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Lu Yurong

Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers. Chapter 9. Capital Budgeting and Risk. Lu Yurong. McGraw Hill/Irwin. Topics Covered. Company and Project Costs of Capital Measuring the Cost of Equity Capital Structure and COC

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Lu Yurong

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

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

  4. Company Cost of Capital

  5. Company Cost of Capital • A company’s cost of capital can be compared to the CAPM required return 13 5.5 0 SML Required return Company Cost of Capital Project Beta 1.26

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

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

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

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

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

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

  13. 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. Company Cost of Capitalsimple 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. Company Cost of Capitalsimple 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. Capital Structure 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 )

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

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

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

  20. Union Pacific Corp.

  21. Union Pacific Corp. Example

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

  23. Asset Betas

  24. Asset Betas

  25. Risk,DCF and CEQ

  26. 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. 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. 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. 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. 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. 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. 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. 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. 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. Preparation for Next Class • Please read: • BM Chapter 10 , P259-284

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