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Risk And Capital Budgeting

Chapter 9. Risk And Capital Budgeting. Professor John Zietlow MBA 621. Chapter 9: Overview. 9.1 Choosing the Right Discount Rate The cost of equity The weighted average cost of capital (WACC) Connecting WACC to the CAPM Asset betas and project discount rates 9.2 A Closer Look at Risk

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Risk And Capital Budgeting

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  1. Chapter 9 Risk And Capital Budgeting Professor John ZietlowMBA 621

  2. Chapter 9: Overview • 9.1 Choosing the Right Discount Rate • The cost of equity • The weighted average cost of capital (WACC) • Connecting WACC to the CAPM • Asset betas and project discount rates • 9.2 A Closer Look at Risk • Breakeven analysis • Sensitivity analysis • Scenario analysis and Monte Carlo simulation • Decision trees

  3. Chapter 9: Overview (Continued) • 9.3 Real Options • Why NPV doesn’t always give the right answer • Types of real options • Expansion options • Abandonment options • Follow-on investment options • The surprising link between risk and real option values • 9.4 Strategy and Capital Budgeting • Competition and NPV • Strategic thinking and real options • 9.5 Summary

  4. Choosing the Right Discount Rate • To calculate an NPV, an analyst must evaluate project’s risk • Often, the best place to look for clues is a firm’s securities • What discount rate should managers use in cap budgeting? • Rate should reflect opportunity cost of all firm’s investors • Rate should also reflect the risk of the specific project • To find discount rate, start with simplifying assumptions: • Assume all equity financing, so only have to satisfy S/Hs • Assume firm makes all investments in a single industry • These allow firm to use cost of equity as discount rate • Know from chapter 6 that cost of equity found with CAPM (Eq 9.1)

  5. Determining All Leather’s Cost of Equity • All Leather Inc., an all-equity firm, is evaluating a proposal to build a new manufacturing facility • Firm produces leather sofas • As a luxury good producer, firm very sensitive to economy • All Leather’s stock has a beta of 1.3 • Managers note Rf = 4%, believe market’s return will be 9% • Can use CAPM to find All Leather’s cost of equity E(Re ) = Rf + (E(Rm) - Rf) = 4% + 1.3 (9% - 4%) =10.5% cost of equity • All Leather beta is 1.3 due partly to high economic sensitivity • Higher risk must be reflected in discount rate used to evaluate new manufacturing facility • Low beta company (food processor) would use lower rate

  6. Finding All Leather’s Cost of Equity (Cont) • Other factors, besides economic sensitivity, impact beta • A firm’s cost structure & production process very important • Mix of variable & fixed costs determines operating leverage • OL implies CF volatility will rise with fixed cost • Substituting fixed for variable cost increases profits more than proportionally when sales increase, but hurt if sales fall • Define degree of operating leverage (DOL) as % in EBIT divided by % in sales • High DOL: small change in sales  large change in EBIT (Eq 9.2) • Table on next slide details All Leather’s & competitor’s costs & prices • Microfiber also produces sofas, but less fixed costs

  7. Financial Data for All Leather Inc. and Microfiber Corp. • Suppose both firms achieve 10% rise in sales volume to 44,000 sofas • next year, holding all other figures constant. Fixed cost don’t change. • Both firms’ revenues go from $38,000,000 to $41,800,000; a 10% rise • All Leather’s total costs increase by $600/sofa, or $2,400,000 total • Microfiber’s total costs increase by $800/sofa, or $3,200,000 total • All Leather’s EBIT increases by $350/sofa, $1,400,000 total • Microfiber’s EBIT increases by $150/sofa, $600,000 total

  8. Calculating Operating Leverage for All Leather and Microfiber • Using data from previous table, can compute OL for both firms • Note key terms: EBIT= contribution margin - fixed costs • Contribution margin = gross profit per unit of sales • Gross profit = price per unit - variable cost per unit DOLAll Leather = DOLMicrofiber = • All Leather has a degree of operating leverage (DOL) of 3.5 • EBIT increases by 35% if sales increase by 10% • Microfiber has lower DOL of 1.5 due to lower fixed costs • EBIT increases by only 15% if sales increase by 10% • But firm would weather sales decline better than All Leather

  9. Operating Leverage for All Leather and Microfiber EBIT All Leather Microfiber Sales

  10. Measuring Financial Leverage and its Impact on Firm’s Stock Beta • Operating leverage: using fixed cost assets to magnify (leverage) impact of change in sales on change in EBIT • Increasing OL yields increasing stock beta • Firms also use fixed cost financing (debt & PS) to magnify effect of given change in EBIT on net income • Measured as degree of financial leverage (DFL) • If sales and EBIT increase, FL will yield magnified rise in NI • But also works on downside; if sales & EBIT fall, so will NI • FL increases expected net profits, but also increases risk • Thus use of FL also increases a firm’s stock beta

  11. Measuring Financial Leverage (Cont.) • Demonstrate FL with firms on next table; same except financing • Firm 1: 100% equity, Firm 2: 60% equity, 40% debt • Cost of Firm 2’s debt = 8.5%; assume neither firm pays tax • Both firms have $250mn assets, identical production process • Case #1: Assume both firms generate 25% gross return on assets, or $62.5mn EBIT, and both pay out net income to S/H • Firm 1 pays no interest, so $62.5 mn paid to S/Hs; 25% ROE • Firm 2 pays $8.5mn int, so $54mn paid to S/Hs; 36% ROE • Case #2: Assume both firms generate 5% gross return on assets, $12.5mn EBIT; again both pay out net income to S/H • Firm 1 pays no interest, so $12.5 mn paid to S/Hs; 5% ROE • Firm 2 pays $8.5mn int, so only $4mn paid to S/Hs; 2.7% ROE • If EBIT high, FL increases ROE; decreases ROE if EBIT low

  12. The Effect Of Financial Leverage on Shareholder Returns

  13. The Weighted Average Cost of Capital (WACC) • Cost of equity the right discount rate for all-equity firm • But what if firm has both debt and equity? • Problem akin to finding expected return of portfolio • Use weighted avg cost of capital (WACC) as discount rate • Let D and E represent market values of debt & equity • Demonstrate using Comfy Inc’s capital structure • Comfy Inc builds residential houses • Firm has $150mn equity (E), with cost of equity re= 12.5% • Also has bonds (D) worth $50mn O/S, with rd = 6.5% • Calculate WACC = 11%

  14. Finding the WACC (Cont) • How can Comfy’s managers be sure WACC = 11%? • First way: assume wealthy investor purchases all firm’s debt and equity. This is return he/she would earn • Second way: Suppose firm invests in a project earning 11% and distributes return to investors. Will they be satisfied? • Following table shows CF generated & distributed satisfies claims

  15. Finding WACC for Firms with Complex Capital Structures • How to calculate WACC if firm has long-term (LT) debt as well as preferred (P) & common stock (E)? • Find weighted average of individual capital costs • Assume S.N. Sherwin Co. wants to determine its WACC • Has 10,000,000 common shares O/S; price = $15/sh; rc = 15% • Has $40mn L-T, fixed rate notes with 8% coupon rate, but 7% YTM; notes sell at premium and worth $49mn • Has 500,000 pref shrs, 8% coupon, $75price, $12.5mn value • Total value = $150m E+ $49m LT+$12.5m P =$211.5m

  16. Connecting the WACC to the CAPM • Developed separately, but WACC consistent with CAPM • Have so far looked only at all-equity firm • But can use CAPM to compute WACC for levered firm • Calculate beta for bonds of a large corporation • First find covariance between bonds & stock market, then • Plug computed debt beta (d),Rf & Rm into CAPM to find rd • Debt beta typically quite low for healthy, low-debt firms • Debt beta rises with leverage, approaches equity beta in B/R • Example shows CAPM can be used for any security • Any asset that generates a CF has a beta, and that beta determines its required return as per CAPM

  17. Calculating Asset Betas and Equity Betas • The CAPM establishes direct link between required return on D & E and betas of these securities • Beta of firm’s assets equals weighted avg of D & E betas (Eq 9.4) • A firm’s asset beta thus equals the cov of firm’s CFs with RM, return on market p/f, divided by var of market’s return • For all-equity firm, asset beta = equity beta • For levered firm, asset beta will be less than equity beta • If asset beta known, anddebt beta is assumed to be 0, can compute equity beta directly from A (Eq 9.5)

  18. Finding Equity Betas from Asset Betas, and Vice Versa • If market values of D & E known, and any two of the three betas are known, can compute the other beta • Usually assume debt beta known (say d = 0.15) • Assume firm has manufacturing assets with asset beta = 1.2 • If firm unlevered, equity beta equals asset beta, E = A =1.2 • Now suppose firm decides to raise 20% of funding needs by issuing relatively safe bonds (d = 0.15) & retiring equity • Use Eq 9.4 to find E, given A = 1.2 and d = 0.15

  19. Finding Equity Betas from Asset Betas, and Vice Versa (Cont) • Can only use Eq 9.5 if debt beta assumed = 0 • Since debt = 20% of capital and equity = 80%, the debt-to-equity ratio D/E = 0.2 ÷ 0.8 = 0.25 • Not surprisingly, equity beta is higher if debt beta assumed 0 • Can now state decision rule for determining discount rate to use for projects with asset betas similar to firm’s own • For all equity firm, use cost of equity given by CAPM • For levered firm, use WACC computed using CAPM and betas of individual capital components • If a project’s asset beta differs from firm’s asset beta, must compute and use project betas

  20. Finding the Discount Rate to Use for Projects Unrelated to Firm’s Industry • What if a company has diversified investments in many industries? • In this case, using firm’s WACC to evaluate an individual project would be inappropriate • Instead use project’s asset beta adjusted for desired leverage • Assume GE evaluating an investment in oil & gas industry • Much different from any of GE’s existing businesses • Instead GE would examine existing firms that are pure plays • These are public firms operating only in O&G industry • Say GE selects Berry Petroleum & Forest Oil as pure plays • Operationally similar firms, but Berry Petroleum’s E = 0.65 and Forest Oil’s E = 0.90; why so different? • Reason: Forest uses debt for 39% of financing; Berry: 14% • Even if core business the same risk (A equal), E will differ

  21. Data for Berry Petroleum and Forest Oil • Computed using Eq 9.4 and assuming debt beta = 0 • Berry Petrol: A = (%D)d + (%E)E = (0.14)(0) + (0.86)(0.65) = 0.56 • Forest Oil: A = (%D)d + (%E)E = (0.39)(0) + (0.61)(0.90) = 0.55

  22. Converting Equity Betas to Asset Betas for Two Pure Play Firms • To determine correct A to use as discount rate for O&G project, GE must convert pure play E to A, then average • Previous table lists data needed to compute unlevered equity beta • Unlevered equity beta (same as A) strips out effect of financial leverage, so always less than or equal to equity beta • Berry’s A = 0.56, Forest’s A = 0.55, so average A = 0.55 • GE capital structure consists of 20% debt and 80% equity (D/E ratio = 0.25). Compute relevered equity beta:

  23. Converting Equity Betas to Asset Betas for Two Pure Play Firms (Continued) • Assume risk-free rate of interest is 6% and expected risk premium on the market is 7% • Using CAPM equation, compute rate of return GE shareholders require for the oil and gas investment E(R) = 6% + 0.69(7%) = 10.83% • One more step to find the right discount rate for GE’s investment in this industry – calculate project WACC • GE’s financing is 80% equity and 20% debt. Assume investors expect 6.5% on GE’s bonds

  24. Summarizing Rules for Selecting an Appropriate Project Discount Rate • When an all equity firm invests in an asset similar to its existing assets, the cost of equity is the appropriate discount rate to use in NPV calculations. • When a levered firm invests in an asset similar to its existing assets, the WACC is the right discount rate. • When a firm invests in an asset that is different than its existing assets, it should look for pure play firms to find the right discount rate. • Firms can calculate an industry asset beta by unlevering the betas of pure play firms • Given the industry asset beta, firms can determine an appropriate discount rate using the CAPM

  25. Accounting for Taxes in Finding WACC • Have thus far assumed away taxes, but often important • Tax deductibility of interest payments favors use of debt • Accounting for interest tax shields yields after-tax WACC (Eq 9.6) • Can likewise present method of computing after-tax equity beta from asset beta • Again assuming debt beta = 0, equity beta given by eq below • Accounting for taxes doesn’t change key lessons above (Eq 9.7)

  26. A Closer Look at RiskBreak-Even Analysis • Managers often want to assess business’ key value drivers • Key to assessing operating risk is finding break-even point • Break-even point (BEP) is level of output where all operating costs (fixed and variable) are covered • BEP found by dividing FC by contribution margin (CM) • Use this to find BEP for All Leather & Microfiber • All Leather: FC = $10,000,000; Pr = $950/un; VC = $600/un • Microfiber: FC = $2,000,000; Pr = $950/un; VC = $800/un

  27. Break-Even Point for All Leather Costs & Revenues Total revenue Total costs $10,000,000 Fixed costs 28,572 units Units All Leather has high fixed costs ($10,000,000), but also high contribution margin ($350/sofa). High BEP, but once FC covered, profits grow rapidly.

  28. Break-Even Point for Microfiber Costs & Revenues Total revenue Total costs Fixed costs $2,000,000 13,334 units Units Microfiber has low fixed costs ($2,000,000), but also low contribution margin ($150/sofa). Low BEP, but profits grow slowly after FC covered.

  29. Sensitivity Analysis • Sensitivity analysis allows mangers to test importance of each assumption underlying a forecast • Test deviations from “base case” and associated NPV • Best Electronics Inc (BEI) has new DVD players project. Base case assumptions (below) yields Exp NPV = $1,139,715 • 1.   The project’s life is five years. • 2.   The project requires an up-front investment of $41 million. • 3.   BEI will depreciate initial investment on S-L basis for five years • 4.   One year from now, DVD industry will sell 3,000,000 units • 5.   Total industry unit volume will increase by 5% per year. • 6.   BEI expects to capture 10% of the market in the first year • 7. BEI expects to increase its market share one percentage point each year after year one. • 8. The selling price will be $100 in year one. • 9.   Selling price will decline by 5% per year after year one. • 10. Variable production costs will equal 60% of the selling price. • 11. The appropriate discount rate is 14 percent.

  30. Sensitivity Analysis of DVD Project If all optimistic scenarios play out, project’s NPV rises to $37,635,010. If all pessimistic scenarios play out, project’s NPV falls to -$19,271,270!

  31. Using Decision Trees to Make Multi-Step Investment Decisions • Many real investment projects are conditional & multi-stage: will only proceed to stage 2 if stage 1 successful • Occurs frequently with new product introductions • Begin selling in test market; if successful, build factory for full-scale production & nationwide roll-out • Very hard to evaluate in standard cap budgeting framework • Decision trees allow managers to break investment analysis into distinct phases • Forces managers to perform extended “if--then” analysis • Assume Trinkle Foods (Canada) has invented new salt substitute, Odessa; assessing market testing in Vancouver • Market test will cost C$5 million, but no new facilities needed • If test successful, Trinkle will spend additional C$50mn to build factory and launch nationwide one year later

  32. Using Decision Trees (Cont) • If market test successful, Trinkle predicts full product launch will generate +C$12mn NCF per year for 10 years • If test unsuccessful, expect full product launch to generate only +C$2 mn NCF per year for 10 years. • If Trinkle’s WACC=15% should Trinkle invest? If so, in what? • Next figure shows decision tree for investment problem • Initially, firm can choose to spend C$5 mn on market test • If market test executed, expect probability of success = 0.5 • Proper way to use tree: begin at end & work backwards • Suppose in one year, Trinkle learns test is successful. • At that point, the NPV of launching the product is: • Clearly, Trinkle would invest if it winds up on this branch

  33. Decision Tree From Odessa Investment

  34. Using Decision Trees (Cont) • But what if the initial tests are unfavorable? • In that case, project’s NPV equals -C$39.96 mn & firm should walk away--not fund nationwide roll-out. • Note that C$5 mn test market cost is a sunk cost at t=1, so the NPV of doing nothing at time one is zero • Now have set of simple “if--then” decision rules from tree • If test successful, launch nationwide and NPV = C$10.23 mn • If test unsuccessful, don’t invest C$50 mn for national launch

  35. Using Decision Trees (Cont) • Now must decide (at t=0) whether to spend C$5 mn for test • Must realize NPVs computed at t=1 and use prob (success) • Seems unwise to invest in market test • But very sensitive to discounting future CF at 15% rate • Since test results known t=1, may use lower rate afterwards

  36. Real Options in Capital Budgeting • Though decision trees helpful in examining multi-stage projects, most promising method is option pricing analysis • Imbedded options arise naturally from investment • Called real options to distinguish from financial options • Options are valuable rights, not obligations • Can transform negative NPV projects into positive NPV • Value of a project equals value captured by NPV, plus option • Several types of real options frequently encountered: 1. Expansion options: If a product is a hit, expand production 2. Abandonment options: Can abandon a project if not successful; S/Hs have valuable option to default on debt 3. Follow-on investment options: Similar to expansion options, but more complex (Ex: movie rights to sequel) 4. Flexibility options: Ability to use multiple production inputs (Ex: dual-fuel industrial boiler) or produce multiple ouputs

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