Risk And Capital Budgeting

1. Risk And Capital Budgeting Professor XXXXX Course Name / Number

2. The numerator focuses on project cash flows, covered in chapter 8: The denominator is the discount rate, the focus of chapter 9. Reflect the opportunity costs of the firm’s investors. The denominator should: Reflect the project’s risk. • Be derived from market data. Choosing the Right Discount Rate

3. Project discount rate is easy to determine if we assume : Firm is financed with 100% equity. Project is similar to the firm’s existing assets. A Simple Case In this case, the appropriate discount rate equals the cost of equity. Cost of equity estimated using the CAPM

4. All Leather’s Cost of Equity All Leather Inc., an all-equity firm, is evaluating a proposal to build a new manufacturing facility. • Firm produces leather sofas. • As a luxury good producer, firm very sensitive to economy. • All Leather’s stock has a beta of 1.3. • Managers note Rf = 4%, expect the market risk premium will be 5%. E(Re ) = Rf + (E(Rm) - Rf) = 10.5% cost of equity

5. The mix of fixed and variable costs Operating leverage The extent to which a firm finances operations by borrowing Financial Leverage The fixed costs of repaying debt increase a firm’s beta in the same way that operating leverage does. Cost of Equity Beta plays a central role in determining whether a firm’s cost of equity is high or low. What factors influence a firm’s beta?

6. 44,000 sofas 44,000 sofas $41,800,000 $41,800,000 $36,400,000 $37,200,000 $5,400,000 $4,600,000 All Leather Inc. and Microfiber Corp. The two firms are in the same industry What if sales volume increases by 10% ? All Leather’s EBIT increases faster because it has high operating leverage.

7. Operating Leverage for All Leather and Microfiber: EBIT All Leather Microfiber Sales Other things equal, higher operating leverage means that All Leather’s beta will be higher than Microfiber’s beta.

8. The Effect of Leverage on Beta: Financial leverage makes Firm 2’s ROE more volatile, so its beta will be higher.

9. An example… • Comfy Inc builds houses. • Firm has $150 million equity (E), with cost of equity re= 12.5%. • Also has bonds (D) worth $50 million, with rd = 6.5% • Assume initially that there are no corporate taxes. The Weighted Average Cost of Capital (WACC) Cost of equity applies to projects of an all-equity firm. • But what if firm has both debt and equity? • Problem akin to finding expected return of portfolio • Use weighted average cost of capital (WACC) as discount rate:

10. Has 10,000,000 common shares; price = $15/share; re = 15%. An example.... Sherwin Co. Total value = 211.5 million Has 500,000 preferred shares, 8% coupon, price = $25/share, $12.5 million value. Has $40 million long term debt, fixed rate notes with 8% coupon rate, but 7% YTM. Notes sell at premium and worth $49 million. Finding WACC for Firms with Complex Capital Structures How do we calculate WACC if firm has long-term (D) debt as well as preferred (P) and common stock (E)?

11. Connecting the WACC to the CAPM WACC consistent with CAPM Can use CAPM to compute WACC for levered firm. • First find covariance between bonds and stock market. • Plug computed debt beta (d),Rfand Rm into CAPM to find rd. • Debt beta typically quite low for healthy, low-debt firms • Debt beta rises with leverage. Calculate beta for bonds of a large corporation: Any asset that generates a cash flow has a beta, and that beta determines its required return as per CAPM.

12. An asset beta is the covariance of the cash flows generated by a firm’s assets withRM, return on market portfolio, divided by variance of market’s return. • For all-equity firm, asset beta = equity beta. • For levered firm, asset beta will be less than equity beta (still assuming no taxes). • If asset beta known, anddebt beta is assumed to be 0, can compute equity beta directly from A: Calculating Asset Betas and Equity Betas The CAPM establishes direct link between required return on debt and equity and betas of these securities.

13. An example… • Assume GE is evaluating an investment in oil and gas industry. • GE would examine existing firms that are pure plays (public firms operating only in oil and industry). Discount Rate for Unique Projects What if a company has diversified investments in many industries? In this case, using firm’s WACC to evaluate an individual project would be inappropriate. Use project’s asset beta adjusted for desired leverage.

14. Berry Petroleum Forest Oil Stock beta 0.65 0.90 Fraction Debt 0.14 0.39 Fraction Equity 0.86 0.61 D/E ratio 0.16 0.64 Asset beta * 0.56 0.55 * Assumes debt beta = 0 and no taxes Data for Berry Petroleum and Forest Oil Say GE selects Berry Petroleum & Forest Oil as pure plays: Operationally similar firms, but Berry Petroleum’s E = 0.65 and Forest Oil’s E = 0.90 Why so different? Reason: Forest Oil uses debt for 39% of financing; Berry Petroleum: 14%.

15. Converting Equity Betas to Asset Betas for Two Pure Play Firms To determine correct A to use as discount rate for the project, GE must convert pure play E to A, then average. • Previous table lists data needed to compute unlevered equity beta. • Unlevered equity beta (same as A when taxes are zero) strips out effect of financial leverage, so always less than or equal to equity beta. • Berry’s A = 0.56, Forest’s A = 0.55, so average A = 0.55 • GE capital structure consists of 20% debt and 80% equity (D/E ratio = 0.25). Compute relevered equity beta:

16. Using CAPM, compute rate of return GE shareholders require for the oil and gas investment. • Assume risk-free rate of interest is 6% and expected risk premium on the market is 7%: • E(R) = 6% + 0.69(7%) = 10.83%. Converting Equity Betas to Asset Betas for Two Pure Play Firms • GE’s financing is 80% equity and 20% debt. Assume investors expect 6.5% on GE’s bonds: One more step to find the right discount rate for GE’s investment in this industry: calculate project WACC.

17. After-tax formula for equity beta changes to: • We are still assuming debt beta = 0. Accounting for Taxes • Have thus far assumed away taxes • Tax deductibility of interest payments favors use of debt. • Accounting for interest tax shields yields after-tax WACC. • βU is the beta of an unlevered firm. • Analogous to asset beta, but not strictly equal to βA due to taxes

18. Summary: Finding Discount Rate for Unique Projects 1) Identify pure play firms. 2) Calculate after-tax, unlevered betas for these firms and average them. 3) Relever beta to reflect the investing firm’s capital structure. 4) Plug relevered beta into CAPM to obtain re.. 5) Use re, rd, and capital structure weights to obtain after-tax project WACC.

19. A Closer Look at RiskBreak-Even Analysis Managers often want to assess business’ value drivers: Useful to assessing operating risk is finding break-even point. Break-even point is level of output where all operating costs (fixed and variable) are covered.

20. Sensitivity Analysis • Sensitivity analysis allows mangers to test importance of each assumption underlying a forecast. • Test deviations from “base case” and associated NPV. • Best Electronics Inc has new DVD players project. Base case assumptions (below) yields Exp NPV = $1,139,715. 1. The project’s life is five years. 2. The project requires an up-front investment of $41 million. 3. BEI will depreciate initial investment on S-L basis for five years. 4. One year from now, DVD industry will sell 3,000,000 units. 5. Total industry unit volume will increase by 5% per year. 6. BEI expects to capture 10% of the market in the first year. 7. BEI expects to increase its market share one percentage point each year after year one. 8. The selling price will be $100 in year one. 9. Selling price will decline by 5% per year after year one. 10. Variable production costs will equal 60% of the selling price. 11. The appropriate discount rate is 14 percent.

21. Sensitivity Analysis of DVD Project If all optimistic scenarios play out, project’s NPV rises to$37,635,010. If all pessimistic scenarios play out, project’s NPV falls to-$19,271,270!

22. Real Options in Capital Budgeting Option pricing analysis helpful in examining multi-stage projects Embedded options arise naturally from investment; Called real options to distinguish from financial options. Value of a project equals value captured by NPV, plus option. Can transform negative NPV projects into positive NPV!

23. Expansion options • If a product is a hit, expand production. Abandonment options • Can abandon a project if not successful. • Shareholders have valuable option to default on debt. Follow-on investmentoptions • Similar to expansion options, but more complex (Ex: movie rights to sequel) • Ability to use multiple production inputs (Ex: dual-fuel industrial boiler) or produce multiple outputs Flexibility options Real Options in Capital Budgeting

24. All-equity firms can discount their standard investment projects at cost of equity. Firms with debt and equity can discount their standard investment projects using WACC. WACC and CAPM are connected. Cost of debt and equity are driven by debt and equity betas. Use pure play equity betas when invest in unique projects. Risk And Capital Budgeting