Principles of Corporate Finance Brealey and Myers Sixth Edition Capital Budgeting and Risk Slides by Matthew Will Irwin/McGraw Hill Chapter ©The McGraw-Hill Companies, Inc., 200 9- Topics Covered Measuring Betas Capital Structure and COC Discount Rates for Intl Projects Estimating Discount Rates Risk and DCF Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- Company Cost of Capital A firm’s value can be stated as the sum of the value of its various assets Firm value PV(AB) PV(A) PV(B) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- Company Cost of Capital A company’s cost of capital can be compared to the CAPM required return SML Required return 13 Company Cost of Capital 5.5 1.26 Irwin/McGraw Hill Project Beta ©The McGraw-Hill Companies, Inc., 200 9- Measuring Betas The SML shows the relationship between return and risk CAPM uses Beta as a proxy for risk Beta is the slope of the SML, using CAPM terminology Other methods can be employed to determine the slope of the SML and thus Beta Regression analysis can be used to find Beta Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- Measuring Betas Hewlett Packard Beta Hewlett-Packard return (%) Price data - Jan 78 - Dec 82 R2 = 53 B = 1.35 Slope determined from 60 months of prices and plotting the line of best fit Irwin/McGraw Hill Market return (%) ©The McGraw-Hill Companies, Inc., 200 9- Measuring Betas Hewlett Packard Beta Hewlett-Packard return (%) Price data - Jan 83 - Dec 87 R2 = 49 B = 1.33 Slope determined from 60 months of prices and plotting the line of best fit Irwin/McGraw Hill Market return (%) ©The McGraw-Hill Companies, Inc., 200 9- Measuring Betas Hewlett Packard Beta Hewlett-Packard return (%) Price data - Jan 88 - Dec 92 R2 = 45 B = 1.70 Slope determined from 60 months of prices and plotting the line of best fit Irwin/McGraw Hill Market return (%) ©The McGraw-Hill Companies, Inc., 200 9- Measuring Betas Hewlett Packard Beta Hewlett-Packard return (%) Price data - Jan 93 - Dec 97 R2 = 35 B = 1.69 Slope determined from 60 months of prices and plotting the line of best fit Irwin/McGraw Hill Market return (%) ©The McGraw-Hill Companies, Inc., 200 9- 10 Measuring Betas A T & T Beta Price data - Jan 78 - Dec 82 A T & T (%) R2 = 28 B = 0.21 Slope determined from 60 months of prices and plotting the line of best fit Irwin/McGraw Hill Market return (%) ©The McGraw-Hill Companies, Inc., 200 9- 27 Pinnacle West Corp COC rassets D E rdebt requity V V .35(.08) 65(.10) .093 or 9.3% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 28 International Risk Correlation Ratio Beta coefficien t Argentina 3.52 416 1.46 Brazil 3.80 160 62 Kazakhstan 2.36 147 35 Taiwan 3.80 120 47 Source: The Brattle Group, Inc Ratio - Ratio of standard deviations, country index vs S&P composite index Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 29 Unbiased Forecast Given three outcomes and their related probabilities and cash flows we can determine an unbiased forecast of cash flows Possible cash flow 1.2 Probability Prob weighted Unbiased forecast 25 cash flow 1.0 50 $1.0 million 0.8 25 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 30 Asset Betas Cash flow = revenue - fixed cost - variable cost PV(asset) = PV(revenue) - PV(fixed cost) - PV(variable cost) or PV(revenue) = PV(fixed cost) + PV(variable cost) + PV(asset) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 31 Asset Betas PV(fixed cost) PV(fixed cost) BBrevenue B revenue Bfixed fixedcost cost PV(revenue) PV(revenue) PV(variabl eecost) PV(asset) PV(variabl cost) BBvariable cost BBasset PV(asset) variable cost asset PV(revenue) PV(revenue ) PV(revenue) PV(revenue) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 32 Asset Betas PV(revenue )) PV(variabl eecost) PV(revenue PV(variabl cost) BBasset B asset Brevenue revenue PV(asset) PV(asset) PV(fixed cost) PV(fixed cost) 11 BBrevenue revenue PV(asset) PV(asset) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 33 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? Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 34 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? r rf B ( rm rf ) 6 75(8) 12% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 35 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? r rf B ( rm rf ) 6 75(8) 12% Irwin/McGraw Hill Year Project A Cash Flow PV @ 12% 100 89.3 100 79.7 100 71.2 Total PV 240.2 ©The McGraw-Hill Companies, Inc., 200 9- 36 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? Project A Year Cash Flow PV @ 12% 100 100 89.3 79.7 100 Total PV 71.2 240.2 r rf B ( rm rf ) Now assume that the cash flows change, but are RISK FREE What is the new PV? 6 75(8) 12% Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 37 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? Now assume that the cash flows change, but are RISK FREE What is the new PV? Year Project A Cash Flow PV @ 12% 100 89.3 100 79.7 100 71.2 Total PV 240.2 Irwin/McGraw Hill Year Project B Cash Flow PV @ 6% 94.6 89.3 89.6 84.8 79.7 71.2 Total PV 240.2 ©The McGraw-Hill Companies, Inc., 200 9- 38 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? Now assume that the cash flows change, but are RISK FREE What is the new PV? Year Project A Cash Flow PV @ 12% 100 89.3 100 79.7 100 71.2 Total PV 240.2 Year Project B Cash Flow PV @ 6% 94.6 89.3 89.6 79.7 84.8 71.2 Total PV 240.2 Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 39 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? 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 Risky cash flow certainty equivalent cash flow 1.054 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 40 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? Now assume that the cash flows change, but are RISK FREE What is the new PV? 100 Year 94.6 1.054 100 Year 89.6 1.054 100 Year 84.8 1.054 Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- 41 Risk,DCF and CEQ The prior example leads to a generic certainty equivalent formula Ct CEQt PV t t (1 r ) (1 rf ) Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 ... 200 Company Cost of Capital 9- 16 simple 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... Inc., 200 Company Cost of Capital 9- 17 simple 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... Irwin/McGraw Hill ©The McGraw-Hill Companies, Inc., 200 9- Company Cost of Capital A firm’s value can be stated as the sum of the value of its various assets Firm value PV(AB) PV(A) PV(B) Irwin/McGraw