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
Professor John ZietlowMBA 621
E(Re ) = Rf + (E(Rm) - Rf) = 4% + 1.3 (9% - 4%) =10.5% cost of equity
DOLAll Leather =
E(R) = 6% + 0.69(7%) = 10.83%
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.
Microfiber has low fixed costs ($2,000,000), but also low contribution
margin ($150/sofa). Low BEP, but profits grow slowly after FC covered.
each year after year one.
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!
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