Remember use:

1
Remember use Incremental Cash Flows

• Discount incremental cash flows
• Include All Indirect Effects
• Forget Sunk Costs
• Include Opportunity Costs
• Beware of Allocated Overhead Costs

2
Sequence of Firm Decisions

• Capital Budget - The list of planned investment
  projects.
• The Decision Process
• 1 - Develop and rank all investment projects
• 2 - Authorize projects based on
• Govt regulation
• Production efficiency
• Capacity requirements
• NPV (most important)

3
Capital Budgeting Process

• Capital Budgeting Problems
• Consistent forecasts
• Conflict of interest
• Forecast bias
• Selection criteria (NPV and others)

4
How To Handle Uncertainty
Sensitivity Analysis - Analysis of the effects of
changes in sales, costs, etc. on a
project. Scenario Analysis - Project analysis
given a particular combination of
assumptions. Simulation Analysis - Estimation of
the probabilities of different possible
outcomes. Break Even Analysis - Analysis of the
level of sales (or other variable) at which the
company breaks even.
5
Sensitivity Analysis
Example Given the expected cash flow forecasts
listed on the next slide, determine the NPV of
the project given changes in the cash flow
components using an 8 cost of capital. Assume
that all variables remain constant, except the
one you are changing.
6
Sensitivity Analysis
Example - continued
NPV 478
7
Sensitivity Analysis
Example - continued Possible Outcomes
8
Sensitivity Analysis
Example - continued NPV Calculations for
Pessimistic Investment Scenario
NPV (121)
9
Sensitivity Analysis
Example - continued NPV Possibilities
10
Break Even Analysis
Example Given the forecasted data on the next
slide, determine the number of planes that the
company must produce in order to break even, on
an NPV basis. The companys cost of capital is
10.
11
Break Even Analysis
12
Break Even Analysis
Answer The break even point, is the of Planes
Sold that generates a NPV0. The present
value annuity factor of a 6 year cash flow at 10
is 4.355 Thus,
13
Break Even Analysis
Answer Solving for Planes Sold
14
Flexibility Options

• Decision Trees - Diagram of sequential decisions
  and possible outcomes.
• Decision trees help companies determine their
  Options by showing the various choices and
  outcomes.
• The Option to avoid a loss or produce extra
  profit has value.
• The ability to create an Option thus has value
  that can be bought or sold.

15
Decision Trees
Success
Test (Invest 200,000)
Pursue project NPV2million
Failure
Stop project NPV0
Dont test
NPV0
16
Decision Tree Example

• You invest in a dot com company.
• At the start of each year for 3 years, it
  requires 1 million to continue.
• The future value of a successful dot.com in at
  the beginning of the 4th year is 10 million.
• Each year it has a 50 of surviving.
• What is the NPV of this investment at r.1?

17
You want to be a millionaire

• You have no life-lines and are risk neutral. For
  simplicity assume if you answer wrong you get 0.
  
• If your are at 500,000, at what certainty would
  you guess for the million?
• Given your previous answer. Before seeing the
  question your certainty of answering correctly
  the 500,000 is either 25 or 75 with equal
  chance.
• At what certainty at 250,000, would you go for
  it?

18
Risk

• Rates of Return
• 73 Years of Capital Market History
• Measuring Risk
• Risk Diversification
• Thinking About Risk

19
The value of a 1 investment in 19266
Index
Year End
Source Ibbotson Associates
20
Rates of Return
Percentage Return
Year
Source Ibbotson Associates
21
Expected Return
22
Equity Premium Puzzle.

• In 1985, a pair of economists, Rajnish Mehra and
  Edward Prescott, examined almost a century of
  returns for American shares and bonds. After
  adjusting for inflation, equities had made
  average real returns of around 7 a year, compared
  with only 1 for Treasury bonds-a 6 point equity
  premium. Given that shares are riskier (in the
  sense that their prices bounce around more) there
  should have been some premium. But theory
  suggested it should not have been much more than
  1 point. The extra five points seemed
  redundant--evidence of some inexplicable market
  inefficiency

23
Measuring Risk
Variance - Average value of squared deviations
from mean. A measure of volatility. Standard
Deviation Square-Root of Variance. A measure
of volatility.
24
Measuring Risk
Coin Toss Game-calculating variance and standard
deviation
25
Risk and Diversification
Diversification - Strategy designed to reduce
risk by spreading the portfolio across many
investments. Unique Risk - Risk factors affecting
only that firm. Also called diversifiable
risk. Market Risk - Economy-wide sources of risk
that affect the overall stock market. Also
called systematic risk.
26
Risk and Diversification
27
Risk and Diversification
What does this tell you about mutual funds (unit
trusts)?
28
Topics Covered

• Measuring Beta
• Portfolio Betas
• CAPM and Expected Return
• Security Market Line
• Capital Budgeting and Project Risk

29
Measuring Market Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market index,
such as the SP Composite, is used to represent
the market. Beta - Sensitivity of a stocks
return to the return on the market portfolio.
30
Measuring Market Risk
Example - Turbo Charged Seafood has the following
returns on its stock, relative to the listed
changes in the return on the market portfolio.
The beta of Turbo Charged Seafood can be derived
from this information.
31
Measuring Market Risk
Example - continued
32
Measuring Market Risk
Example - continued

• When the market was up 1, Turbo average change
  was 0.8
• When the market was down 1, Turbo average
  change was -0.8
• The average change of 1.6 (-0.8 to 0.8) divided
  by the 2 (-1.0 to 1.0) change in the market
  produces a beta of 0.8.
• Beta is a measure of risk with respect to the
  market (covariance). Can be additional risk!
• Betting on Israel vs. Austria WC game.

33
Measuring Market Risk
Example - continued
34
Portfolio Betas

• Diversification decreases variability from unique
  risk, but not from market risk.
• The beta of your portfolio will be an average of
  the betas of the securities in the portfolio.
• If you owned all of the SP Composite Index
  stocks, you would have an average beta of 1.0

35
Measuring Market Risk
Market Risk Premium - Risk premium of market
portfolio. Difference between market return and
return on risk-free Treasury bills.
36
Measuring Market Risk
Market Risk Premium - Risk premium of market
portfolio. Difference between market return and
return on risk-free Treasury bills.
Market Portfolio
37
Measuring Market Risk
CAPM - Theory of the relationship between risk
and return which states that the expected risk
premium on any security equals its beta times the
market risk premium.
38
Measuring Market Risk
Security Market Line - The graphic representation
of the CAPM.
39
Problems with CAPM

• Plotting average return vs. Beta, a zero Beta
  beats Risk-free rate.
• Short term doesnt do so well.
• Unstable Betas.
• Tough to test. Will the real market portfolio
  stand up?
• Beta is not a very good predictor of future
  returns.

However, Jagannathan Wang do find support with
adjustments.
40
Capital Budgeting Project Risk

• The project cost of capital depends on the use to
  which the capital is being put. Therefore, it
  depends on the risk of the project and not the
  risk of the company.

41
Capital Budgeting Project Risk
Example - Based on the CAPM, ABC Company has a
cost of capital of 17. (4 1.3(10)). A
breakdown of the companys investment projects is
listed below. When evaluating a new dog food
production investment, which cost of capital
should be used? 1/3 Nuclear Parts Mfr..
B2.0 1/3 Computer Hard Drive Mfr.. B1.3 1/3 Dog
Food Production B0.6
42
Capital Budgeting Project Risk
Example - Based on the CAPM, ABC Company has a
cost of capital of 17. (4 1.3(10)). A
breakdown of the companys investment projects is
listed below. When evaluating a new dog food
production investment, which cost of capital
should be used? R 4 0.6 (14 - 4 ) 10
10 reflects the opportunity cost of capital on
an investment given the unique risk of the
project.
You should use this value in computing that
projects NPV!!
43
Wait a second!

• A project has a NPV10,000 when r.05 and a
  NPV-10,000 when r.1 and the company can borrow
  at 5. Why shouldnt the company invest even if
  the cost of capital is 10 because of a beta?
• Shouldnt a project that is risky but has Beta0
  be considered worse than a project that is safe
  and has Beta0?