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
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COMPANY COST OF CAPITAL AND REQUIRED RETURN ON PROJECT

REQUIRED RETURN Security market line showing required return on project

Company cost of capital

Average beta of firm's assets

PROJECT BETA

Copyright 1996 by The McGraw-Hill Companies, Inc

COMPANY 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!!
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COMPANY 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

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CATEGORY
SPECULATIVE VENTURES NEW PRODUCTS EXPANSION OF EXISTING BUSINESS COST IMPROVEMENT KNOWN TECHNOLOGY

DISCOUNT RATE
30% 20% 15% (company cost of capital) 10%

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USING CAPM AND PROJECT b

MANY LARGE CORPORATIONS USE CAPM AND AN ESTIMATE OF THE PROJECT b TO ESTIMATE PROJECT DISCOUNT RATE EXPECTED PROJECT RETURN = rf + bproject (rm- rf)

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BEGIN WITH PROBLEMS IN MEASURING COMPANY b

b IS DIFFICULT TO MEASURE FOR INDIVIDUAL FIRM BETTER ACCURACY BY LOOKING AT AVERAGE OF SIMILAR COMPANIES BUT FIRMS BORROWING POLICIES AFFECTS ITS STOCK b IBM AND DEC ARE NOT SIMILAR COMPANIES FOR PURPOSE OF ESTIMATING b BECAUSE THEY USE DIFFERENT DEGREES OF LEVERAGE

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MEASURING COMPANY b
APPROPRIATE FOR ACROSS-THE-BOARD EXPANSION COMPARE RETURN ON STOCK WITH MARKET RETURN OVER 60-MONTH TIME PERIOD AT&T HEWLETT-PACKARD SLOPE IS b VARIES BY PERIOD

ESTIMATES OF b ARE PUBLISHED BY BROKERAGE HOUSES AND ADVISORY SERVICES

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ESTIMATING BETA
RETURN ON SHARE RETURN ON SHARE + + + + + + + + + + + + + + + + + + +

Beta = 1.6

+ +++
+ ++ +

+
+ Beta = .4 + + + + + + + + + + +

+ +++ + + + +
+

+
+

+ RETURN ON MARKET

+
+

+ RETURN ON MARKET

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PFIZER
WHICH IS THE BETTER ESTIMATE OF b FOR PFIZER? PFIZER HAS A b OF 1.02 WITH A STANDARD ERROR OF 0.14 A MARKET VALUE-WEIGHTED INDUSTRY PORTFOLIO OF LARGE PHARMACEUTICAL COMPANIES HAS A b 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
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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 COMPANYS COST OF CAPITAL IS EXPECTED RETURN ON THIS PORTFOLIO

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HOW CHANGING CAPITAL STRUCTURE AFFECTS b

AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED BUT BOTH DEBT AND EQUITY ARE INDIVIDUALLY LESS RISKY FIRMS ASSET BETA IS WEIGHTED AVERAGE OF PORTFOLIO OF DEBT AND EQUITY BETAS
b assets b portfolio

D E bdebt b equity V V

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HOW CHANGING CAPITAL STRUCTURE AFFECTS b

AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED BUT BOTH DEBT AND EQUITY ARE INDIVIDUALLY LESS RISKY FIRMS ASSET BETA IS WEIGHTED AVERAGE OF PORTFOLIO OF DEBT AND EQUITY BETAS
b assets b portfolio

D E bdebt b equity V V

SUPPOSE bdebt FALLS TO .1 .8 = (.3 X .1) + (.7 X b equity ) bequity = 1.1

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UNLEVERING BETAS
GOING FROM AN OBSERVED bequity TO bassets WE KNOW bequity bdebt MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)
b assets b portfolio

D E bdebt b equity V V

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UNLEVERING BETAS
GOING FROM AN OBSERVED bequity TO bassets WE KNOW bequity bdebt MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)
b assets b portfolio

D E bdebt b equity V V

WE WILL ADD TAX EFFECTS LATER

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Copyright 1996 by The McGraw-Hill Companies, Inc

REVIEW
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 FIRMS DEBT AND EQUITY RELATED TO FIRMS 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 16 Copyright 1996 by The McGraw-Hill Companies, Inc DO NOT CHANGE

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
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OPERATING 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)

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bFIXED COST = 0

OPERATING LEVERAGE

ALSO bREVENUES @ bVARIABLE COST

AS THEY ARE BOTH PROPORTIONAL TO OUTPUT

b ASSET

b REVENUE

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

b REVENUE [1 PV(FIXED COST) ] PV(ASSET)

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Copyright 1996 by The McGraw-Hill Companies, Inc

NET 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
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Copyright 1996 by The McGraw-Hill Companies, Inc

INTERNAL RATE OF RETURN, IRR

C1 C2 CT . . . . 0 NPV = C0 2 T (1 IRR) (1 IRR) (1 IRR)

IRR IS THE DISCOUNT RATE FOR WHICH NPV=0

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Copyright 1996 by The McGraw-Hill Companies, Inc

CALCULATING 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
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Copyright 1996 by The McGraw-Hill Companies, Inc

NET PRESENT VALUE PROFILE

C0 = - 4 C1 = +2 C3 = +4

NPV +2 IRR = 28% 0 DISCOUNT RATE (%)

50

-1

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INTERNAL RATE OF RETURN RULE

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
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Copyright 1996 by The McGraw-Hill Companies, Inc

CONVENTIONAL PROJECT

CASH OUTFLOWS FOLLOWED BY CASH INFLOWS

NPV DECLINES WITH INCREASING DISCOUNT RATES

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Copyright 1996 by The McGraw-Hill Companies, Inc

WARNING
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 Copyright 1996 by The McGraw-Hill Companies, Inc LEVEL OF PROFITABILITY
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LENDING OR BORROWING?
Year: 0 1 IRR(%) NPV At 10% ($)

A B

-1,000 +1,000

+1,500 -1,500

+50 +50

+364 +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
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Copyright 1996 by The McGraw-Hill Companies, Inc

MULTIPLE 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
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Copyright 1996 by The McGraw-Hill Companies, Inc

MULTIPLE RATES OF RETURN

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

TWO CHANGES IN SIGN OF CASH FLOWS TWO INTERNAL RATES OF RETURN r < 25%, NPV < 0

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Copyright 1996 by The McGraw-Hill Companies, Inc

MULTIPLE RATES OF RETURN

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

30
Copyright 1996 by The McGraw-Hill Companies, Inc

IRR MAY GIVE THE WRONG DECISION WITH MUTUALLY EXCLUSIVE PROJECTS WHICH DIFFER IN:
SCALE PATTERN OF CASH FLOWS OVER TIME COMPARE PROJECTS G AND H
0 G H -9 -9 1 +6 +1.8 2 +5 +1.8 3 +4 +1.8 4 0 5 IRR NPV @ 10% 3,592 9,000 0 ........ 33%

+1.8 +1.8...... 20%

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Copyright 1996 by The McGraw-Hill Companies, Inc

IRR MAY GIVE THE WRONG DECISION WITH MUTUALLY EXCLUSIVE PROJECTS WHICH DIFFER IN:
SCALE PATTERN OF CASH FLOWS OVER TIME COMPARE PROJECTS G AND H
0 G H I -9 -9 1 +6 +1.8 -6 2 +5 +1.8 +1.2 3 +4 +1.8 +1.2 4 0 5 IRR NPV @ 10% 3,592 9,000 6,000 0 ........ 33%

+1.8 +1.8...... 20% +1.2 +1.2...... 20%

PROJECT H HAS HIGHER NPV THAN PROJECT G 32 Copyright 1996 by The McGraw-Hill Companies, Inc BUT LOWER IRR

NPV($)

6,000

15.6 33.3
DISCOUNT RATE

20

H
33
Copyright 1996 by The McGraw-Hill Companies, Inc

MUTUALLY 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

34
Copyright 1996 by The McGraw-Hill Companies, Inc

Real Options

35
Copyright 1996 by The McGraw-Hill Companies, Inc

Topics Covered
Sensitivity Analysis Break Even Analysis Monte Carlo Simulation Decision Trees

36
Copyright 1996 by The McGraw-Hill Companies, Inc

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.

37
Copyright 1996 by The McGraw-Hill Companies, Inc

Monte Carlo Simulation

Modeling Process

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

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Decision Trees
960 (.8)

Turboprop -550
NPV= ?

+150(.6)

220(.2) 930(.4)

+30(.4)

140(.6)
800(.8) -150 100(.2) 410(.8) 0 180(.2)

+100(.6) or

Piston -250 NPV= ?

+50(.4)

220(.4) 100(.6)
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Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
960 (.8)

Turboprop -550
NPV= ?

+150(.6)

812

220(.2) 930(.4) 456

+30(.4)

140(.6)
800(.8) -150 100(.2) 410(.8) 0 180(.2)

660

+100(.6) or

Piston -250 NPV= ?

+50(.4)

364

220(.4) 100(.6) 148

40
Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
960 (.8)

Turboprop -550
NPV= ?

+150(.6)

812

220(.2) 930(.4) 456

+30(.4)

140(.6)
800(.8) -150 100(.2) 410(.8) 0 180(.2)

660

+100(.6) or

Piston -250 NPV= ?

364

960 .80 +50(.4) .20 812 220 100(.6)

220(.4) 148
41

Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
Turboprop -550
NPV= ?

660 +150(.6) 150 450 1.10

+30(.4)
*450

960 (.8) 220(.2) 930(.4) 140(.6)

800(.8) -150 100(.2) 410(.8) 0 180(.2)

812

456

660

+100(.6) or

Piston -250 NPV= ?

+50(.4)
331

364

220(.4) 100(.6) 148

42
Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
NPV=888.18

960 (.8) +150(.6) 220(.2) 930(.4) +30(.4)

Turboprop -550
NPV= ?
NPV=444.55

812

456

140(.6)
*450
800(.8) -150 100(.2) 410(.8) 0 180(.2)

Piston

812 NPV=550.00 150 888.18 +100(.6) 1.10

-250 ?
+50(.4)
NPV=184.55

660

or
331

364

220(.4) 100(.6) 148

43
Copyright 1996 by The McGraw-Hill Companies, Inc

NPV=

Decision Trees
NPV=888.18

960 (.8) +150(.6) 220(.2) 930(.4) 140(.6)

*450
800(.8) -150 100(.2) 410(.8)

Turboprop -550
NPV= ?
NPV=444.55

812

710.73
+30(.4)

456

660

NPV=550.00

Piston -250 NPV= ?

180(.2) 888403.82 .60 444 .55 .40 .18 331 0 364

+100(.6) or

220(.4) 100(.6)

+50(.4)
NPV=184.55

148
44

Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
NPV=888.18

960 (.8) +150(.6) 220(.2) 930(.4) 140(.6)

*450
800(.8) -150 100(.2) 410(.8)

Turboprop -550
NPV=96.12
NPV=444.55

812

710.73
+30(.4)

456

660

NPV=550.00

+100(.6) or

Piston -250 NPV=117.00

0 710.73 180(.2) 331 96.12 403.82 550 220(.4) 1.10

364

+50(.4)

NPV=184.55

100(.6)

148
45

Copyright 1996 by The McGraw-Hill Companies, Inc

Decision Trees
NPV=888.18

960 (.8) +150(.6) 220(.2) 930(.4) 140(.6)

*450
800(.8) -150 100(.2) 410(.8) 0 180(.2)

Turboprop -550
NPV=96.12
NPV=444.55

812

710.73
+30(.4)

456

660

NPV=550.00

+100(.6) or

Piston -250 NPV=117.00

403.82
+50(.4)
NPV=184.55

364

331

220(.4) 100(.6) 148

46
Copyright 1996 by The McGraw-Hill Companies, Inc