Capital Budgeting and Risk презентация

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

Company Cost of Capital
A firm’s value can be stated as the sum of the value of its various assets

Company Cost of Capital

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

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

Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
Dell return (%)
R2 = .11
B = 1.62

Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Dell return (%)
R2 = .27
B = 2.02

Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
GM return (%)
R2 = .13
B = 0.80

Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
GM return (%)
R2 = .25
B = 1.00

Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
Exxon Mobil return (%)
R2 = .28
B = 0.52

Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Exxon Mobil return (%)
R2 = .16
B = 0.42

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)

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 = rf + B ( rm - rf )
becomes
Requity = rf + B ( rm - rf )
Capital Structure

Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
Bassets = Bdebt (D) + Bequity (E)
(V) (V)
requity = rf + Bequity ( rm - rf )
IMPORTANT
E, D, and V are all market values

Capital Structure & COC
Expected return (%)
Bdebt
Bassets
Bequity
Rrdebt=8
Rassets=12.2
Requity=15
Expected Returns and Betas prior to refinancing

Union Pacific Corp.
Requity = Return on Stock
= 15%
Rdebt = YTM on bonds
= 7.5 %

Union Pacific Corp.

Union Pacific Corp.
Example

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

Asset Betas

Asset Betas

Risk,DCF and CEQ

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?

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?

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?

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?

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?

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.

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

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