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Chapter 12

Chapter 12. Risk, Return, and Capital Budgeting. Review Item. Yahoo is considering building a cafeteria for its employees. At a high discount rate appropriate to Yahoo’s risk, the NPV of the cafeteria is negative.

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Chapter 12

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  1. Chapter 12 Risk, Return, and Capital Budgeting

  2. Review Item • Yahoo is considering building a cafeteria for its employees. • At a high discount rate appropriate to Yahoo’s risk, the NPV of the cafeteria is negative. • At a low discount rate appropriate to a Wendy’s, the NPV of the cafeteria is positive. • Should Yahoo build the cafeteria? • Explain briefly.

  3. Answer • Build the cafeteria. • The project is safe like a Wendy’s, not risky like an internet service. • NPV is market value. • The market is not deceived but sees the project for the safe investment that it is.

  4. Example of beta and NPV • Wingmar Inc. has a beta of 2. • The Market risk premium is 8.5% • The risk-free rate is 4%. • Wingmar has a project with cash flows -100, 60, 80. • The project is typical of Wingmar’s core business. • Should the project be undertaken?

  5. Answer • Part 1. Cost of equity financing. The appropriate discount rate for projects of Wingmar is .04+.085(2)=.21. • Part 2. The NPV of the project is 4.2278533. • Take the project.

  6. Chapter 12 Risk, Return, and Capital Budgeting • Determinants of the Cost of Equity Capital • Estimation of Beta • Financial leverage.

  7. The Cost of Equity • E(rs) = RF + bs x [E(RM) - RF] • Business risk 1: Cyclicality of revenues • Business risk 2: Operating leverage. • Financial Leverage

  8. Cyclicality • Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.

  9. Operating leverage • Fixed cost of debt service, leases, employment contractsversus variable costs. • High operating leverage means high fixed costs. MRI labs. • Low leverage, low fixed cost. Fast food, services. • EBIT = earnings before interest and taxes. Assume depreciation = loss of market value.

  10. Beta Estimation • Problems • Betas may vary over time. • The sample size may be inadequate. • Solutions • More sophisticated statistical techniques.

  11. Beta Estimation • Problem: Beta for a firm is overly influenced by random factors peculiar to the firm. • Solution: Look at average beta estimates of several comparable firms in the industry. • Problem: Firms have financial leverage, which shouldn’t matter in NPV. • Solution: Adjust as follows.

  12. Financial leverage means debt • Equity beta for the firm’s shares. • Debt beta for the firm’s debt. • Asset beta for the physical firm.

  13. The physical firm (the asset) is a portfolio • S = market value of equity (stock) • B = “ “ “ debt (bonds) • A = “ “ “ asset (firm) • Portfolio weights are

  14. Beta of the (physical) firm • Beta of a portfolio is the weighted sum of the betas of the components.

  15. Normally • Stock is risky • Debt is less risky • Asset is in between.

  16. Weighted Average Cost of Capital

  17. Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets • 13.1 Can Financing Decisions Create Value? • 13.2 A Description of Efficient Capital Markets • 13.3 The Different Types of Efficiency

  18. Reaction of Stock Price to New Information in Efficient and Inefficient Markets Stock Price Overreaction to “good news” with reversion Delayed response to “good news” Efficient market response to “good news” -30 -20 -10 0 +10 +20 +30 Days before (-) and after (+) announcement

  19. Reaction of Stock Price to New Information in Efficient and Inefficient Markets Overreaction andreversion Delayed response Efficient-marketresponse to new information StockPrice Days before (+) andafter (-) announcement –10 0 +10 +20 +30 –30 –20

  20. Sets of Information relevant to a stock All information Publicly availableinformation Past prices

  21. Three Forms of Market Efficient Hypothesis • Weak • Prices reflect information in past prices • Random Walk • Semi-strong • Prices reflect publicly available information • Strong • Prices reflect all information

  22. Implications for Corporate Financial Managers • Can financial managers “fool” investors? • Can financial managers “time” security sales? • Are there price pressure effects?

  23. Some anomalies • Monday effects • Weekend effects • January effects • Small firm effects • Pre acquisition run-ups

  24. Some explanations • Closing positions over the weekend. • ditto • Tax timing, annual reporting, data mining. • Trading with better informed quasi-insiders. • Information leaking out bit by bit.

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