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![Page 1: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/1.jpg)
Principles of Corporate Finance
Sixth Edition
Richard A. Brealey
Stewart C. Myers
Lu Yurong
Chapter 9
McGraw Hill/Irwin
Capital Budgeting and Risk
![Page 2: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/2.jpg)
9- 2
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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
![Page 3: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/3.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Company Cost of Capital
A firm’s value can be stated as the sum of the value of its various assets
PV(B)PV(A)PV(AB) valueFirm
![Page 4: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/4.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Company Cost of Capital
10%nologyknown tech t,improvemenCost COC)(Company 15%business existing ofExpansion
20%products New30% ventureseSpeculativ
RateDiscount Category
![Page 5: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/5.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Company Cost of Capital
A company’s cost of capital can be compared to the CAPM required return
Required
return
Project Beta1.26
Company Cost of Capital
13
5.5
0
SML
![Page 6: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/6.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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
![Page 7: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/7.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
Dell return (%
)R2 = .11
B = 1.62
![Page 8: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/8.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
Dell Computer
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Dell return (%
)R2 = .27
B = 2.02
![Page 9: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/9.jpg)
9- 9
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
GM
return (%)R2 = .13
B = 0.80
![Page 10: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/10.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
General Motors
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
GM
return (%)R2 = .25
B = 1.00
![Page 11: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/11.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Aug 88- Jan 95
Market return (%)
Exxon Mobil return (%
)
R2 = .28
B = 0.52
![Page 12: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/12.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
Measuring Betas
Exxon Mobil
Slope determined from plotting the line of best fit.
Price data – Feb 95 – Jul 01
Market return (%)
Exxon Mobil return (%
)
R2 = .16
B = 0.42
![Page 13: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/13.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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)
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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
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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
Example1/3 New Ventures B=2.01/3 Expand existing business B=1.31/3 Plant efficiency B=0.6
AVG B of assets = 1.3
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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
![Page 17: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/17.jpg)
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Capital Structure & COC
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
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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
![Page 19: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/19.jpg)
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Union Pacific Corp.
Requity = Return on Stock
= 15%
Rdebt = YTM on bonds
= 7.5 %
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Union Pacific Corp.
.17.50PortfolioIndustry
.21.40PacificUnion
.26.52SouthernNorfolk
.24.46tionTransporta CSX
.20.64Northern BurlingtonError Standard.Beta
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Union Pacific Corp.Example
100 valueFirmAssets Total70ueEquity val30Debt value100Assets
%75.12%157030
70%5.77030
30
assets
equitydebtassets
R
requitydebt
equityrequitydebt
debtR
![Page 22: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/22.jpg)
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McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
International Risk
0.77.302.58Venezuela1.39.482.91Thailand0.81.421.93Poland0.55.183.11Egypt
BetatcoefficiennCorrelatio
Ratio
Source: The Brattle Group, Inc. Ratio - Ratio of standard deviations, country index vs. S&P composite index
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Asset Betas
)PV(revenuePV(asset)B
)PV(revenuecost) ePV(variablB
)PV(revenuecost) PV(fixedBB
assetcost variable
cost fixedrevenue
![Page 24: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/24.jpg)
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Asset Betas
PV(asset)cost) PV(fixed1B
PV(asset)cost) ePV(variabl-)PV(revenueBB
revenue
revenueasset
![Page 25: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/25.jpg)
9- 25
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Risk,DCF and CEQ
tf
tt
t
rCEQ
rCPV
)1()1(
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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?
![Page 27: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/27.jpg)
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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?
%12)8(75.6
)(
fmf rrBrr
![Page 28: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/28.jpg)
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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?
%12)8(75.6
)(
fmf rrBrr
240.2 PVTotal71.2100379.7100289.31001
12% @ PV FlowCashYearAProject
![Page 29: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/29.jpg)
9- 29
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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?
%12)8(75.6
)(
fmf rrBrr
240.2 PVTotal71.2100379.7100289.31001
12% @ PV FlowCashYearAProject
Now assume that the cash flows change, but are RISK FREE. What is the new PV?
![Page 30: Principles of Corporate Finance Sixth Edition Richard A. Brealey Stewart C. Myers Lu Yurong Chapter 9 McGraw Hill/Irwin Capital Budgeting and Risk.](https://reader034.fdocuments.in/reader034/viewer/2022042515/5a4d1b637f8b9ab0599ae76c/html5/thumbnails/30.jpg)
9- 30
McGraw Hill/Irwin Copyright © 2003 by The McGraw-Hill Companies, Inc. All rights reserved
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 PVTotal71.284.8379.789.6289.394.61
6% @ PV FlowCashYearProject B
240.2 PVTotal71.2100379.7100289.31001
12% @ PV FlowCashYearAProject
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9- 31
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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 PVTotal71.284.8379.789.6289.394.61
6% @ PV FlowCashYearProject B
240.2 PVTotal71.2100379.7100289.31001
12% @ PV FlowCashYearAProject
Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.
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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? DEDUCTION FOR RISK
15.284.8100310.489.610025.494.61001
riskfor Deduction
CEQFlowCash Year
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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
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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?
8.84054.1100 3Year
6.89054.1100 2Year
6.94054.1
100 1Year
3
2
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Preparation for Next Class
Please read:
BM Chapter 10 , P259-284