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Capital Budgeting & Risk

Capital Budgeting & Risk. Invest in highest NPV project. Need Discount rate to get NPV. Capital Budgeting & Risk. Invest in highest NPV project. Need Discount rate to get NPV. Use CAPM to get discount rate. Capital Budgeting & Risk. Invest in highest NPV project.

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Capital Budgeting & Risk

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  1. Capital Budgeting & Risk Invest in highest NPV project Need Discount rate to get NPV

  2. Capital Budgeting & Risk Invest in highest NPV project Need Discount rate to get NPV Use CAPM to get discount rate

  3. Capital Budgeting & Risk Invest in highest NPV project Need Discount rate to get NPV Use CAPM to get discount rate Modify CAPM (account for proper risk)

  4. Capital Budgeting & Risk • Modify CAPM • (account for proper risk) • Use COC unique to project, • rather than Company COC • Take into account Capital Structure

  5. Company Cost of Capitalsimple approach • Company Cost of Capital (COC) is based on the average beta of the assets • The average Beta of the assets is based on the % of funds in each asset

  6. Company Cost of Capitalsimple approach • Company Cost of Capital (COC) is based on the average beta of the assets • The average Beta of the assets is based on the % of funds in each asset • Example • 1/3 New Ventures B=2.0 • 1/3 Expand existing business B=1.3 • 1/3 Plant efficiency B=0.6 • AVG B of assets = 1.3

  7. Capital Structure • Capital Structure - the mix of debt & equity within a company • Expand CAPM to include CS • R = rf + B ( rm - rf ) • becomes • Requity = rf + B ( rm - rf )

  8. Capital Structure • COC =rportfolio = rassets

  9. Capital Structure • COC =rportfolio = rassets • rassets = WACC = rdebt (D) + requity (E) • (V) (V)

  10. Capital Structure • COC =rportfolio = rassets • rassets = WACC = rdebt (D) + requity (E) • (V) (V) • Bassets = Bdebt (D) + Bequity (E) • (V) (V)

  11. Capital Structure • COC =rportfolio = rassets • rassets = WACC = rdebt (D) + requity (E) • (V) (V) • Bassets = Bdebt (D) + Bequity (E) • (V) (V) requity = rf + Bequity ( rm - rf )

  12. Capital Structure • COC =rportfolio = rassets • rassets = WACC = rdebt (D) + requity (E) • (V) (V) • Bassets = Bdebt (D) + Bequity (E) • (V) (V) IMPORTANT E, D, and V are all market values requity = rf + Bequity ( rm - rf )

  13. Capital Structure & COC Expected Returns and Betas prior to refinancing Expected return (%) Requity=15 Rassets=12.2 Rrdebt=8 Bdebt Bassets Bequity

  14. Capital Budgeting • Problems with Capital Budgeting • How to Handle Problems with CB • 1 - Sensitivity Analysis • 2 - Break Even Analysis • 3 - Monte Carlo Simulation • 4 - Decision Trees • 5 - Certainty Equivalent

  15. Monte Carlo Simulation • Modeling Process • Step 1: Modeling the Project • Step 2: Specifying Probabilities • Step 3: Simulate the Cash Flows

  16. Decision Tree

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

  18. Decision Trees 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) Turboprop -550 NPV= ? -150 +100(.6) +50(.4) or Piston 0 -250 NPV= ?

  19. Decision Trees 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) Turboprop -550 NPV= ? -150 +100(.6) +50(.4) or Piston 0 -250 NPV= ?

  20. Decision Trees 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) Turboprop -550 NPV= ? *450 -150 +100(.6) +50(.4) or Piston 0 331 -250 NPV= ?

  21. Decision Trees 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) Turboprop -550 NPV= ? NPV=444.55 *450 -150 NPV=550.00 +100(.6) +50(.4) or Piston 0 331 -250 NPV= ? NPV=184.55

  22. Decision Trees 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) Turboprop -550 NPV= ? NPV=444.55 *450 -150 NPV=550.00 +100(.6) +50(.4) or Piston 0 331 -250 NPV= ? NPV=184.55

  23. Decision Trees 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= ? NPV=444.55 *450 -150 NPV=550.00 +100(.6) 403.82 +50(.4) or Piston 0 331 -250 NPV= ? NPV=184.55

  24. Decision Trees 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

  25. Decision Trees 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

  26. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?

  27. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?

  28. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?

  29. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project? Now assume that the cash flows change, but are RISK FREE. What is the new PV?

  30. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

  31. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV? Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.

  32. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV? The difference between the 100 and the certainty equivalent (94.6) is 5.4%…this % can be considered the annual premium on a risky cash flow

  33. Risk,DCF and CEQ • Example • Project A is expected to produce CF = $100 mil for each of three years. Given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the PV of the project?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

  34. Risk,DCF and CEQ • The prior example leads to a generic certainty equivalent formula.

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