Risk And Capital Budgeting

1
Risk And Capital Budgeting

• Professor XXXXX
• Course Name / Number

2
Choosing the Right Discount Rate
3
A Simple Case
In this case, the appropriate discount rate
equals the cost of equity.
Cost of equity estimated using the CAPM
4
All Leathers 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 Leathers 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
Cost of Equity
Beta plays a central role in determining whether
a firms cost of equity is high or low.
What factors influence a firms beta?
6
All Leather Inc. and Microfiber Corp.
The two firms are in the same industry
What if sales volume increases by 10 ?
All Leathers 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 Leathers beta will be higher than
Microfibers beta.
8
The Effect of Leverage on Beta
Financial leverage makes Firm 2s ROE more
volatile, so its beta will be higher.
9
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
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.
Calculate beta for bonds of a large corporation

• First find covariance between bonds and stock
  market.
• Plug computed debt beta (?d), Rf and Rm into
  CAPM to find rd.
• Debt beta typically quite low for healthy,
  low-debt firms
• Debt beta rises with leverage.

Any asset that generates a cash flow has a beta,
and that beta determines its required return as
per CAPM.
12
Calculating Asset Betas and Equity Betas
The CAPM establishes direct link between required
return on debt and equity and betas of these
securities.
13
Discount Rate for Unique Projects
What if a company has diversified investments in
many industries?
In this case, using firms WACC to evaluate an
individual project would be inappropriate.
Use projects asset beta adjusted for desired
leverage.
14
Data for Berry Petroleum and Forest Oil
Say GE selects Berry Petroleum Forest Oil as
pure plays
Operationally similar firms, but Berry
Petroleums ?E 0.65 and Forest Oils ?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.
• Berrys ?A 0.56, Forests ?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
Converting Equity Betas to Asset Betas for Two
Pure Play Firms
One more step to find the right discount rate
for GEs investment in this industry calculate
project WACC.

• GEs financing is 80 equity and 20 debt. Assume
  investors expect 6.5 on GEs bonds

17
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.

ßU is the beta of an unlevered firm. Analogous to
asset beta, but not strictly equal to ßA 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 firms
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 projects 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, projects
NPV rises to 37,635,010. If all pessimistic
scenarios play out, projects 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
Real Options in Capital Budgeting
24
Risk And Capital Budgeting
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.