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

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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 Need Discount rate to get NPV Use CAPM to get discount rate Modify CAPM (account for proper risk)

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

Company Cost of Capital simple 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

Company Cost of Capital simple 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

Capital Structure - the mix of debt & equity within a company Expand CAPM to include CS R = r f + B ( r m - r f ) becomes R equity = r f + B ( r m - r f ) Capital Structure

COC = r portfolio = r assets

Capital Structure COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V)

COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V) Capital Structure

COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V) Capital Structure r equity = r f + B equity ( r m - r f )

Capital Structure COC = r portfolio = r assets r assets = WACC = r debt (D) + r equity (E) (V) (V) B assets = B debt (D) + B equity (E) (V) (V) r equity = r f + B equity ( r m - r f ) IMPORTANT E, D, and V are all market values

Capital Structure & COC Expected return (%) B debt B assets B equity R rdebt =8 R assets =12.2 R equity =15 Expected Returns and Betas prior to refinancing

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

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

Decision Tree

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

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) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 Turboprop Piston

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) +100(.6) +50(.4) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 Turboprop Piston

Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) *450 331 Turboprop Piston

Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 *450 331 Turboprop Piston

Decision Trees 960 (.8) 220(.2) 930(.4) 140(.6) 800(.8) 100(.2) 410(.8) 180(.2) 220(.4) 100(.6) -550 NPV= ? -250 NPV= ? -150 0 or 812 456 660 364 148 +150(.6) +30(.4) +100(.6) +50(.4) NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 *450 331 Turboprop Piston

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) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 -550 NPV= ? -250 NPV= ? Turboprop Piston

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) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

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) 710.73 +30(.4) +100(.6) 403.82 +50(.4) -550 NPV=96.12 -250 NPV=117.00 -150 0 *450 331 or NPV=444.55 NPV=888.18 NPV=550.00 NPV=184.55 Turboprop Piston

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?

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?

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?

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?

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?

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.

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

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?

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

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