Capital Budgeting Analysis and Incorporating Risk

Assignment #4: Capital Investment and Incorporating Risk in Capital Analysis Henry Avery HSA525 Health Financial Management August 24, 2010

Capital Budgeting Analysis and Incorporating Risk

Medical Associates is a large for-profit group practice. Its dividends are expected to grow at a constant rate of 7% per year into the foreseeable future. The firms last dividend (D0) was $2, and its current stock price is $23. The firms beta coefficient is 1.6; the rate of return on 20-year T-bonds currently is 9%; the expected rate of return is 13%. The firms target capital structure calls for 50% debt financing, the interest rate required on the business new debt is 10%, and its tax rate is 40%. 1) Calculate Medical Associates cost of equity using DCF method. E(Re) = Do X [1 + E(g) ] + E(g) Po E(Re) = 2 X [1 + 7%] + 7% = 2 X (1 + 0.07) + 0.07 23 E(Re) = 2 X (1.07) + 0.07 23 2) Calculate Medical Associates cost of equity using CAPM method. R(Re) = RF + [R(Rm) RF] X b = 9% + [13% - 9%] X 1.6 = 9% + (4% x 1.6) = 9% + 6.4% = 15.4% 3) What is your final estimate for the firm cost of equity? The final estimate for the firm cost of equity I would say is 15.4% using the CAPM method. But there is a great deal of uncertainties in this estimate of the cost of equity. Because of these uncertainties the firm cost of equity using the CAPM estimates, it is highly likely that 23 = 9.30% + 7% = 16.23%

Capital Budgeting Analysis and Incorporating Risk

the firm true, but unobservable, cost of equity is 15.4 percent. It would be better to develop high and low estimates. 4) Calculate the firms corporate cost of capital. The firms corporate cost of capital can be calculated as follows: CCC = [Wd X R(Rd) X (1-T)] + [We X R(Re)] = [50% X 10% X (1-40%)] + (50% X 15.4%) = .50 X .10 X .60 + .50 X .154 = 0.3 X .10 + 0.077 = 0.107 = 10.7% Describe the four (4) steps of capital budgeting analysis Virtually all general managers face capital-budgeting decisions in the course of their careers. The most common of these is the simple yes versus no choice about a capital investment. The following are some general guidelines to orient the decision maker in these situations. 1. Focus on cash flows, not profits. One wants to get as close as possible to the economic reality of the project. Accounting profits contain many kinds of economic fiction. Flows of cash, on the other hand, are economic facts. 2. Focus on incremental cash flows. The point of the whole analytical exercise is to judge whether the firm will be better off or worse off if it undertakes the project. Thus one wants to focus on the changes in cash flows affected by the project. The analysis may require some careful thought: a project decision identified as a simple

Capital Budgeting Analysis and Incorporating Risk go/no-go question may hide a subtle substitution or choice among alternatives. For instance, a proposal to invest in an automated machine should trigger many

questions: Will the machine expand capacity (and thus permit us to exploit demand beyond our current limits)? Will the machine reduce costs (at the current level of demand) and thus permit us to operate more efficiently than before we had the machine? Will the machine create other benefits (e.g., higher quality, more operational flexibility)? The key economic question asked of project proposals should be, How will things change (i.e., be better or worse) if we undertake the project? 3. Account for time. Time is money. We prefer to receive cash sooner rather than later. Use NPV as the technique to summarize the quantitative attractiveness of the project. Quite simply, NPV can be interpreted as the amount by which the market value of the firms equity will change as a result of undertaking the project. 4. Account for risk. Not all projects present the same level or risk. One wants to be compensated with a higher return for taking more risk. The way to control for variations in risk from project to project is to use a discount rate to value a flow of cash that is consistent with the risk of that flow. Describe how project risk is incorporated into a capital budgeting analysis. When evaluating a capital budgeting project, we need to examine the risk associated with the project and how the existing assets of the firm will be affected if the project is purchased. The reason we need to evaluate the risk of a project is to determine if the appropriate required rate of return is used to compute the projects NPV (or to compare to its IRR). If a firm is

Capital Budgeting Analysis and Incorporating Risk considering a project that is much riskier than the existing assets, then it makes sense that the firm should expect to earn a higher return on the project than on its existing assets.

There are three risks that we generally identify when evaluating a project: (1) stand-alone risk, which is the risk of the asset when it is held in isolationthat is, when it stands alone; (2) corporate, or within-firm, risk, which is measured by the impact an asset is expected to have on the operations of the firmthat is, how an asset will affect the firms total risk if it is purchased and added to existing assets; and (3) beta, or market, risk, which is the portion of an assets risk that cannot be eliminated through diversificationthat is, how an asset will affect the firms market risk, or beta, if it is purchased and added to existing assets

Capital Budgeting Analysis and Incorporating Risk Reference Gapenski,L.(2008)Healthcare finance: An introduction to accounting and financial Management (4th ed). Chicago:AUPHA press/Health Administration Press