Risk And Capital Budgeting

1. Risk And Capital Budgeting Professor XXXXX Course Name / Number

2. The numerator focuses on project cash flows covered in chapter 9. The denominator is the discount rate, the focus of chapter 10. Reflect opportunity costs to firm’s investors The denominator should: Reflect the project’s risk Be derived from market data Choosing the Right Discount Rate

3. Project discount rate is easy to determine if we assume : Firm is financed with 100% equity Project is similar to the firm’s existing assets A Simple Case In this case, the appropriate discount rate equals the cost of equity. Cost of equity estimated using the CAPM

4. Carbonlite Inc. Cost of Equity Carbonlite Inc., an all-equity firm, is evaluating a proposal to build a new manufacturing facility. • Firm manufactures bicycle frames. • As a luxury good producer, firm is very sensitive to economy (product demand is elastic). • Carbonlite’s stock has a beta of 1.5 • Managers note Rf = 5%, expect the market return will be 11%. E(Re ) = Rf + (E(Rm) - Rf) = 5% + 1.5(11%-5%)= 14% cost of equity

5. The mix of fixed and variable costs Operating leverage The extent to which a firm finances operations by borrowing Financial Leverage The fixed costs of repaying debt increase a firm’s beta in the same way that operating leverage does. Cost of Equity Beta plays a central role in determining whether a firm’s cost of equity is high or low. What factors influence a firm’s beta?

6. 11,000 frames 11,000 frames $11,000,000 $11,000,000 $9,400,000 $9,700,000 $1,600,000 $1,300,000 Carbonlite Inc. vs. Fiberspeed Corp. The two firms are in the same industry. What if sales volume increases by 10% ? Carbonlite’s EBIT increases faster because it has high operating leverage.

7. Operating Leverage for Carbonlite and Fiberspeed EBIT Carbonlite Fiberspeed Sales Other things equal, higher operating leverage means that Carbonlite’s beta will be higher than Fiberspeed’s beta.

8. The Effect of Financial Leverage on Beta Financial leverage makes Firm 2’s ROE more volatile, so its beta will be higher .

9. Lox-in-a-Box is a chain of fast food stores. • Firm has $100 million equity (E), with cost of equity re= 15%; • Also has bonds (D) worth $50 million, with rd = 9%. • Assume that the investment considered will not change the cost structure or financial structure. The Weighted Average Cost of Capital (WACC) Cost of equity applies to projects of an all-equity firm. • But what if firm has both debt and equity? • Problem is akin to finding expected return of portfolio. • Use weighted average cost of capital (WACC) as discount rate.

10. Has 1,000,000 common shares; price = $50/share; re = 15%. An example.... S.D. Williams Total value = $50 million Has 200,000 preferred shares, 8% coupon, price = $80/share, 10% rate of return, $16 million value. Has $47.1 million long term debt, fixed rate notes with 8% coupon rate, but 7% YTM. Notes sell at premium and worth $49 million. Finding WACC for Firms with Complex Capital Structures How do we calculate WACC if firm has long-term (D) debt as well as preferred (P) and common stock (E)?

11. Rules for Selecting an Appropriate Project Discount Rate • Cost of equity is the appropriate discount rate for an all-equity firm. • When a levered firm invests in a project similar to its existing projects, the WACC is the right discount rate. • When a firm invests in a project different than its existing projects, using the WACC may lead to mistakes.

12. We have thus far assumed away taxes, which are often important in financing decisions. • Tax deductibility of interest payments favors use of debt. • Accounting for interest tax shields yields after-tax WACC. Accounting for Taxes in Finding WACC • Accounting for taxes doesn’t change the rules for selecting the discount rate.

13. A Closer Look at RiskBreak-Even Analysis Managers often want to assess business’ value drivers. Finding the break-even point is often useful for assessing operating risk. Break-even point (BEP) is level of output where all operating costs (fixed and variable) are covered.

14. Break-Even Point for Carbonlite Costs & Revenues Total revenue Total costs $5,000,000 Fixed costs 8,333 units Units Carbonlite has high fixed costs ($5,000,000), but also high contribution margin ($600/bike). High BEP, but once FC covered, profits grow rapidly.

15. Break-Even Point for Fiberspeed Costs & Revenues Total revenue Total costs Fixed costs $2,000,000 6,667 units Units Fiberspeed has low fixed costs ($2,000,000), but also low contribution margin ($300/bike). Low BEP, but profits grow slowly after FC covered.

16. Sensitivity analysis allows mangers to test importance of each assumption underlying a forecast. • Test deviations from “base case” and associated NPV Sensitivity Analysis 1.   The project’s life is five years. 2.   The project requires an up-front investment of $7 million. 3.   GTI will depreciate initial investment on straight line basis for five years. GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000.

17. Sensitivity Analysis 4.   One year from now, the skateboard industry will sell 500,000 units. 5.   Total industry unit volume will increase by 5% per year. 6.   BEI expects to capture 5% 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 $200 in year one 9.   Selling price will decline by 10% per year after year one. 10. Variable production costs will equal 60% of the selling price. 11. The appropriate discount rate is 14 percent.

18. Sensitivity Analysis of Skateboard Project Dollar values in thousands except price

19. Real Options in Capital Budgeting Option pricing analysis is helpful in examining multi-stage projects. Embedded options arise naturally from investment Called real options to distinguish from financial options. Value of a project equals value captured by NPV, plus option. Can transform negative NPV projects into positive NPV!

20. Expansion options • If a product is a hit, expand production. Abandonment options • Firm can abandon a project if not successful. • Shareholders have valuable option to default on debt. Follow-on investmentoptions • Similar to expansion options, but more complex (Ex: movie rights to sequel) • Ability to use multiple production inputs (Ex: dual-fuel industrial boiler) or produce multiple outputs Flexibility options Real Options in Capital Budgeting

21. All-equity firms can discount their standard investment projects at cost of equity. Firms with debt and equity can discount their standard investment projects using WACC. A variety of tools exist to assist managers in understanding the sources of uncertainty of a project’s cash flows. Risk And Capital Budgeting