Capital Budgeting & Risk Invest in highest NPV project Need Discount rate to get NPV.
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Transcript of Capital Budgeting & Risk Invest in highest NPV project Need Discount rate to get NPV.
Capital Budgeting & Risk
Invest in highest NPV project
Need Discount rate to get NPV
Capital Budgeting & Risk
Invest in highest NPV project
Need Discount rate to get NPV
Use CAPM to get discount rate
Capital Budgeting & Risk
Invest in highest NPV project
Need Discount rate to get NPV
Use CAPM to get discount rate
Modify CAPM (account for proper risk)
Capital Budgeting & Risk
Modify CAPM (account for proper risk)
• Use COC unique to project, rather than Company COC
• Take into account Capital Structure
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
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
• 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 )
Capital Structure
Capital Structure
COC = rportfolio = rassets
Capital Structure
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V) (V)
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E) (V) (V)
Bassets = Bdebt (D) + Bequity (E) (V) (V)
Capital Structure
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E) (V) (V)
Bassets = Bdebt (D) + Bequity (E) (V) (V)
Capital Structure
requity = rf + Bequity ( rm - rf )
Capital Structure
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E) (V) (V)
Bassets = Bdebt (D) + Bequity (E) (V) (V)
requity = rf + Bequity ( rm - rf )
IMPORTANT
E, D, and V are all market values
0
20
0 0.2 0.8 1.2
Capital Structure & COC
Expected return (%)
Bdebt Bassets Bequity
Rrdebt=8
Rassets=12.2
Requity=15
Expected Returns and Betas prior to refinancing
Capital Budgeting
Problems with Capital Budgeting
How to Handle Problems with CB
1 - Sensitivity Analysis
2 - Break Even Analysis
3 - Monte Carlo Simulation
4 - Decision Trees
5 - Certainty Equivalent
Monte Carlo Simulation
Step 1: Modeling the Project
Step 2: Specifying Probabilities
Step 3: Simulate the Cash Flows
Modeling Process
Decision Tree
Decision 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
Decision 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
812
456
660
364
148
Turboprop
Piston
Decision 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
812
456
660
364
148 81220.22080.960
Turboprop
Piston
Decision Trees
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
Decision Trees
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
Turboprop
Piston
Decision Trees
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
Decision Trees
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
Decision Trees
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
Decision Trees
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
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?
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?
%12
)8(75.6
)(
fmf rrBrr
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?
%12
)8(75.6
)(
fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
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?
%12
)8(75.6
)(
fmf rrBrr
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Now assume that the cash flows change, but are RISK FREE. What is the new PV?
Risk,DCF and CEQ
ExampleProject 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?
240.2 PVTotal
71.284.83
79.789.62
89.394.61
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Risk,DCF and CEQ
ExampleProject 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?
240.2 PVTotal
71.284.83
79.789.62
89.394.61
6% @ PV FlowCashYear
Project B
240.2 PVTotal
71.21003
79.71002
89.31001
12% @ PV FlowCashYear
AProject
Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.
Risk,DCF and CEQ
ExampleProject 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
flow cash equivalentcertainty 054.1
flow cashRisky
Risk,DCF and CEQ
ExampleProject 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?
8.84054.1
100 3Year
6.89054.1
100 2Year
6.94054.1
100 1Year
3
2
Risk,DCF and CEQ
The prior example leads to a generic certainty equivalent formula.
tf
tt
t
r
CEQ
r
CPV
)1()1(
