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Risk And Capital Budgeting Professor Thomson Fin 3013

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2 Creating Value: Choosing the Right Discount Rate The numerator, that is, the project cash flows, were the focus last chapter. This chapter we focus on the discount rate. The denominator should: Reflect opportunity costs to firms investors Reflect the projects risk Be derived from market data

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3 A Simple Case: Look for similar risk Firm is financed with 100% equity Project risk is similar to the firms existing asset risk Project discount rate is easy to determine if we assume : In this case, the appropriate discount rate equals the cost of equity. Cost of equity estimated using the CAPM

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4 Another simple case (less likely) The project has no systematic risk Theory says use the risk free rate

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5 Carbonlite Inc. Cost of Equity E(R c ) = R f + c (E(R m ) - R f ) = 5% + 1.5(11%-5%) = 14% 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 economy (product demand is elastic). Carbonlites stock has a beta of 1.5 (Does it make sense for beta of this stock to be high?) Managers note R f = 5%, expect the market return will be 11%.

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6 Leverage Lever Old FrenchOld French levier, the agent noun to lever "to raise", c. f. levant) is a rigid object that is used with an appropriate fulcrum or pivot point to multiply the mechanical force that can be applied to another object. levant

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7 Cost of Equity Beta plays a central role in determining whether a firms cost of equity is high or low. Beta measures sensitivity to the market What factors influence a firms beta? Operating leverage The mix of fixed and variable costs Financial Leverage The extent to which a firm finances operations by borrowing The fixed costs of repaying debt increase a firms beta in the same way that operating leverage does.

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8 Carbonlite IncFiberspeed Corp Sales volume10,000 sofas Price$1,000 Total Revenue$10,000,000 Fixed costs per year$5,000,000$2,000,000 Variable costs this year$4,0000,000$7,000,000 Total cost$9,000,000 EBIT$1,000,000 Carbonlite Inc. ($400 Variable Cost per frame ) vs. Fiberspeed Corp. ($700 VC per frame) What if sales volume increases by 10% ? 10,000 frames $10,000,000 $9,000,000 $1,000,000 The two firms are in the same industry. Carbonlites EBIT increases faster because it has high operating leverage.

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9 Carbonlite IncFiberspeed Corp Sales volume10,000 sofas Price$1,000 Total Revenue$10,000,000 Fixed costs per year$5,000,000$2,000,000 Variable costs this year$4,4000,000$7,700,000 Total cost$9,000,000 EBIT$1,000,000 Carbonlite Inc. ($400 Variable Cost per frame ) vs. Fiberspeed Corp. ($700 VC per frame) EBIT for Carbonlite is up 60%, while its up only 30% for Fiberspeed What if sales volume decreases by 20% (from Base) ? 11,000 frames $11,000,000 $9,700,000$9,400,000$1,300,000$1,600,000 With 10% higher sales

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10 Carbonlite IncFiberspeed Corp Sales volume10,000 sofas Price$1,000 Total Revenue$10,000,000 Fixed costs per year$5,000,000$2,000,000 Variable costs this year$3,200,000$5,600,000 Total cost$9,000,000 EBIT$1,000,000 Carbonlite Inc. ($400 Variable Cost per frame ) vs. Fiberspeed Corp. ($700 VC per frame) EBIT for Carbonlite is down -120%, while its down only -60% for Fiberspeed Conclusion: Lower operating risk leads to lower financial risk 8,000 frames $8,000,000 $7,600,000$8,200,000$400,000$ -200,000 With 20% Lower sales

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11 Operating Leverage for Carbonlite and Fiberspeed Fiberspeed Carbonlite EBIT Sales Other things equal, higher operating leverage means that Carbonlites beta will be higher than Fiberspeeds beta.

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12 The Effect of Financial Leverage on Beta Firm NoLeverFirm Lever Assets$100 million Debt$0$50 million Equity$100 million$50 million Case #1: Gross Return on Assets Equals 20 Percent (Great Year) EBIT$20 million Interest$0$4 million Cash to equity$20 million$16 million ROE20 ÷ 100 = 20%16 ÷ 50 = 32% Case #2: Gross Return on Assets Equals 5 Percent (Poor Year) EBIT$5 million Interest$0$4 million Cash to equity$5 million$1 million ROE5 ÷ 100 = 5%1 ÷ 50 = 2% Financial leverage makes Firm Levers ROE more volatile, so its beta will be higher.

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13 Conclusion – Firms decisions determine the risk of the firm Firms create higher market risk (along with higher expected returns) as they employ more –Operating leverage (e.g. use fixed cost capital rather than variable cost labor) –Financial leverage (use fixed cost debt, rather than variable return equity) Either action will reveal itself in a higher beta; thus, firms in the same industry can have quite different Betas

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14 The WACC – Weighted Average Cost of Capital It is common for firms to use debt and preferred as well as equity to finance itself (using debt increases financial leverage). The firms financing can be see as a portfolio, with the overall return on a firm being the weighted average of the components

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15 Review: Return on a Portfolio E(R p ) = w 1 E(R 1 ) + w 2 E(R 2 ) + w 3 E(R 3 ) WACC = w E r E ) + w F r F + w D r D (1-T c ) Where: w E = capital structure weight in Equity w F = capital structure weight in PreFerred w D = capital structure weight in Debt r E = cost of Equity capital r F = cost of PreFerred capital r D = pretax cost of Debt capital T C = marginal corporate tax rate

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16 Cost of Equity (market evidence) We know from the Dividend Discount Model (DDM, Chapter 5) that: P 0 = D 1 /(R-g) –Where R = the appropriate discount rate to use in discounting the firms future dividends –This rate, R, varies with the systematic risk of the company If we know, (or can estimate) D 1, g, and P 0 ) then we can compute r E = D 1 /P 0 + g The is one way to measure R E = cost of equity

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17 Cost of Equity (Alternate market based approach) We know from the CAPM (Chapter 8) that: E(R i ) = R f + i [E(R m ) – R f ] E(R i ) can also be seen as an estimate of the cost of equity (i.e. a measure of r E )

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18 Cost of Debt (market price) From Chapter 6, we learned to compute the YTM of a bond. The YTM is what the market requires for a return on that bond; therefore, if a firm issue new bonds it will have to pay this rate Interest paid to bond holders is a business expense and is tax deductible The after tax cost of bonds is the pre tax cost less the tax effect

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19 Cost of Debt Define: r D = cost of debt (which = YTM) The the after tax cost of debt is: = r D (1-T C ) Where T C = corporate tax rate

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20 The Weighted Average Cost of Capital (WACC) 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 r e = 15%; Also has bonds (D) worth $50 million, with r d = 9%. Assume that the investment considered will not change the cost structure or financial structure. If a firm uses financial leverage, and if the project under consideration represents the average market risk of the firm we:

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21 Example 10.1 WACC for Nobles Best Doughnuts Nobles Best Doughnuts has a beta of 0.7. Treasury bills are yielding 3% and the market risk premium is 7%. It has 1,000,000 shares outstanding that are trading at $35 per share. It has 20,000 outstanding bonds trading at 120% of par (7% coupon with 15 years until maturity). It also has issued 25,000 shares of preferred that have an annual dividend of $8.00, and are trading for $125. What is the WACC for Noble given its 30% tax rate?

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22 Rules for Selecting an Appropriate Project Discount Rate Cost of equity is the appropriate discount rate for an all-equity firm undertaking projects of average systematic risk for that firm When a levered firm invests in a project similar to its existing projects, the WACC is the right discount rate. (The market beta for the stock takes into account the leverage for the firm When a firm invests in a project different than its existing projects, using the WACC may lead to wrong investment choices. If Google decides to go into the Doughnut business, it should check the WACC of Krispy Kreme for a market justified discount rate.

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23 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.

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

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

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26 Sensitivity Analysis Sensitivity analysis allows mangers to test importance of each assumption underlying a forecast. Test deviations from base case and associated NPV GTI has developed a new skateboard. Base case assumptions yield NPV = $236,000. 1. The projects 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.

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27 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. BEI expects to capture 5% of the market in the first year. 7. BEI 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.

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28 Sensitivity Analysis of Skateboard Project NPVPessimisticAssumptionOptimisticNPV -$558$8,000,000Initial investment$6,000,000$1,030 -343450,000 unitsMarket size in year 1550,000 units815 -732% per yearGrowth in market size8% per year563 -1,5123%Initial market share7%1,984 -1,1890%Growth in market share2% per year1,661 -488$175Initial selling price$225960 -5462% of salesVariable costs58% of sales526 -873-20% per yearAnnual price change0% per year1,612 -11516%Discount rate12%617 Dollar values in thousands except price

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29 Management Science Approach One could do a type of computer generated sensitivity analysis where each variable of interest can be randomly chosen from a distribution, and perform the NPV with these inputs. This is called a Monte Carlo simulation One could do a decision tree approach –See Figure 10.3, page 438

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30 Real Options You own an oil field, where your production costs are $35 per barrel. The market price of oil is $30 per barrel. If we apply standard NPV analysis to this problem (i.e. static assumptions), it will have a negative NPV Can you conceive of anyone willing to pay a positive price to buy this from you? Why would they do this?

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31 Real Options in Capital Budgeting Embedded options arise naturally from investment Called real options to distinguish from financial options. Option pricing analysis is helpful in examining multi- stage projects. Can transform negative NPV projects into positive NPV! Value of a project equals value captured by NPV, plus option.

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32 Real Options in Capital Budgeting Expansion options If a product is a hit, expand production. Add more stories to your parking garage. Abandonment options Firm can abandon a project if not successful. Shareholders have valuable option to default on debt. Follow-on investment options Similar to expansion options, but more complex (Ex: movie rights to sequel) Flexibility options Ability to use multiple production inputs (Ex: dual-fuel industrial boiler) or produce multiple outputs

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33 An example closer to home If you computed the NPV of your undergraduate education, using the approach showed last chapter, you would underestimate its value. Why? Because the successful completion of your BBA, also buys you the option to get an MBA, if that seems to be good project, sometime in the future.

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All-equity firms can discount their standard investment projects at cost of equity. Firms with debt and equity can discount their standard investment projects using WACC. For projects that look more like an investment some other firm would undertake, use the market data from that other firm A variety of tools exist to assist managers in understanding the sources of uncertainty of a projects cash flows and to evaluate them appropriately Risk And Capital Budgeting

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38 Finding WACC for Firms with Complex Capital Structures How do we calculate WACC if firm has long-term (D) debt as well as preferred (P) and common stock (E)? An example.... S.D. Williams Total value = $50 million Has 1,000,000 common shares; price = $50/share; r e = 15%. Has 200,000 preferred shares, 8% coupon, price = $80/share, 10% rate of return, $16 million value. Has $47.1 million long term debt, fixed rate notes with 8% coupon rate, but 7% YTM. Notes sell at premium and worth $49 million.

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39 Accounting for Taxes in Finding WACC 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 doesnt change the rules for selecting the discount rate.

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