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110.CapitalBudgetingandRiskPrinciplesofCorporateFinanceSeventhEditionRichardA.BrealeyStewartC.MyersSlidesbyMatthewWillSlidesEditedbyMinggaoShen10-2McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedTopicsCoveredŠCompanyandProjectCostsofCapitalŠMeasuringtheCostofEquityŠCapitalStructureandCOCŠDiscountRatesforIntl.ProjectsŠEstimatingDiscountRatesŠRiskandDCF10-3McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCompanyCostofCapitalŠAfirm’svaluecanbestatedasthesumofthevalueofitsvariousassetsPV(B)PV(A)PV(AB)valueFirm+==10-4McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCompanyCostofCapital10%nologyknowntecht,improvemenCostCOC)(Company15%businessexistingofExpansion20%productsNew30%ventureseSpeculativRateDiscountCategoryCompanycostofcapital:ŠRateofreturnrequiredbyinvestorsŠOpportunitycostofcapitalforfirm’sexistingassetsTruecostofcapitaldependsontheusetowhichthecapitalisput.10-5McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCompanyCostofCapitalŠAcompany’scostofcapitalcanbecomparedtotheCAPMrequiredreturnRequiredreturnProjectBeta1.26CompanyCostofCapital135.50SML10-6McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasŠTheSMLshowstherelationshipbetweenreturnandriskŠCAPMusesBetaasaproxyforriskŠOthermethodscanbeemployedtodeterminetheslopeoftheSMLandthusBetaŠRegressionanalysiscanbeusedtofindBeta210-7McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasDellComputerSlopedeterminedfromplottingthelineofbestfit.Pricedata–Aug88-Jan95Marketreturn(%)Dellreturn(%)R2=.11B=1.6210-8McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasDellComputerSlopedeterminedfromplottingthelineofbestfit.Pricedata–Feb95–Jul01Marketreturn(%)Dellreturn(%)R2=.27B=2.0210-9McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasGeneralMotorsSlopedeterminedfromplottingthelineofbestfit.Pricedata–Aug88-Jan95Marketreturn(%)GMreturn(%)R2=.13B=0.8010-10McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasGeneralMotorsSlopedeterminedfromplottingthelineofbestfit.Pricedata–Feb95–Jul01Marketreturn(%)GMreturn(%)R2=.25B=1.0010-11McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasExxonMobilSlopedeterminedfromplottingthelineofbestfit.Pricedata–Aug88-Jan95Marketreturn(%)ExxonMobilreturn(%)R2=.28B=0.5210-12McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedMeasuringBetasExxonMobilSlopedeterminedfromplottingthelineofbestfit.Pricedata–Feb95–Jul01Marketreturn(%)ExxonMobilreturn(%)R2=.16B=0.42310-13McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedBetaStability%INSAME%WITHINONERISKCLASS5CLASS5CLASSYEARSLATERYEARSLATER10(Highbetas)356991854816457134161439514424134031645221611(Lowbetas)4062Source:SharpeandCooper(1972)10-14McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCompanyCostofCapitalSimpleApproach:ŠCompanyCostofCapital(COC)isbasedontheaveragebetaoftheassetsŠTheaverageBetaoftheassetsisbasedonthe%offundsineachasset10-15McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCompanyCostofCapitalCompanyCostofCapital(COC)isbasedontheaveragebetaoftheassetsTheaverageBetaoftheassetsisbasedonthe%offundsineachassetExample1/3NewVenturesB=2.01/3ExpandexistingbusinessB=1.31/3PlantefficiencyB=0.6AVGBofassets=1.310-16McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCapitalStructure-themixofdebt&equitywithinacompanyWACC–WeightedaveragecostofcapitalExpandCAPMtoincludecapitalstructure(CS)r=rf+B(rm-rf)becomesrasset=rf+B(rm-rf)CapitalStructure&WACC10-17McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedCapitalStructure&WACCCOC=rportfolio=rassetsrassets=WACC=rdebt(D)+requity(E)(V)(V)Bassets=Bdebt(D)+Bequity(E)(V)(V)requity=rf+Bequity(rm-rf)IMPORTANTE,D,andVareallmarketvalues10-18McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.Allrightsreserved02000.20.81.2CapitalStructure&WACCExpectedreturn(%)BdebtBassetsBequityRdebt=8Rassets=12.2Requity=15ExpectedReturnsandBetas410-19McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedUnionPacificCorp.Requity=ReturnonStock=15%Rdebt=YTMonbonds=7.5%10-20McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedUnionPacificCorp..17.50PortfolioIndustry.21.40PacificUnion.26.52SouthernNorfolk.24.46tionTransportaCSX.20.64NorthernBurlingtonErrorStandard.Beta10-21McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedUnionPacificCorp.Example100valueFirmAssetsTotal70ueEquityval30Debtvalue100Assets%75.12%15703070%5.7703030=+++=+++=assetsequitydebtassetsRrequitydebtequityrequitydebtdebtR10-22McGrawHill/IrwinCopyright©2003byTheMcGraw-HillCompanies,Inc.AllrightsreservedInternationalRisk0.77.302.58Venezuela1