1 Copyright 1996 by The McGraw-Hill Companies, Inc WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL...

1

Copyright 1996 by The McGraw-Hill Companies, Inc

WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING?

WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING?

MANY FIRMS USE OVERALL FIRM COST OF CAPITAL TO DISCOUNT CASH FLOWS FOR ALL NEW PROJECTS

WRONG IF NEW PROJECT MORE OR LESS RISKY THAN ITS EXISTING BUSINESS

EACH PROJECT SHOULD IN PRINCIPLE BE DISCOUNTED USING ITS OWN OPPORTUNITY COST OF CAPITAL

2


COMPANY COST OF CAPITAL AND

REQUIRED RETURN ON PROJECT

COMPANY COST OF CAPITAL AND

REQUIRED RETURN ON PROJECT

REQUIRED RETURN

PROJECT BETA

Company cost of capital

required return on projectSecurity market line showing

Average betaof firm's assets

3


COMPANY COST OF CAPITAL RULECOMPANY COST OF CAPITAL RULE

DUKE POWER HAS LOW RISK AND LOW COMPANY COST OF CAPITAL

MICROSOFT HAS HIGH RISK AND HIGH COMPANY COST OF CAPITAL

IF BOTH FIRMS USED THE COMPANY COST OF CAPITAL RULE TO EVALUATE THE SAME PROJECT, POSSIBLE THAT

– DUKE POWER WOULD ACCEPT THE PROJECT

– MICROSOFT WOULD REJECT THE PROJECT

WRONG!!

4


COMPANY COST OF CAPITAL RULECOMPANY COST OF CAPITAL RULE

WIDESPREAD USE OF A UNIFORM COST OF CAPITAL BY MANY COMPANIES IN EVALUATING PROJECTS

BUT MANY FIRMS DO REQUIRE DIFFERENT RETURNS FOR DIFFERENT CATEGORIES OF INVESTMENT– EXAMPLE ON NEXT SLIDE

5


CATEGORY DISCOUNT RATE

SPECULATIVE VENTURES 30%

NEW PRODUCTS 20%

EXPANSION OF 15% (company cost of capital)

EXISTING BUSINESS

COST IMPROVEMENT 10%KNOWN TECHNOLOGY

6


USING CAPM AND PROJECT USING CAPM AND PROJECT

MANY LARGE CORPORATIONS USE CAPM AND AN

ESTIMATE OF THE PROJECT TO ESTIMATE

PROJECT DISCOUNT RATE

EXPECTED PROJECT RETURN = rf + project (rm-

rf)

7


BEGIN WITH PROBLEMS IN MEASURING COMPANY

BEGIN WITH PROBLEMS IN MEASURING COMPANY

IS DIFFICULT TO MEASURE FOR INDIVIDUAL FIRM

BETTER ACCURACY BY LOOKING AT AVERAGE OF SIMILAR COMPANIES

– BUT FIRM’S BORROWING POLICIES AFFECTS ITS STOCK

– IBM AND DEC ARE NOT SIMILAR COMPANIES FOR PURPOSE OF ESTIMATING BECAUSE THEY USE DIFFERENT DEGREES OF LEVERAGE

8


MEASURING COMPANY MEASURING COMPANY

APPROPRIATE FOR ACROSS-THE-BOARD EXPANSION

COMPARE RETURN ON STOCK WITH MARKET RETURN

OVER 60-MONTH TIME PERIOD

– AT&T

– HEWLETT-PACKARD

SLOPE IS

VARIES BY PERIOD

ESTIMATES OF ARE PUBLISHED BY BROKERAGE

HOUSES AND ADVISORY SERVICES

9


ESTIMATING BETA

ESTIMATING BETA

RETURN ON SHARE

RETURN ON MARKET

+

Beta = .4

++

++ +

++++

++

+

+

++

+

++

+

++ +

++

+++

RETURN ON SHARE

RETURN ON MARKET

+

Beta = 1.6

++

+

+ +

++++

++

+

+

++

+

++

+

++ +

++

+

+

+

10


PFIZERPFIZER

WHICH IS THE BETTER ESTIMATE OF FOR PFIZER?

– PFIZER HAS A OF 1.02 WITH A STANDARD ERROR OF 0.14

– A MARKET VALUE-WEIGHTED INDUSTRY PORTFOLIO OF LARGE PHARMACEUTICAL COMPANIES HAS A OF 0.98 WITH A STANDARD ERROR OF 0.07

DIFFERENCE BETWEEN ESTIMATE OF COMPANY BETA AND INDUSTRY BETA IS PROBABLY NOISE

– UNLESS YOU HAVE REASON TO BELIEVE THAT PFIZER IS RISKIER THAN INDUSTRY AVERAGE

11


HOW CAPITAL STRUCTURE AFFECTS EXPECTED RETURNS

HOW CAPITAL STRUCTURE AFFECTS EXPECTED RETURNS

IF YOU OWN ALL OF THE EQUITY AND ALL OF THE

DEBT OF A COMPANY, YOU WOULD ALSO

RECEIVE ALL CASH FLOWS FROM THE COMPANY

COMPANY’S COST OF CAPITAL IS EXPECTED

RETURN ON THIS PORTFOLIO

12


HOW CHANGING CAPITAL STRUCTURE AFFECTS


AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED – BUT BOTH DEBT AND EQUITY ARE

INDIVIDUALLY LESS RISKYFIRM’S ASSET BETA IS WEIGHTED AVERAGE OF

PORTFOLIO OF DEBT AND EQUITY BETAS assets portfolio

DV

EV

debt equity

13




AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED – BUT BOTH DEBT AND EQUITY ARE INDIVIDUALLY

LESS RISKYFIRM’S ASSET BETA IS WEIGHTED AVERAGE OF

PORTFOLIO OF DEBT AND EQUITY BETAS

SUPPOSE debt FALLS TO .1

.8 = (.3 X .1) + (.7 X equity )

equity = 1.1

assets portfolio

DV

EV

debt equity

14


UNLEVERING BETASUNLEVERING BETAS

GOING FROM AN OBSERVED equity TO assets

WE KNOW equity

debt

MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)

assets portfolio

DV

EV

debt equity

15


UNLEVERING BETASUNLEVERING BETAS

GOING FROM AN OBSERVED equity TO assets

WE KNOW equity

debt

MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)

WE WILL ADD TAX EFFECTS LATER

assets portfolio

DV

EV

debt equity

16


REVIEWREVIEW

COST OF CAPITAL IS RELEVANT IN CAPITAL BUDGETING DECISIONS– NOT EXPECTED RETURN ON COMMON STOCK

COMPANY COST OF CAPITAL IS WEIGHTED AVERAGE RETURN THAT INVESTORS EXPECT ON FIRM’S DEBT AND EQUITY– RELATED TO FIRM’S ASSET BETA, NOT TO EQUITY BETA

ASSET BETA CALCULATED AS WEIGHTED AVERAGE OF BETAS OF DEBT AND EQUITY

WHEN FIRM CHANGES ITS CAPITAL STRUCTURE– RISK AND EXPECTED RETURNS OF DEBT AND EQUITY

CHANGE– ASSET BETA AND COMPANY COST OF CAPITAL DO

NOT CHANGE

17


WHAT DETERMINES ASSET BETAS?WHAT DETERMINES ASSET BETAS?

FIRMS WITH HIGH ACCOUNTING OR CASH

FLOW BETAS ALSO TEND TO HAVE HIGH STOCK

BETAS

– CYCLICAL FIRMS WHOSE EARNINGS ARE

STRONGLY RELATED TO THE BUSINESS

CYCLE TEND TO BE HIGH BETA FIRMS

DEMAND A HIGHER RATE OF RETURN FROM

SECURITIES WHOSE PERFORMANCE MOVES

WITH THE ECONOMY

18


OPERATING LEVERAGEOPERATING LEVERAGE

WE KNOW FINANCIAL LEVERAGE INCREASES BETA

FOR SIMILAR REASONS, OPERATING LEVERAGE

ALSO INCREASES BETA

– PRESENCE OF FIXED COSTS OF PRODUCTION CASH FLOWS FROM THE ASSET

= REVENUES - FIXED COST - VARIABLE COST

PV(CASH FLOWS FROM THE ASSET) = PV(ASSET)

=PV(REVENUE) - PV(FIXED COST) - PV(VARIABLE

COST)

PV(REVENUE)

=PV(FIXED COST) + PV(VARIABLE COST) + PV(ASSET)

19


OPERATING LEVERAGEOPERATING LEVERAGEFIXED COST = 0

ALSO REVENUES VARIABLE COST

– AS THEY ARE BOTH PROPORTIONAL TO OUTPUT

REVENUEASSET

[1PV(FIXED COST)

PV(ASSET)]REVENUE

PV(REVENUE) -PV(FIXED COST)PV(ASSET)

20


NET PRESENT VALUE RULENET PRESENT VALUE RULE

WHY DOES THE NPV OF A PROJECT SHOW UP AS INCREASE IN MARKET VALUE?

IMAGINE THE CASH FLOWS OF THE PROJECT ARE PAID OUT AS DIVIDENDS

THE SHARE PRICE WOULD INCREASE BY THE PRESENT VALUE OF THE DIVIDENDS LESS THE COST OF THE PROJECT (DIVIDENDS FOREGONE) THIS IS THE NPV OF THE PROJECT

21


INTERNAL RATE OF RETURN, IRR

INTERNAL RATE OF RETURN, IRR

CC C C

01 2

2T

T(1 IRR) (1 IRR)....

(1 IRR)0

NPV

=

IRR IS THE DISCOUNT RATE FOR WHICH NPV=0

22


CALCULATING IRRCALCULATING IRR

FINANCIAL CALCULATOR .

TRIAL AND ERROR

– EXAMPLE: C0 = - 4,000

C1 = +2,000

C3 = +4,000

TRY IRR = 0, NPV = +2,000, IRR > 0

TRY IRR = 50%, NPV = - 889, IRR < 50

TRY IRR = 25%, NPV = +160, IRR >25

TRY IRR = 28%, NPV = 0

23


IRR = 28%

+2

0

-1

50DISCOUNTRATE (%)

NPV

NET PRESENT VALUE PROFILE

C0 = - 4

C1 = +2

C3 = +4

24


INTERNAL RATE OF RETURN RULEINTERNAL RATE OF RETURN RULE

ACCEPT PROJECT

IF IRR IS GREATER THAN

THE OPPORTUNITY COST OF

CAPITAL

ACCEPT PROJECT

IF IRR IS GREATER THAN

THE OPPORTUNITY COST OF

CAPITAL

LOOKING AT THE NET PRESENT VALUE PROFILE

FOR A CONVENTIONAL PROJECT,

WE WILL BE ACCEPTING PROJECTS

WITH POSITIVE NPV

25


CONVENTIONAL PROJECTCONVENTIONAL PROJECT

CASH OUTFLOWS FOLLOWED BY CASH INFLOWS

NPV DECLINES WITH INCREASING DISCOUNT RATES

26


WARNINGWARNING

DISTINGUISH BETWEEN IRR AND OPPORTUNITY COST OF CAPITAL

– BOTH APPEAR AS DISCOUNT RATES IN NPV FORMULA.

IRR IS A MEASURE OF PROFITABILITY, DEPENDS ON AMOUNT AND TIMING OF CASH FLOWS

OPPORTUNITY COST OF CAPITAL MEASURES WHAT WE COULD EARN BY INVESTING IN FINANCIAL ASSETS OF SIMILAR RISK

– SET BY CAPITAL MARKETS

– IT IS A COST OF FINANCING THE PROJECT

– IT PROVIDES US WITH A MINIMUM ACCEPTABLE LEVEL OF PROFITABILITY

27


NPV Year: 0 1 IRR(%) At 10% ($)

A -1,000 +1,500 +50 +364 B +1,000 -1,500 +50 +364

NPV Year: 0 1 IRR(%) At 10% ($)

A -1,000 +1,500 +50 +364 B +1,000 -1,500 +50 +364

BOTH PROJECTS HAVE IRR OF 50%

NPV PROFILE FOR PROJECT B INCREASES

WITH INCREASING DISCOUNT RATES

ACCEPT PROJECT B WHEN IRR IS LESS THAN

THE OPPORTUNITY COST OF CAPITAL

LENDING OR BORROWING?

28


MULTIPLE RATES OF RETURNMULTIPLE RATES OF RETURN

DESCARTES’ RULE OF SIGNS SAYS THERE ARE AS THERE ARE CHANGES IN SIGN

– BUT SOME OF THE ROOTS MAY BE THE SAME!

OFTEN HAVE CASH OUTCASH OUTFLOWS FROM INITIAL INVESTMENT,

FOLLOWED BY POSITIVE CASH FLOWS DURING PROJECT LIFE, FOLLOWED BY CASH OUTFLOWS AT END OF PROJECT

LIFE– DECOMMISSIONING COSTS OF NUCLEAR POWER PLANT

– RECLAMATION COSTS AFTER STRIPMINING COAL

– DELAY BETWEEN EARNING INCOME AND PAYING TAX

29



Year: 0 1 2 IRR NPV @ 10 C -4 +25 -25 25% & 400% -1.9

TWO CHANGES IN SIGN OF CASH FLOWS

TWO INTERNAL RATES OF RETURN

r < 25%, NPV < 0

30



Year: 0 1 2 IRR NPV @ 10 C -4 +25 -25 25% & 400% -1.9

TWO CHANGES IN SIGN OF CASH FLOWS

TWO INTERNAL RATES OF RETURN

r < 25%, NPV < 0

25% < r < 400%, NPV > 0

ACCEPT PROJECT

31


IRR MAY GIVE THE WRONG DECISION WITH MUTUALLY

EXCLUSIVE PROJECTS WHICH DIFFER IN:



SCALEPATTERN OF CASH FLOWS OVER TIME

– COMPARE PROJECTS G AND H

0 1 2 3 4 5

IRR NPV @ 10% -9 +6 +5 +4

0 0 ........ 33% 3,592 -9 +1.8

+1.8 +1.8 +1.8 +1.8...... 20% 9,000

G

H

32






SCALEPATTERN OF CASH FLOWS OVER TIME

– COMPARE PROJECTS G AND H 0

1 2 3 4 5 IRR NPV @ 10% -9

+6 +5 +4 0 0 ........ 33% 3,592 -9

+1.8 +1.8 +1.8 +1.8 +1.8...... 20% 9,000

-6 +1.2 +1.2 +1.2 +1.2...... 20% 6,000

PROJECT H HAS HIGHER NPV THAN PROJECT G – BUT LOWER IRR

G

H

I

33


H

G

33.3

15.6

20

NPV($)

DISCOUNT RATE

6,000

34


MUTUALLY EXCLUSIVE PROJECTSMUTUALLY EXCLUSIVE PROJECTS

PROJECT G HAS IRR OF 33%PROJECT H HAS IRR OF 20%NPVG = NPVH AT CROSSOVER POINT OF 15.6%CASH FLOWS OF PROJECT H ARE LARGER BUT

OCCUR LATER – FOR DISCOUNT RATES < 15.6%, PROJECT H

HAS HIGHER NPV– FOR DISCOUNT RATES > 15.6%, PROJECT G

HAS HIGHER NPV

35


Real OptionsReal Options

36


Topics CoveredTopics Covered

Sensitivity Analysis Break Even Analysis Monte Carlo Simulation Decision Trees

37


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.

38


Monte Carlo SimulationMonte Carlo Simulation

Step 1: Modeling the Project Step 2: Specifying Probabilities Step 3: Simulate the Cash Flows

Modeling Process

39


Decision TreesDecision Trees

960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

+150(.6)

+30(.4)

+100(.6)

+50(.4)

-550

NPV= ?

-250

NPV= ?

-150

0

or

Turboprop

Piston

40



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

+150(.6)

+30(.4)

+100(.6)

+50(.4)

-550

NPV= ?

-250

NPV= ?

-150

0

or

812

456

660

364

148

Turboprop

Piston

41



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

+150(.6)

+30(.4)

+100(.6)

+50(.4)

-550

NPV= ?

-250

NPV= ?

-150

0

or

812

456

660

364

148 81220.22080.960

Turboprop

Piston

42



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

-550

NPV= ?

-250

NPV= ?

-150

0

or

812

456

660

364

148

+150(.6)

+30(.4)

+100(.6)

+50(.4)

*450

331

45015010.1

660 450150

10.1

660Turboprop

Piston

43



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

-550

NPV= ?

-250

NPV= ?

-150

0

or

812

456

660

364

148

+150(.6)

+30(.4)

+100(.6)

+50(.4)

NPV=444.55

NPV=888.18

NPV=550.00

NPV=184.55

*450

331

18.88815010.1

812 18.888150

10.1

812

Turboprop

Piston

44



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

812

456

660

364

148

+150(.6)

710.73

+30(.4)

+100(.6)

403.82

+50(.4)

-150

0

*450

331

or

NPV=444.55

NPV=888.18

NPV=550.00

NPV=184.55

-550

NPV= ?

-250

NPV= ?

40.55.44460.18.888 40.55.44460.18.888

Turboprop

Piston

45



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

812

456

660

364

148

+150(.6)

710.73

+30(.4)

+100(.6)

403.82

+50(.4)

-550

NPV=96.12

-250

NPV=117.00

-150

0

*450

331

or

NPV=444.55

NPV=888.18

NPV=550.00

NPV=184.55

12.9655010.1

73.710 12.96550

10.1

73.710

Turboprop

Piston

46



960 (.8)

220(.2)

930(.4)

140(.6)

800(.8)

100(.2)

410(.8)

180(.2)

220(.4)

100(.6)

812

456

660

364

148

+150(.6)

710.73

+30(.4)

+100(.6)

403.82

+50(.4)

-550

NPV=96.12

-250

NPV=117.00

-150

0

*450

331

or

NPV=444.55

NPV=888.18

NPV=550.00

NPV=184.55

Turboprop

Piston

1 Copyright 1996 by The McGraw-Hill Companies, Inc WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL...

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Transcript of 1 Copyright 1996 by The McGraw-Hill Companies, Inc WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL...