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Corporate Financial Theory

Corporate Financial Theory. Lecture 3. Interest Rate and Cash Flow - REALITY. Is not guaranteed. Has many different sources. Beta and the COC. Company cost of capital (COC) is based on the average beta of the assets

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Corporate Financial Theory

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  1. Corporate FinancialTheory Lecture 3

  2. Interest Rate and Cash Flow - REALITY Is not guaranteed Has many different sources

  3. Beta and the COC • 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 • Assets = debt + equity

  4. Beta and the COC Expected return (%) Requity= 15 Rassets= 12.2 Rdebt= 8 Bequity Bdebt Bassets

  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 Assets = Debt + Equity

  6. Company Cost of Capital IMPORTANT E, D, and V are all market values of Equity, Debt and Total Firm Value

  7. Weighted Average Cost of Capital • WACC is the traditional view of capital structure, risk and return.

  8. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r rE rD D V

  9. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r rE WACC rD D V

  10. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r rE rD Includes Bankruptcy Risk D V

  11. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r rE rD Includes Bankruptcy Risk D V

  12. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r rE WACC rD Includes Bankruptcy Risk D V

  13. Weighted Average Cost of Capitalwithout taxes & bankruptcy risk r WACC r* Includes Bankruptcy Risk D V D*

  14. Beta and the COC • Company cost of capital (COC) is based on average beta of assets • Average beta of assets is based on the % of funds in each asset • Example 1/3 new ventures β = 2.0 1/3 expand existing business β = 1.3 1/3 plant efficiency β = 0.6 AVG βof assets = 1.3

  15. Beta and the COC • Company Cost of Capital

  16. Project risk Allowing for Possible Bad Outcomes Example Project Z will produce one cash flow, forecasted at $1 million at year 1. It is regarded as average risk, suitable for discounting at 10% company COC:

  17. Project risk Allowing for Possible Bad Outcomes Example, continued Company’s engineers are behind schedule developing technology for project. There is a small chance that it will not work. Most likely outcome still $1 million, but some chance that project Z will generate zero cash flow next year:

  18. Project risk Allowing for Possible Bad Outcomes Example, continued If technological uncertainty introduces a 10% chance of zero cash flow, unbiased forecast could drop to $900,000:

  19. Risk, DCF and CEQ Risk, Discounted Cash Flow (DCF), and Certainty Equivalents (CEQ)

  20. 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?

  21. 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?

  22. 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?

  23. 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?

  24. 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?

  25. 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.

  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? DEDUCTION FOR RISK

  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?.. 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

  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?.. Now assume that the cash flows change, but are RISK FREE. What is the new PV?

  29. 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) Modify Cash Flows

  30. Capital Budgeting & Risk Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis (Monte Carlo) - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even. Decision Trees – Binomial model in which outcomes are path dependent. Real Options – The value of flexibility.

  31. Sensitivity Analysis Example Given the expected cash flow forecasts for Otobai Company’s Motor Scooter project, listed on the next slide, determine the NPV of the project given changes in the cash flow components using a 10% cost of capital. Assume that all variables remain constant, except the one you are changing.

  32. Sensitivity Analysis Example - continued Possible Outcomes

  33. Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

  34. Sensitivity Analysis NPV= 3.43 billion Yen

  35. Sensitivity Analysis Example - continued Possible Outcomes

  36. Sensitivity Analysis NPV Calculations for Optimistic Market Size Scenario NPV= +5.77 bil yen

  37. Sensitivity Analysis Example - continued NPV Possibilities (Billions Yen)

  38. Break Even Analysis Accounting break-even does not consider time value of money Otobai Motors has accounting break-even point of 60,000 units sold 60 40 20 Revenues Accounting revenue and costs (Yen) Billions Break -even Profit =0 Costs Sales, thousands 60 200

  39. Break Even Analysis Point at which NPV=0 is break-even point Otobai Motors has a break-even point of 85,000 units sold PV inflows PV (Yen) Billions 400 200 19.6 Break-even NPV = 0 PV Outflows Sales, thousands 85 200

  40. Monte Carlo Simulation • Step 1: Modeling the Project • Step 2: Specifying Probabilities • Step 3: Simulate the Cash Flows • Step 4: Calculate NPV Modeling Process

  41. Monte Carlo Simulation

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

  43. 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 Piston 0 -250 NPV= ?

  44. 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= ?

  45. 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= ?

  46. 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 0 Piston 331 -250 NPV= ? NPV=184.55

  47. 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

  48. 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

  49. 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= ?

  50. 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

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