Chapter 10

12/7/2013
1
Chapter 10
Principles Principles
of of
Corporate Corporate
Finance Finance
Capital Budgeting
and Risk
Ninth Edition
and Risk
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin
Topics Covered
Company and Project Costs of Capital
Measuring the Cost of Equity g q y
Setting Discount Rates w/o Beta
Certainty Equivalents
Discount Rates for International Projects
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Company Cost of Capital
A firms value can be stated as the sum of
the value of its various assets
PV(B) PV(A) PV(AB) value Firm + = =
A companys cost of capital can be compared
to the CAPM required return q
Required
return
Company Cost
of Capital
12.9
50
SML
Project Beta
1.13
5.0
0
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10% nology known tech t, improvemen Cost
COC) (Company 15% business existing of Expansion
20% products New
30% ventures e Speculativ
Rate Discount Category
Debt and COC
IMPORTANT
E, D, and V are
all market values
r
equity
= r
f
+ B
equity
( r
m
- r
f
)
COC =r
portfolio
=r
assets
r
assets
=WACC =r
debt
(D) +r
equity
(E)
(V) (V)
all market values
of Equity, Debt
and Total Firm
Value
After tax WACC=(1-T
c
)r
debt
(D) +r
equity
(E)
(V) (V)
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20
Capital Structure & COC
E t d
Expected Returns and Betas prior to refinancing
20 Expected
return (%)
R
rdebt
=8
R
assets
=12.2
R
equity
=15
0
0 0.2 0.8 1.2
B
debt
B
assets B
equity
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
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Measuring Betas
Intel Computer
P i d t J l 1996 J 2001
20.00
30.00
40.00
Price data: J uly 1996 J une 2001
R
2
=.29
B =1.54
-20.00
-10.00
0.00
10.00
-20.00 -10.00 0.00 10.00 20.00
I
n
t
e
l
r
e
t
u
r
n
, %
Slope determined from plotting the
line of best fit.
-50.00
-40.00
-30.00
Market return, %
30.00
40.00
Measuring Betas
Intel Computer
P i d t J l 2001 J 2006
-10.00
0.00
10.00
20.00
-20.00 -10.00 0.00 10.00 20.00
In
t
e
l r
e
t
u
r
n
, %
R
2
=.30
B =2.22
-40.00
-30.00
-20.00
Market return, %
line of best fit.
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6
20.00
Measuring Betas
GE
P i d t J l 1996 J 2001
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
-20.00 -10.00 0.00 10.00 20.00
G
E

r
e
t
u
r
n
,

%
R
2
=.13
B =1.17
-20.00
Market return, %
line of best fit.
20.00
Measuring Betas
GE
P i d t J l 2001 J 2006
-15.00
-10.00
-5.00
0.00
5.00
10.00
15.00
-20.00 -10.00 0.00 10.00 20.00
G
E

r
e
t
u
r
n
,

%
R
2
=.17
B =.83
-20.00
Market return, %
line of best fit.
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Measuring Betas
Heinz
P i d t J l 1996 J 2001
-10.00
-5.00
0.00
5.00
10.00
15.00
-20.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 20.00
H
e
i
n
z

r
e
t
u
r
n
,

%
R
2
=.18
B =.47
-15.00
Mar ket r et ur n, %
line of best fit.
Measuring Betas
Heinz
P i d t J l 2001 J 2006
1500
-10.00
-5.00
0.00
5.00
10.00
15.00
-20.00 -15.00 -10.00 -5.00 0.00 5.00 10.00 15.00 20.00
H
e
i
n
z

r
e
t
u
r
n
,

%
R
2
=.15
B =.36
-15.00
Mar ket r et ur n, %
line of best fit.
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Capital Structure - the mix of debt & equity within a company
E dCAPM t i l d CS
Capital Structure
Expand CAPM to include CS
R =r
f
+B ( r
m
- r
f
)
becomes
R =r +B ( r r )
R
equity
=r
f
+B ( r
m
- r
f
)
Risk,DCF and CEQ
t
f
t
t
t
r
CEQ
r
C
PV
) 1 ( ) 1 ( +
=
+
=
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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?
) 8 ( 75 6
) (
+
+ =
f m f
r r B r r
% 12
) 8 ( 75 . 6
=
+ =
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Risk,DCF and CEQ
Example
89.3 100 1
12% @ PV Flow Cash Year
A Project
% 12
) 8 ( 75 . 6
) (
=
+ =
+ =
f m f
r r B r r
240.2 PV Total
71.2 100 3
79.7 100 2
Risk,DCF and CEQ
Example
2402 PV T t l
71.2 100 3
79.7 100 2
89.3 100 1
A Project
Now assume that the cash
flows change, but are
RISK FREE What isthe
% 12
) 8 ( 75 . 6
) (
=
+ =
+ =
f m f
r r B r r
240.2 PV Total RISK FREE. What is the
new PV?
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Risk,DCF and CEQ
Example
of 75 what isthePV of theproject? Nowassumethat thecashflows 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?
89.3 94.6 1
Project B
893 100 1
A Project
240.2 PV Total
71.2 84.8 3
79.7 89.6 2
240.2 PV Total
71.2 100 3
79.7 100 2
89.3 100 1
Risk,DCF and CEQ
Example
79.7 89.6 2
89.3 94.6 1
Project B
79.7 100 2
89.3 100 1
A Project
240.2 PV Total
71.2 84.8 3
240.2 PV Total
71.2 100 3
Since the 94.6 is risk free, we call it a Certainty Equivalent
of the 100.
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Risk,DCF and CEQ
Example
of .75, what is the PV of the project? DEDUCTION FOR RISK
54 946 100 1
risk for
Deduction
CEQ Flow Cash Year
15.2 84.8 100 3
10.4 89.6 100 2
5.4 94.6 100 1
Risk,DCF and CEQ
Example
The difference between the 100 and the certainty equivalent
(94.6) is 5.4%this % can be considered the annual
premiumonariskycashflow
premium on a risky cash flow
flow cash equivalent certainty
054 . 1
flow cash Risky
=
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13
Risk,DCF and CEQ
Example
100
6 . 94
054 . 1
100
1 Year = =
8 . 84
054 . 1
100
3 Year
6 . 89
054 . 1
100
2 Year
3
2
= =
= =

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