Remember use: Incremental Cash Flows

Discount incremental cash flows Include All Indirect Effects Forget Sunk Costs Include Opportunity Costs Beware of Allocated Overhead Costs

Incremental Cash Flow

cash flow with project

cash flow without project

Sequence of Firm Decisions

Capital Budget - The list of planned investment projects. The Decision Process 1 - Develop and rank all investment projects 2 - Authorize projects based on:
Govt regulation Production efficiency Capacity requirements NPV (most important)

Capital Budgeting Process

Capital Budgeting Problems
Consistent forecasts Conflict of interest Forecast bias Selection criteria (NPV and others)

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects of changes in sales, costs, etc. on a project. Scenario Analysis - Project analysis given a particular combination of assumptions. Simulation Analysis - Estimation of the probabilities of different possible outcomes. Break Even Analysis - Analysis of the level of sales (or other variable) at which the company breaks even.

Sensitivity Analysis
Example Given the expected cash flow forecasts listed on the next slide, determine the NPV of the project given changes in the cash flow components using an 8% cost of capital. Assume that all variables remain constant, except the one you are changing.

Sensitivity Analysis
Example - continued
Investment Sales Variable Costs Fixed Costs Depreciation Pretax profit . Taxes @ 40% Profit after tax Operating cash flow Net Cash Flow - 5,400 Year 0 - 5,400 Years 1 - 12 16,000 13,000 2,000 450 550 220 330 780 780

NPV= $478

Sensitivity Analysis
Example - continued
Possible Outcomes
Range Variable Pessimistic Expected Optimistic Investment (000s) Sales(000s) Var Cost (% of sales) Fixed Costs(000s) 6,200 14,000 83% 2,100 5,400 16,000 81.25% 2,000 5,000 18,000 80% 1,900

Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Investment Scenario
Investment Sales Variable Costs Fixed Costs Depreciation Pretax profit . Taxes @ 40% Profit after tax Operating cash flow Net Cash Flow - 6,200 Year 0 - 6,200 Years 1 - 12 16,000 13,000 2,000 450 550 220 330 780 780

NPV= ($121)

Sensitivity Analysis
Example - continued
NPV Possibilities
Variable Pessimistic Investment (000s) - 121 Sales(000s) - 1,218 Var Cost (% of sales) - 788 Fixed Costs(000s) 26 NPV ( 000s ) Expected Optimistic 478 778 478 2,174 478 1,382 478 930

Break Even Analysis

Example Given the forecasted data on the next slide, determine the number of planes that the company must produce in order to break even, on an NPV basis. The companys cost of capital is 10%.

Break Even Analysis

Year 0 Years 1 - 6 Investment Sales Var. Cost Fixed Costs Depreciation Pretax Profit Taxes (50%) Net Profit Net Cash Flow - 900 $900 15.5xPlanes Sold 8.5xPlanes Sold 175 900 / 6 = 150 (7xPlanes Sold) - 325 (3.5xPlanes Sold) - 162.5 (3.5xPlanes Sold) - 162.5 (3.5xPlanes Sold) - 12.5

Break Even Analysis

Answer The break even point, is the # of Planes Sold that generates a NPV=$0. The present value annuity factor of a 6 year cash flow at 10% is 4.355 Thus,
NPV = -900 + 43553 . (. 5xPlanes Sold - 12.5)

Break Even Analysis

Answer Solving for Planes Sold
0 = -900 + 4355 . (3 . 5xPlanes Sold - 12.5)

Planes Sold = 63

Flexibility & Options

Decision Trees - Diagram of sequential decisions and possible outcomes. Decision trees help companies determine their Options by showing the various choices and outcomes. The Option to avoid a loss or produce extra profit has value. The ability to create an Option thus has value that can be bought or sold.

Decision Trees
Success Test (Invest $200,000) Pursue project NPV=$2million

Failure Stop project Dont test NPV=0 NPV=0

Decision Tree: Example

You invest in a dot com company. At the start of each year for 3 years, it requires 1 million to continue. The future value of a successful dot.com in at the beginning of the 4th year is 10 million. Each year it has a 50% of surviving. What is the NPV of this investment at r=.1?

You want to be a millionaire

You have no life-lines and are risk neutral. For simplicity assume if you answer wrong you get 0. If your are at 500,000, at what certainty would you guess for the million? Given your previous answer. Before seeing the question your certainty of answering correctly the 500,000 is either 25% or 75% with equal chance. At what certainty at 250,000, would you go for it?

Risk
Rates of Return 73 Years of Capital Market History Measuring Risk Risk & Diversification Thinking About Risk

The value of a $1 investment in 19266

1000

Index

10 Common Stocks Long T-Bonds T-Bills 0.1

19 30

19 40

19 50

19 60

19 70

19 80

Source: Ibbotson Associates

Year End

19 90 19 98

Rates of Return
60

Percentage Return

40

20

-20
Common Stocks Long T-Bonds T-Bills

-40 -60 26 30 35 40 45 50

55

60

65

70

75

80

85

90

95

Source: Ibbotson Associates

Year

Expected Return
Expected market interest rate on normal risk = + return Treasury bills premium (1981) 23.3% (1999)14.1% = = 14 4.8 + + 9.3 9.3

Equity Premium Puzzle.

In 1985, a pair of economists, Rajnish Mehra and Edward Prescott, examined almost a century of returns for American shares and bonds. After adjusting for inflation, equities had made average real returns of around 7 a year, compared with only 1% for Treasury bonds-a 6% point equity premium. Given that shares are riskier (in the sense that their prices bounce around more) there should have been some premium. But theory suggested it should not have been much more than 1 point. The extra five points seemed redundant-evidence of some inexplicable market inefficiency

Measuring Risk
Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation Square-Root of Variance. A measure of volatility.

Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1) + 40 + 10 + 10 - 20 (2) + 30 0 0 - 30 (3) 900 0 0 900

Percent Rate of Return Deviation from Mean Squared Deviation

Variance = average of squared deviations = 1800 / 4 = 450 Standard deviation = square of root variance = 450 = 21.2%

Risk and Diversification

Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called diversifiable risk. Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called systematic risk.

Risk and Diversification

Year Rate of Return 1994 1.31 1995 37.43 1996 23.07 1997 33.36 1998 25.58 Total 123.75 Average rate of return = 123.75/5 = 24.75 Variance = average of squared deviations = 801.84/5=160.37 Standard deviation = squared root of variance = 12.66% Deviation from Average Return -23.44 12.68 -1.6 8.61 3.83 Squared Deviation 549.43 160.78 2.82 74.13 14.67 801.84

Risk and Diversification

Portfolio standard deviation

Unique risk Market risk

0 5 10 15 Number of Securities

What does this tell you about mutual funds (unit trusts)?

Topics Covered
Measuring Beta Portfolio Betas CAPM and Expected Return Security Market Line Capital Budgeting and Project Risk

Measuring Market Risk

Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Measuring Market Risk

Example - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information.

Measuring Market Risk

Example - continued
Month Market Return % Turbo Return % 1 2 3 4 5 6 + 1 + 1 + 1 -1 -1 -1 + 0.8 + 1.8 - 0.2 - 1.8 + 0.2 - 0.8

Measuring Market Risk

Example - continued When the market was up 1%, Turbo average % change was +0.8% When the market was down 1%, Turbo average % change was -0.8% The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. Beta is a measure of risk with respect to the market (covariance). Can be additional risk! Betting on Israel vs. Austria WC game.

Measuring Market Risk

Example - continued
Turbo return % 1 0.8 0.6 0.4 0.2 0 -0.2-0.8 -0.6 -0.4 -0.2 -0.4 -0.6 -0.8 0 0.2 0.4 Market Return %

0.6

0.8

Portfolio Betas
Diversification decreases variability from unique risk, but not from market risk. The beta of your portfolio will be an average of the betas of the securities in the portfolio. If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0

Measuring Market Risk

Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.

Measuring Market Risk

Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.
14 12

Expected Return (%) .

10 8 6 4 2 0 0 0.2 0.4 Beta 0.6 0.8

Market Portfolio

Measuring Market Risk

CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.

Market risk premium = rm - rf Risk premium on any asset = r - rf Expected Return = rf + B(rm - rf )

Measuring Market Risk

Security Market Line - The graphic representation of the CAPM.
20

Expected Return (%) .

Rm

Security Market Line

Rf 0 0 Beta 1

Problems with CAPM

Plotting average return vs. Beta, a zero Beta beats Risk-free rate. Short term doesnt do so well. Unstable Betas. Tough to test. Will the real market portfolio stand up? Beta is not a very good predictor of future returns.
However, Jagannathan & Wang do find support with adjustments.

Capital Budgeting & Project Risk

The project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.

Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used? 1/3 Nuclear Parts Mfr.. B=2.0 1/3 Computer Hard Drive Mfr.. B=1.3 1/3 Dog Food Production B=0.6

Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the companys investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used? R = 4 + 0.6 (14 - 4 ) = 10% 10% reflects the opportunity cost of capital on an investment given the unique risk of the project. You should use this value in computing that projects NPV!!

Wait a second!
A project has a NPV=10,000 when r=.05 and a NPV=-10,000 when r=.1 and the company can borrow at 5%. Why shouldnt the company invest even if the cost of capital is 10% because of a beta? Shouldnt a project that is risky but has Beta=0 be considered worse than a project that is safe and has Beta=0?