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Risk and Capital Budgeting (Chapter 10)

Risk and Capital Budgeting (Chapter 10). 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.

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Risk and Capital Budgeting (Chapter 10)

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  1. Risk and Capital Budgeting(Chapter 10) Fußzeile

  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 Fußzeile

  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 Fußzeile

  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 the economic situation (product demand is elastic). • Carbonlite’s stock has a beta of 1.5 Managers note Rf = 5%, expected market return assumed to be 11%: E(Re ) = Rf + (E(Rm) - Rf) = 5% + 1.5(11%-5%)= 14% cost of equity Fußzeile

  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? Fußzeile

  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. Carbonlite’s EBIT increases faster because it has high operating leverage. Fußzeile

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

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

  9. The Effect of Financial Leverage on Beta Fußzeile

  10. The Effect of Financial Leverage on Beta [L=1;r=32%] Fußzeile

  11. The Effect of Financial Leverage on Beta Debt Equity Gear EBIT Capital(E+D)

  12. The Financial Leverage At a leverage of 0 (all equity financed !!) the standard deviation of 6.24% can be interpreted as operational risk. As the company / project is not debt-financed, there is no capital-structure related risk. While the operational risk remains always constant and idepen-dent of the capital structure, the total risk (standard deviation) will increase when we establish a higher degree of indebtedness. LEVERAGE D/E Fußzeile

  13. The Financial Leverage Statistically the mean return from the project (at L=1) will be 21.7% at a standard deviation of 12.5 %. Thus we can expect the result to be between 21.7% - 12.5% and 21.7% + 12.5% at a statistical probability of 68%.... 68% - 1s mean + 1s Fußzeile

  14. 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. • 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%. • Cost structure / financial structure remains unchanged.

  15. 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. Fußzeile

  16. 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. Fußzeile

  17. A Closer Look at Risk Break-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.

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

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

  20. 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 a NPV of $236,000. Fußzeile

  21. 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.  GTI expects to capture 5% of the market in the first year. • 7. GTI 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. Fußzeile

  22. Sensitivity Analysis of Skateboard Project Base Case NPV: 236,000 USD Dollar values in thousands except price per unit Fußzeile

  23. Sensitivity Analysis of Skateboard Project Base Case NPV: 236,000 USD Market Share NPV Invest-ment In % of base case 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160 170 Selling Price

  24. Risk And Capital Budgeting • All-equity firms can discount their standard invest-ment projects at cost of equity. • Firms with debt and equity can discount their stan-dard investment projects using WACC. • A variety of tools exist to assist managers in under-standing the sources of uncertainty of a project’s cash flows. • If risk is explicitly measured as a type of deviation from a mean expected value, decision rules must be able to handle two parameters, expected risk and expected return. Fußzeile

  25. Real Options in Capital Budgeting Option pricing analysis is helpful in examining multi-stage projects. Embedded options arise naturally from investment are 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! (-:, (-: …… the story is over) Fußzeile

  26. Payoff Payoff at Expiration slope = 1 75 83 stock price -8 Net payoff Excursion: Long Call Option Payoffs Call = Right to buy an underlying instrument at a fixed price Long Call = Bying a Call x = $75, premium = $8

  27. Excursion: Short Call Option Payoffs Call = Right to buy an underlying instrument at a fixed price Short Call = Selling a Call 75 83 +8 stock price x = $75, premium = $8 Payoff Payoff at expiration Net payoff slope = -1

  28. 75 68 Payoff Payoff at expiration Price of stock 68 75 -7 Net payoff Excursion: Long Put Option Payoffs Put = Right to sell an underlying instrument at a fixed price Long Put = Bying a call x = 75, premium = $7

  29. Net payoff 7 75 68 Stock price Payoff at expiration Payoff -75 Excursion: Short Put Option Payoffs Put = Right to sell an underlying instrument at a fixed price Short Put = Selling a call x = 75, premium = $7

  30. Expansion options • If a product is a hit, expand production (call option). Abandonment options • Firm can abandon a project if not successful (put option). • 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 Fußzeile

  31. Flexibility & Real Options Decision Trees - Diagram of sequential decisions and possible outcomes. • Decision trees help companies determine their Options by showing the various choices and outcomes. • The Option to avoid a loss or produce extra profit has value. • The ability to create an Option thus has value that can be bought or sold. Fußzeile

  32. Decision Trees Success Test (Invest $200,000) Pursue project NPV=$2million Failure Stop project NPV=0 Don’t test NPV=0 Fußzeile

  33. Decision Trees(Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston Fußzeile

  34. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston Fußzeile

  35. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop -150 +100(.6) +50(.4) or 0 -250 NPV= ? Piston Fußzeile

  36. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? Turboprop *450 -150 +100(.6) +50(.4) or 0 331 -250 NPV= ? Piston Fußzeile

  37. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) +30(.4) -550 NPV= ? NPV=444.55 Turboprop *450 -150 NPV=550.00 +100(.6) +50(.4) or 0 331 -250 NPV= ? NPV=184.55 Piston Fußzeile

  38. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) 710.73 +30(.4) -550 NPV= ? NPV=444.55 Turboprop *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or 0 331 -250 NPV= ? NPV=184.55 Piston Fußzeile

  39. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 812 456 660 364 148 +150(.6) 710.73 +30(.4) Turboprop -550 NPV=96.12 NPV=444.55 *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or Piston 0 331 -250 NPV=117.00 NPV=184.55 Fußzeile

  40. Decision Trees (Magna Charta) 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) NPV=888.18 +150(.6) 710.73 +30(.4) 812 456 660 364 148 Turboprop -550 NPV=96.12 NPV=444.55 +450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or Piston 331 0 -250 NPV=117.10 NPV=184.55 Fußzeile

  41. Decision Trees (Magna Charta) Net Present Value Calculation without considering any option: Fußzeile

  42. Decision Trees (Magna Charta) Net Present Value Calculation without considering any option: Fußzeile

  43. Decision Trees (Magna Charta)Option to Expand the Business Thus, the op-tion to expand has a value of 117.10-52.15 = 64.95 T$ In case, Agnes has invested in the Piston plane, she will have to decide whether to expand or not in t1: Agnes will invest !! Fußzeile

  44. Decision Trees (Magna Charta)Option to Abandon (Piston Put) In case, Agnes has invested in the Piston plane, she may in t1 decide whether to abandon the business or to go on: Agnes will abandon the business and sell the plane !! Thus, the option to abandon the business has a value of 122.72 -117.10 = 5.62 T$ Fußzeile

  45. Decision Trees (Magna Charta)Option to Abandon (Turbo Put) In case, Agnes has invested in the Piston plane, she may in t1 decide whether to abandon the business or to go on: Agnes will abandon the business and sell the Turbo !! Thus, the option to abandon the business has a value of 127.18 -96 = 31.18 T$ Fußzeile

  46. Magna Charta Valuation Including Option Values As investments are actively managed, there each investment may include options to be exercised in the future. These options may significantly change the value of an investment. Fußzeile

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