Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 C o r p o r a t C o r p o r a t e e F i n a n c e F i n a n c e Fifth Edition Ross Jaffe Westerfi eld . . 12- 12-1 Chapter 12 Risk, Return, and Capital Budgeting
Apr 01, 2015
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Chapter 12Chapter 12
Risk, Return, and
Capital Budgeting
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Review ItemReview 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.
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AnswerAnswer
Build the cafeteria. The project is safe like a Wendy’s, not risky like an
internet service. NPV is market value. The market it not deceived but sees the project for the
safe investment that it is.
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Example of beta and NPVExample 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?
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AnswerAnswer
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.
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Chapter 12 Risk, Return, and Capital Budgeting
Chapter 12 Risk, Return, and Capital Budgeting
Determinants of the Cost of Equity Capital
Estimation of Beta Financial leverage.
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The Cost of EquityThe Cost of Equity
E(rs) = RF + s x [E(RM) - RF]
Business risk 1: Cyclicality of revenues Business risk 2: Operating leverage. Financial Leverage
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CyclicalityCyclicality
Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.
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Operating leverageOperating 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.
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Beta EstimationBeta Estimation
Problems Betas may vary over time. The sample size may be inadequate.
Solutions More sophisticated statistical techniques.
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Beta EstimationBeta 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.
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Financial leverage means debt
Financial leverage means debt
Equity beta for the firm’s shares. Debt beta for the firm’s debt. Asset beta for the physical firm.
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The physical firm (the asset) is a portfolioThe physical firm (the asset) is a portfolio
S = market value of equity (stock) B = “ “ “ debt (bonds) A = “ “ “ asset (firm) Portfolio weights are
BS
BX
BS
SX BS
,
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Beta of the (physical) firmBeta of the (physical) firm
Beta of a portfolio is the weighted sum of the betas of the components.
BSA BS
B
BS
S
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NormallyNormally
Stock is risky Debt is less risky Asset is in between.
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Weighted Average Cost of CapitalWeighted Average Cost of Capital
BCSWACC rTBS
Br
BS
Sr )1(
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Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets
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
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock Price
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+)
announcement
Efficient market response to “good news”
Overreaction to “good news” with reversion
Delayed response to
“good news”
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Reaction of Stock Price to New Information in Efficient and Inefficient Markets
StockPrice
Days before (+) andafter (-) announcement–30 –20 –10 0 +10 +20 +30
Efficient-marketresponse to new information
Delayed response
Overreaction andreversion
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Sets of Information relevant to a stockSets of Information relevant to a stock
Past prices
Publicly availableinformation
All information
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Three Forms of Market Efficient HypothesisThree 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
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Implications for Corporate Financial Managers
Implications for Corporate Financial Managers
Can financial managers “fool” investors? Can financial managers “time” security sales? Are there price pressure effects?
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Some anomaliesSome anomalies
Monday effects Weekend effects January effects Small firm effects Pre acquisition run-ups
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Some explanationsSome 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.