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1
Chapter 7
Risk, Return and the Cost of Capital
Final objective: Estimating the opportunity cost of
capital.
Explain and calculate
Expected return
Security risk
Diversification
Portfolio risk
beta.
2
Capital Budgeting Example
5
Holding Period Returns
6
The Future Value of an Investment of $1 in
1957: Evidence from Canada
$20.69
Common Stocks
Long Bonds
T-Bills
7
An Investment of $1 in 1900: US evidence
8
An Investment of $1 in 1900: US evidence
Real
Returns
9
How does this relate to cost of capital?
10
Rates of Return 1900-2003
Stock Market Index Returns
Percentage Return
Year
Source: Ibbotson Associates
11
Measuring Risk
Histogram of Annual Stock Market Returns
# of Years
Return %
12
Average Stock Returns and Risk-Free
Returns
The Risk Premium is the additional return
(over and above the risk-free rate) resulting
from bearing risk.
One of the most significant observations of
stock (and bond) market data is this long-run
excess of security return over the risk-free
return.
The historical risk premium was 7.6% for the
US.
13
Average Market Risk Premia (by country)
Risk premium, %
14
Country
Measuring Risk
15
Return Statistics
The history of capital market returns can be
summarized by describing the
average return
( R1 RT )
R
T
( R1 R ) 2 ( R2 R ) 2 ( RT R ) 2
SD VAR
T 1
16
Canada Returns, 1957-2003
Average Standard
Investment Annual Return Deviation Distribution
60% 0% 17
+ 60%
Risk Statistics
18
Historically Are Returns Normal?
19
Expected Return, Variance, and covariance
Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%
20
Expected Return, Variance, and Covariance
21
The Return for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%
23
Portfolio Risk
1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes
N
1 2 3 4 5 6 N
STOCK 24
Diversification
The variance (risk) of the securitys return can
be broken down into:
Systematic (Market) Risk
Unsystematic (diversifiable) Risk
The Effect of Diversification:
unsystematic risk will significantly diminish in
large portfolios
systematic risk is not affected by
diversification since it affects all securities in
any large portfolio
25
Portfolio Risk as a Function of the Number
of Stocks in the Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.
Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities. 26
Beta and Unique Risk
Expected
stock
return
beta
+10%
-10%
28
Definition of Risk When Investors Hold
the Market Portfolio
Researchers have shown that the best measure
of the risk of a security in a large portfolio is the
beta ()of the security.
Beta measures the responsiveness of a security
to movements in the market portfolio.
Cov ( Ri , RM )
i
( RM )
2
29
Chapter 8
Risk and Return
30
Markowitz Portfolio Theory
31
Markowitz Portfolio Theory
Coca Cola
Exxon Mobil
Standard Deviation
32
Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
33
Efficient Frontier
Standard Deviation
34
Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg
Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%
35
Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%
36
Efficient Frontier
Return
B
AB
A
Risk
37
Efficient Frontier
Return
B
N
AB
A
Risk
38
Efficient Frontier
Return
B
ABN AB N
Risk
39
2-Security Portfolios - Various Correlations
return
100%
= -1.0 stocks
= 1.0
100%
= 0.2
bonds
40
Efficient Frontier
return
o nt i er
r
nt f
cie
effi
minimum
variance
portfolio
Individual Assets
41
Riskless Borrowing and Lending
return
L
CM 100%
stocks
Balanced
fund
rf
100%
bonds
return
L
CM efficient frontier
rf
43
Changes in Riskfree Rate
return
L 0 CML 1
CM 100%
stocks
44
Security Market Line
Return
Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf
1.0 BETA
45
Security Market Line
Return
SML
rf
BETA
1.0
SML Equation = rf + B ( rm - rf )
46
Risk & Expected Return
Expected
return
13.5%
3%
1.5
i 1.5 RF 3% R M 10%
R i 3% 1.5 (10% 3%) 13.5%
47
Estimating with regression
Security Returns
i ne
c L
i
r ist
c te
ara
Ch Slope = i
Return on
market %
Ri = i + iRm + ei
48
Estimates of Beta for Selected Stocks
Stock Beta
Research in Motion 3.04
Nortel Networks 3.61
Bank of Nova Scotia 0.28
Bombardier 1.48
Investors Group. 0.36
Maple Leaf Foods 0.25
Roger 1.17
Communications
Canadian Utilities 0.08
49
TransCanada Power 0.08
CAPM versus Reality
50
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-2002
30
SML
20 Investors
10
Market
Portfolio
0
Portfolio Beta
1.0
51
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-65 SML
30
20 Investors
10 Market
Portfolio
0
Portfolio Beta
1.0
52
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1966-2002
30
20 SML
Investors
10
Market
0 Portfolio
Portfolio Beta
1.0
53
Chapter 9 (part 1)
Capital Budgeting and Risk
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment
Shareholders
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
54
Company Cost of Capital
55
Company Cost of Capital
56
Company Cost of Capital
simple approach
Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6
57
Company Cost of Capital
SML
Required
return
13
Company Cost
of Capital
5.5
0
Project Beta
1.26
58
Example
59
Example (continued)
Suppose Stansfield Enterprises is evaluating the following non-
mutually exclusive projects. Each costs $100 and lasts one year.
60
Using the SML to Estimate the Risk-
Adjusted Discount Rate for Projects
Good SML
IRR
Project
A
projects
30% B
C Bad projects
5%
Firms risk (beta)
2.5
61
Capital Structure
Capital Structure - the mix of debt & equity
within a company
R = rf + B ( r m - rf )
becomes
Requity = rf + B ( rm - rf )
62
Capital Structure & COC (company
cost of capital)
COC = rportfolio = rassets
Requity=15
Rassets=12.2
Rrdebt=8
IRR SML
Project
IRR
Project
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF FIRM ( R M RF )
rate
Incorrectly rejected
rf positive NPV projects
Firms risk (beta)
FIRM
67
Measuring Betas
Theoretically, the calculation of beta is straightforward:
Cov ( Ri , RM ) im
2
Var ( RM ) M
68
Measuring Betas
Dell Computer
R2 = .10
B = 1.87
Dell Computer
R2 = .27
B = 1.61
General Motors
R2 = .07
B = 0.72
General Motors
GM return (%)
Price data: Dec 97 - Apr 04
R2 = .29
B = 1.21
73
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
75
Problems with Industry Beta
76
Beware of Fudge Factors
77
Determinants of Beta
Business Risk
Cyclicality of Revenues
Operating Leverage
Financial Risk
Financial Leverage
78
Cyclicality of Revenues
79
Operating Leverage
EBIT
Total
$ costs
Fixed costs
Volume
Fixed costs
Volume
a. What proportion was market risk, and what proportion unique risk?
b. What is the variance of market and unique variance of each stock?
c. What is the confidence level of the Incos beta?
d. What is expected return of Alcn if Rf=5% and market return=12%?
e. Suppose next year the market provides a zero return. What return to 82
you expect for each stock?
Chapter 9: Q9
You run a perpetual encabulator machine, which
generates revenues averaging $20 million per year.
Raw material costs are 50 percent of revenues.
These costs are variable they are always
proportional to revenues. There are no other
operating costs. The cost of capital is 9 percent.
Your firms long-term borrowing rate is 6 percent.
Now you are approached by Studebaker Capital
Corp., which proposes a fixed-price contract to
supply raw materials at $10 million per year for 10
years.
a. What happens to the operating leverage and
business risk of the encabulator machine if you
agree to this fixed-price contact?
b. Calculate the present value of the encabulator
machine with and without the fixed-price contract?
83
Chapter 9 (part 2)
Capital Budgeting and Risk
Ct CEQt
PV
(1 r ) t
(1 rf ) t
84
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?
85
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%
1 100 89.3
2 100 79.7
r rf B ( rm rf )
6 .75(8) 3 100 71.2
12% Total PV 240.2
86
Risk,DCF and CEQ
Example
Project B cash flow is 94.6, 89.6, 84.8 in year 1-3 respectively.
However, these cash flows are RISK FREE. What is Projects B
PV?
Project B
Project A Year Cash Flow PV @ 6%
Year Cash Flow PV @ 12%
1 94.6 89.3
1 100 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2
87
Risk,DCF and CEQ
Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2
89
Long lived assets and discount rates
Example (from text): The scientists at Vegetron have come up
with an electric mop and are ready to go ahead with pilot
production. The preliminary phase will take one year and
costs $125k. Management feels that there is only a 50%
chance that the pilot production will be successful. If the
project fails, the project will be dropped. If the project
succeeds Vegetron will build a $1million plant that would
generate an expected annual cash flow in perpetuity of
$250k.
Rf=7%, Risk Premium=9%. Regular projects of the firm have
a beta of 0.33, however due to the 50% probability of failure
management assumes a beta of 2 for the project.
1. What is NPV?
2. Is management correct about its approach for the NPV
calculation?
90
International Projects
93
Liquidity and the Cost of Capital
Cost of Capital
Liquidity
An increase in liquidity, i.e., a reduction in trading costs,
lowers a firms cost of capital.
94
Liquidity and Adverse Selection
95
What the Corporation Can Do
96
What the Corporation Can Do
99
Chapter 10: Decision Trees
A fundamental problem in NPV analysis is
dealing with uncertain future outcomes.
There is usually a sequence of decisions in
NPV project analysis.
Decision trees are used to identify the
sequential decisions in NPV analysis.
Decision trees allow us to graphically represent
the alternatives available to us in each period
and the likely consequences of our actions.
This graphical representation helps to identify
the best course of action.
100
Example of Decision Tree
Open circles represent decisions to be made.
F 101
Stewart Pharmaceuticals
The Stewart Pharmaceuticals Corporation is considering
investing in developing a drug that cures the common cold.
A corporate planning group, including representatives from
production, marketing, and engineering, has recommended
that the firm go ahead with the test and development phase.
This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance
that tests will prove successful.
If the initial tests are successful, Stewart Pharmaceuticals
can go ahead with full-scale production. This investment
phase will cost $1,600 million. Production will occur over the
next four years.
102
Stewart Pharmaceuticals NPV of Full-Scale Production following
Successful Test
Investment Year 1 Years 2-5
Revenues $7,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
Tax (34%) (612)
Net Profit $1,188
Cash Flow -$1,600 $1,588
4
$1,588
NPV $1,600 t
$3,433.75
t 1 (1.10)
Note that the NPV is calculated as of date 1, the date at which the investment of
$1,600 million is made. Later we bring this number back to date 0.
103
Stewart Pharmaceuticals NPV of Full-Scale Production following
Unsuccessful Test
Investment Year 1 Years 2-5
Revenues $4,050
Variable Costs (1,735)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $115
Tax (34%) (39.10)
Net Profit $75.90
Cash Flow -$1,600 $475
4
$475.90
NPV $1,600 t
$91.461
t 1 (1.10)
Note that the NPV is calculated as of date 1, the date at which the investment of
$1,600 million is made. Later we bring this number back to date 0. 104
Decision Tree for Stewart Pharmaceutical
The firm has two decisions to make: Invest
To test or not to test.
To invest or not to invest. NPV $3,433.75m
Success
Test Do not
NPV = $0
invest
Failure
NPV $91.461m
Do not Invest
NPV $0
test
105
Stewart Pharmaceutical: Decision to Test
Lets move back to the first stage, where the decision boils
down to the simple question: should we invest?
The expected payoff evaluated at date 1 is:
Expected Prob. Payoff Prob. Payoff
payoff sucess given success failure given failure
Expected
.60 $3,433.75 .40 $0 $2,060.25
payoff
The NPV evaluated at date 0 is:
$2,060.25
NPV $1,000 $872.95
1.10
So we should test.
106
Real Options
One of the fundamental insights of modern finance
theory is that options have value.
The phrase We are out of options is surely a sign of
trouble.
Because corporations make decisions in a dynamic
environment, they have options that should be
considered in project valuation.
107
Options
109
Campusteria pro forma Income Statement
Investment Year 0 Years 1-4 We plan to sell 25 meal
plans at $200 per
Revenues $60,000
month with a 12-month
Variable Costs ($42,000) contract.
Fixed Costs ($18,000)
Variable costs are
Depreciation ($7,500) projected to be
Pretax profit ($7,500) $3,500 per month.
Tax shield 34% $2,550 Fixed costs (the lease
Net Profit $4,950 payment) are
projected to be
Cash Flow $30,000 $2,550 $1,500 per month.
4
$2,550 We can depreciate
NPV $30,000 t
$21,916.84 (straight line) our
t 1 (1.10) capitalized leaseholder
improvements. 110
The Option to Expand: Valuing a Start-Up
Note that while the Campusteria test site has a
negative NPV, its negativity is relatively small.
If we expand, we project opening 20 Campusterias in
year four and the size of the project may grow 20 folds.
The value of the project is in the option to expand.
If we hit it big, we will be in a position to score large.
We wont know if this has value if we do not try. Thus, it
seems that we may want to take on this test project
and see what it delivers.
111
Discounted Cash Flows and Options
We can calculate the market value of a project as the sum of
the NPV of the project without options and the value of the
managerial options implicit in the project.
M = NPV + Opt
113
The Option to Abandon: Example
(continued)
Traditional NPV analysis would indicate rejection of the project.
Expected
= (0.50$575) + (0.50$0) = $287.50
Payoff
$287.50
NPV = $300 + = $38.64
1.10
114
The Option to Abandon: Example
Traditional NPV analysis overlooks the option to abandon.
Success: PV = $575
The firm has two decisions to make: drill or not, abandon or115
stay.
The Option to Abandon: Example
(continued)
When we include the value of the option to abandon, the
drilling project should proceed:
Expected
= (0.50$575) + (0.50$250) = $412.50
Payoff
$412.50
NPV = $300 + = $75.00
1.10
116
Valuation of the Option to Abandon
Recall that we can calculate the market value of a project
as the sum of the NPV of the project without options and
the value of the managerial options implicit in the project.
M NPV Opt
$75.00 38.64 Opt
$7,900
$6,529
(1.10) 2
119