we don’t know what that adjusted discount rate is?

15. Continue For many projects, the most likely cash flow is also the unbiased forecast. If there are three possible outcomes with the probabilities shown below, the unbiased forecast is $1 million.

16. Continue This might describe the initial prospects of project Z. But if technological uncertainty introduces a 10 percent chance of a zero cash flow, the unbiased forecast could drop to $900,000:

17. Continue Now, recalculate the PV, – PV = = $818,000

18. Continue – 2. Think about the determinants of asset betas. Often the characteristics of high and low-beta assets can be observed when the beta itself cannot be. Cyclicality, Many people intuitively associate risk with the variability of book, or accounting, earnings. But much of this variability reflects unique or diversifiable risk.

19. Continue What really counts is the strength of the relationship between the firm’s earnings and the aggregate earnings on all real assets. We can measure this either by the accounting beta or by the cash-flow beta. – Firms with high accounting or cash-flow betas should also have high stock betas—and the prediction is correct.

20. Continue This means that cyclical firms—firms whose revenues and earnings are strongly dependent on the state of the business cycle—tend to be high-beta firms. – Thus you should demand a higher rate of return from investments whose performance is strongly tied to the performance of the economy.

21. Continue Operating Leverage, We have already seen that financial leverage increases the beta of an investor’s portfolio. Those who receive the fixed costs are like debt holders in the project; they simply get a fixed payment. – Those who receive the net cash flows from the asset are like holders of common stock; they get whatever is left after payment of the fixed costs.

22. Asset Betas How the asset’s beta is related to the betas of the values of revenue and costs?

23. Asset Betas The betas of the revenues and variable costs should be approximately the same, because they respond to the same underlying variable, the rate of output. Therefore, we can substitute Beta variable cost and solve for the asset beta. Remember that Beta fixed cost = 0.

24. Continue Thus, given the cyclicality of revenues (reflected in Beta revenue ), the asset beta is proportional to the ratio of the present value of fixed costs to the present value of the project.

25. Continue Other things being equal, the alternative with the higher ratio of fixed costs to project value will have the higher project beta. – Empirical tests confirm that companies with high operating leverage actually do have high betas.

26. ANOTHER LOOK AT RISK AND DISCOUNTED CASH FLOW In practical capital budgeting, a single discount rate is usually applied to all future cash flows. – Among other things, the use of a constant discount rate assumes that project risk does not change. This can’t be strictly true, for the risks to which companies are exposed are constantly shifting. It involves converting the expected cash flows to certainty equivalents.

27. Continue We will first explain what certainty equivalents are. Then we will use this knowledge to examine when it is reasonable to assume constant risk. – You are considering construction of an office building that you plan to sell after one year for $400,000. – Since that cash flow is uncertain, you discount at a risk-adjusted discount rate of 12% rather than the 7% risk-free rate of interest.

28. Continue This gives a present value of – PV = 400,000/1.12 = $357,143 Suppose a real estate company offers to fix the price at which it will buy the building from you at the end of the year, – PV = Certain Cash Flow / 1.07 = $357,143 Certain Cash Flow=$382,143

29. Understanding A certain cash flow of $382,143 has exactly the same present value as an expected but uncertain cash flow of $400,000. – The cash flow of $382,143 is therefore known as the certainty-equivalent cash flow. Compensation for uncertainty in-terms of returns is equal to; = $400,000-$357,143 = $42,857 To get rid of the risk, take a cut in the return of; = $400,000 - $382,143 = $17,857

30. Continue Method 1: Discount the risky cash flow at a risk-adjusted discount rate r that is greater than r f. – The risk-adjusted discount rate adjusts for both time and risk. Method 2: Find the certainty-equivalent cash flow and discount at the risk-free interest rate r f.

31. Risk,DCF and CEQ This is called the certainty equivalent of C1 denoted by CEQ 1. Since CEQ 1 is the value equivalent of a safe cash flow, it is discounted at the risk-free rate.

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?

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?

34. 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?

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?

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?

37. 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.

38. 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

39. 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

40. 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?

41. Summary Discount Rates for International Projects International Risk Asset Beta Risk, DCF and CEQ