1 Copyright 1996 by The McGraw-Hill Companies, In WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING? MANY FIRMS USE OVERALL FIRM COST OF CAPITAL TO DISCOUNT CASH FLOWS FOR ALL NEW PROJECTS WRONG IF NEW PROJECT MORE OR LESS RISKY THAN ITS EXISTING BUSINESS EACH PROJECT SHOULD IN PRINCIPLE BE DISCOUNTED USING ITS OWN OPPORTUNITY COST OF CAPITAL
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WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING?
WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING?. MANY FIRMS USE OVERALL FIRM COST OF CAPITAL TO DISCOUNT CASH FLOWS FOR ALL NEW PROJECTS WRONG IF NEW PROJECT MORE OR LESS RISKY THAN ITS EXISTING BUSINESS - PowerPoint PPT Presentation
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1Copyright 1996 by The McGraw-Hill Companies, Inc
WHAT DISCOUNT RATE SHOULD THE FIRM USE IN CAPITAL BUDGETING?
MANY FIRMS USE OVERALL FIRM COST OF CAPITAL TO DISCOUNT CASH FLOWS FOR ALL NEW PROJECTS
WRONG IF NEW PROJECT MORE OR LESS RISKY THAN ITS EXISTING BUSINESS
EACH PROJECT SHOULD IN PRINCIPLE BE DISCOUNTED USING ITS OWN OPPORTUNITY COST OF CAPITAL
2Copyright 1996 by The McGraw-Hill Companies, Inc
COMPANY COST OF CAPITAL AND
REQUIRED RETURN ON PROJECT
REQUIRED RETURN
PROJECT BETA
Company cost of capital
required return on projectSecurity market line showing
Average betaof firm's assets
3Copyright 1996 by The McGraw-Hill Companies, Inc
COMPANY COST OF CAPITAL RULE
DUKE POWER HAS LOW RISK AND LOW COMPANY COST OF CAPITAL
MICROSOFT HAS HIGH RISK AND HIGH COMPANY COST OF CAPITAL
IF BOTH FIRMS USED THE COMPANY COST OF CAPITAL RULE TO EVALUATE THE SAME PROJECT, POSSIBLE THAT– DUKE POWER WOULD ACCEPT THE PROJECT– MICROSOFT WOULD REJECT THE PROJECT
WRONG!!
4Copyright 1996 by The McGraw-Hill Companies, Inc
COMPANY COST OF CAPITAL RULE
WIDESPREAD USE OF A UNIFORM COST OF CAPITAL BY MANY COMPANIES IN EVALUATING PROJECTS
BUT MANY FIRMS DO REQUIRE DIFFERENT RETURNS FOR DIFFERENT CATEGORIES OF INVESTMENT– EXAMPLE ON NEXT SLIDE
5Copyright 1996 by The McGraw-Hill Companies, Inc
CATEGORY DISCOUNT RATE
SPECULATIVE VENTURES 30%
NEW PRODUCTS 20%
EXPANSION OF 15% (company cost of capital)EXISTING BUSINESS
COST IMPROVEMENT 10%KNOWN TECHNOLOGY
6Copyright 1996 by The McGraw-Hill Companies, Inc
USING CAPM AND PROJECT
MANY LARGE CORPORATIONS USE CAPM AND AN ESTIMATE OF THE PROJECT TO ESTIMATE
PROJECT DISCOUNT RATE
EXPECTED PROJECT RETURN = rf + project (rm- rf)
7Copyright 1996 by The McGraw-Hill Companies, Inc
BEGIN WITH PROBLEMS IN MEASURING COMPANY
IS DIFFICULT TO MEASURE FOR INDIVIDUAL FIRM
BETTER ACCURACY BY LOOKING AT AVERAGE OF SIMILAR COMPANIES– BUT FIRM’S BORROWING POLICIES AFFECTS ITS
STOCK – IBM AND DEC ARE NOT SIMILAR COMPANIES
FOR PURPOSE OF ESTIMATING BECAUSE THEY USE DIFFERENT DEGREES OF LEVERAGE
8Copyright 1996 by The McGraw-Hill Companies, Inc
MEASURING COMPANY
APPROPRIATE FOR ACROSS-THE-BOARD EXPANSIONCOMPARE RETURN ON STOCK WITH MARKET RETURN OVER
60-MONTH TIME PERIOD– AT&T– HEWLETT-PACKARD
SLOPE IS VARIES BY PERIODESTIMATES OF ARE PUBLISHED BY BROKERAGE HOUSES
AND ADVISORY SERVICES
9Copyright 1996 by The McGraw-Hill Companies, Inc
ESTIMATING BETA
RETURN ON SHARE
RETURN ON MARKET
+
Beta = .4
++
++ +
++++
++
+
+
++
+
+++
++ +
++
+++
RETURN ON SHARE
RETURN ON MARKET
+
Beta = 1.6
++
+
+ +
++++
++
+
+
++
+
++
+
++ +
++
+
++
10Copyright 1996 by The McGraw-Hill Companies, Inc
PFIZERWHICH IS THE BETTER ESTIMATE OF FOR PFIZER?
– PFIZER HAS A OF 1.02 WITH A STANDARD ERROR OF 0.14
– A MARKET VALUE-WEIGHTED INDUSTRY PORTFOLIO OF LARGE PHARMACEUTICAL COMPANIES HAS A OF 0.98 WITH A STANDARD ERROR OF 0.07
DIFFERENCE BETWEEN ESTIMATE OF COMPANY BETA AND INDUSTRY BETA IS PROBABLY NOISE – UNLESS YOU HAVE REASON TO BELIEVE THAT PFIZER
IS RISKIER THAN INDUSTRY AVERAGE
11Copyright 1996 by The McGraw-Hill Companies, Inc
HOW CAPITAL STRUCTURE AFFECTS EXPECTED RETURNS
IF YOU OWN ALL OF THE EQUITY AND ALL OF THE DEBT OF A COMPANY, YOU WOULD ALSO RECEIVE ALL CASH FLOWS FROM THE COMPANY
COMPANY’S COST OF CAPITAL IS EXPECTED RETURN ON THIS PORTFOLIO
12Copyright 1996 by The McGraw-Hill Companies, Inc
HOW CHANGING CAPITAL STRUCTURE AFFECTS
AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED – BUT BOTH DEBT AND EQUITY ARE
INDIVIDUALLY LESS RISKYFIRM’S ASSET BETA IS WEIGHTED AVERAGE OF
PORTFOLIO OF DEBT AND EQUITY BETAS assets portfolio
DV
EV debt equity
13Copyright 1996 by The McGraw-Hill Companies, Inc
HOW CHANGING CAPITAL STRUCTURE AFFECTS
AFTER REFINANCING, RISK OF TOTAL PORTFOLIO OF DEBT AND EQUITY IS UNCHANGED – BUT BOTH DEBT AND EQUITY ARE INDIVIDUALLY
LESS RISKYFIRM’S ASSET BETA IS WEIGHTED AVERAGE OF
PORTFOLIO OF DEBT AND EQUITY BETAS
SUPPOSE debt FALLS TO .1 .8 = (.3 X .1) + (.7 X equity )
equity = 1.1
assets portfolio
DV
EV debt equity
14Copyright 1996 by The McGraw-Hill Companies, Inc
UNLEVERING BETAS
GOING FROM AN OBSERVED equity TO assets
WE KNOW equity debt
MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)
assets portfolio
DV
EV debt equity
15Copyright 1996 by The McGraw-Hill Companies, Inc
UNLEVERING BETAS
GOING FROM AN OBSERVED equity TO assets
WE KNOW equity debt
MARKET WEIGHTS OF DEBT AND EQUITY, (D/V )AND (E/V)
WE WILL ADD TAX EFFECTS LATER
assets portfolio
DV
EV debt equity
16Copyright 1996 by The McGraw-Hill Companies, Inc
REVIEWCOST OF CAPITAL IS RELEVANT IN CAPITAL BUDGETING
DECISIONS– NOT EXPECTED RETURN ON COMMON STOCK
COMPANY COST OF CAPITAL IS WEIGHTED AVERAGE RETURN THAT INVESTORS EXPECT ON FIRM’S DEBT AND EQUITY– RELATED TO FIRM’S ASSET BETA, NOT TO EQUITY BETA
ASSET BETA CALCULATED AS WEIGHTED AVERAGE OF BETAS OF DEBT AND EQUITY
WHEN FIRM CHANGES ITS CAPITAL STRUCTURE– RISK AND EXPECTED RETURNS OF DEBT AND EQUITY
CHANGE– ASSET BETA AND COMPANY COST OF CAPITAL DO
NOT CHANGE
17Copyright 1996 by The McGraw-Hill Companies, Inc
WHAT DETERMINES ASSET BETAS?
FIRMS WITH HIGH ACCOUNTING OR CASH FLOW BETAS ALSO TEND TO HAVE HIGH STOCK BETAS– CYCLICAL FIRMS WHOSE EARNINGS ARE
STRONGLY RELATED TO THE BUSINESS CYCLE TEND TO BE HIGH BETA FIRMS
DEMAND A HIGHER RATE OF RETURN FROM SECURITIES WHOSE PERFORMANCE MOVES WITH THE ECONOMY
18Copyright 1996 by The McGraw-Hill Companies, Inc
23Copyright 1996 by The McGraw-Hill Companies, Inc
IRR = 28%
+2
0
-1
50DISCOUNTRATE (%)
NPV
NET PRESENT VALUE PROFILE
C0 = - 4C1 = +2C3 = +4
24Copyright 1996 by The McGraw-Hill Companies, Inc
INTERNAL RATE OF RETURN RULE
ACCEPT PROJECT IF IRR IS GREATER THAN
THE OPPORTUNITY COST OF CAPITAL
LOOKING AT THE NET PRESENT VALUE PROFILE FOR A CONVENTIONAL PROJECT, WE WILL BE ACCEPTING PROJECTS
WITH POSITIVE NPV
25Copyright 1996 by The McGraw-Hill Companies, Inc
CONVENTIONAL PROJECT
CASH OUTFLOWS FOLLOWED BY CASH INFLOWSNPV DECLINES WITH INCREASING DISCOUNT
RATES
26Copyright 1996 by The McGraw-Hill Companies, Inc
WARNING
DISTINGUISH BETWEEN IRR AND OPPORTUNITY COST OF CAPITAL
– BOTH APPEAR AS DISCOUNT RATES IN NPV FORMULA.
IRR IS A MEASURE OF PROFITABILITY, DEPENDS ON AMOUNT AND TIMING OF CASH FLOWS
OPPORTUNITY COST OF CAPITAL MEASURES WHAT WE COULD EARN BY INVESTING IN FINANCIAL ASSETS OF SIMILAR RISK– SET BY CAPITAL MARKETS
– IT IS A COST OF FINANCING THE PROJECT
– IT PROVIDES US WITH A MINIMUM ACCEPTABLE LEVEL OF PROFITABILITY
27Copyright 1996 by The McGraw-Hill Companies, Inc
NPV Year: 0 1 IRR(%) At 10% ($)
A -1,000 +1,500 +50 +364 B +1,000 -1,500 +50 +364 BOTH PROJECTS HAVE IRR OF 50%NPV PROFILE FOR PROJECT B INCREASES
WITH INCREASING DISCOUNT RATESACCEPT PROJECT B WHEN IRR IS LESS THAN
THE OPPORTUNITY COST OF CAPITAL
LENDING OR BORROWING?
28Copyright 1996 by The McGraw-Hill Companies, Inc
MULTIPLE RATES OF RETURN
DESCARTES’ RULE OF SIGNS SAYS THERE ARE AS THERE ARE CHANGES IN SIGN
– BUT SOME OF THE ROOTS MAY BE THE SAME! OFTEN HAVE CASH OUTCASH OUTFLOWS FROM INITIAL
INVESTMENT, FOLLOWED BY POSITIVE CASH FLOWS DURING PROJECT LIFE, FOLLOWED BY CASH
OUTFLOWS AT END OF PROJECT LIFE– DECOMMISSIONING COSTS OF NUCLEAR POWER PLANT– RECLAMATION COSTS AFTER STRIPMINING COAL– DELAY BETWEEN EARNING INCOME AND PAYING TAX
29Copyright 1996 by The McGraw-Hill Companies, Inc