Chapter 12 Risk, Return, & Capital Budgeting

 When we calculate NPV, we need an estimate of required rate of return [Eg. Since investors require a higher rate of return from a very risky firm, such a firm will have a higher company cost of capital and will set a higher discount rate for its new investment opportunities] I. COST OF CAPITAL AND RISK [ Comparison between company cost of capital rule and the required return under CAPM] Example ) Suppose UHC has a beta of 1.23. The firm is 100 % equity financed. UHC is considering a number of capital-budgeting projects that will double its size. Because these new projects are similar to firm’s existing ones, the average beta on the new projects is assumed to be equal to the UHC’s existing beta. The risk free rate is 6%. What is the appropriate discount rate for these new projects, assuming an expected market return is 14.537% ? Required rate of Return 16.5 6.0 Avg. Beta of the firm’s assets =1.23 Project Beta  The firm’s cost of capital is about 16.5% and this is the correct discount rate ONLY IF the project beta is 1.23 E ( ri )  rf  [ E ( rm )  rf ]  i  6%  [14. 537%  6%]  1. 23  16. 5%  The firm accepts any project regardless of its risk as long as it offers a higher return than the company’s cost of capital.  NONSENSE !!  The firm’s cost of capital is the correct discount rate for projects that have the same risk as the firm’s existing business but NOT for those projects that are safer or riskier than the companies average. 1  Now suppose UHC is evaluating the following 1-year projects, which initially cost $100, respectively. Project Project  Project’s Exp. CF A B C 1.23 1.23 1.23 $140 $120 $110 Project’s IRR Project’s NPV Decision ?  What are the proper locations of the projects on the graph above ?  The firm should accept any project that more than compensates for the project’s beta. In other words, the firm should accept any project above the upward sloping line that inks expected return to risk. [Rationale for this approach]  Securities provide claim against the cash flows generated by the firm's assets  The CAPM model is widely used by large corporations to estimate the discount rate. 2 II. CAPITAL STRUCTURE AND THE COMPANY COST OF CAPITAL.  The cost of capital is a hurdle rate for capital budgeting decisions. It depends on the business risk of the firm’s investment opportunities. The risk of a common stock reflects Business risk of the assets held by the firm + Financial risk.  Financial Risk : The more the firm has debt, the riskier its common stock is. A. CAPITAL STRUCTURE AND EXPECTED RETURNS. a. Without Tax Effect. rA  rportfolio  D E  rD   rE D E D E [i.e., Ignore the tax issue here]  This approach is proper if the firm is planning to invest in a project that has the same risk as the firm’s existing business [ie., the opportunity cost of capital for this project is the same as the firm’s cost of capital]  The change in financial structure No change in business risk  Decrease in debt and increase in equity  debtholders are likely to be satisfied with a lower return  The lower leverage made the equity safer  equityholders require lower return. 3 b. With Tax Effect.  If we take into account tax effect, the after-tax weighted average cost of capital [WACC] can be expressed as : r *  WACC  D E  rD (1  T )   rE D E D E Notice r* is less than rA because the cost of debt is calculated after tax as r D(1-T). Thus the tax advantages of debt financing are reflected in a lower discount rate. : Rationale  WACC is good approximation of required return on project if risk of project about the same as the firm’s existing assets  The idea behind the weighted average formula is simple and intuitively appealing. If the new project is profitable enough to pay the (after-tax) interest on the debt used to finance it, and also to generate a superior expected rate of return on the equity invested in it, then it must be a good project. What is a superior equity return? One that exceeds rE, the expected rate of return required by investors in the firm’s share. [Example] Assume firm has 450 bonds outstanding and 40,000 shares outstanding. Each bond has a current market value of $925 and each share has a market value of $16.75. The bonds mature in 15 years for $1000 and have a coupon rate of 9% per year paid semiannually. The firm’s equity has a beta of 1.2. The return on T-bills is 4.5% and the market risk premium is 8.5%. What is the firm’s WACC if it’s marginal tax rate is 40%? Procedures for obtaining the answers: 1) Estimate required return on stock by plugging equity beta into CAPM 2) Estimate required return on bonds by calculating yield to maturity on firm’s debt YTM : Think of YTM as the IRR for Bond. 3) rB(1-T) = after-tax cost of debt  interest is tax deductible. 4) Apply the WACC formula.  What if there are more than two sources (i.e., debt and equity) of financing?  Preferred stocks. r *  WACC  D E P  rD (1  T )   rE   rP D E P D E P D E P 4 c. Average of WACC for Firms in same industry as Proxy  Advantages 1) Helps reduce sampling error (errors offset) 2) Helps when project risk different from that of firm’s existing assets  Potential Problems 1) New project may be riskier than established firms  more sensitive to economic conditions 2) New project may be too different from projects of established firms d. SML,  A, and WACC  Plugging  A into the CAPM to get a required return and using WACC as a required return are essentially the same thing 5 CHAPTER 13. Financing and Efficient Capital Markets So far, you've learned how to spend money--how to choose among different potential investment projects. Now let's figure out how to raise it--how firms interface with the capital markets to raise the money to undertake investment projects. I. What Is an "Efficient" Market? We assume that capital markets are efficient. By "efficient" we mean a bunch of things that  All relevant and ascertainable information is reflected in the market price already because it is widely and cheaply available to investors.  Stock prices are a random walk (with drift)  Weak Form Efficiency  Past pattern of prices doesn't allow you to make abnormal return. : Serial correlations [corr(RET t, RETt-1)]  Indications of market inefficiencies.  Semi-strong Form Efficiency  Published information doesn't allow you to make abnormal return.  Strong Form Efficiency  Any information in the world doesn't allow you to make abnormal return. Stock prices appeared to be a random walk (with drift). Price changes are independent of the most recent price changes. What this means for "technical analysis". Competition among investment analysts should lead prices to reflect "true values"--true value does not mean future value, but an expected value that incorporates all the information available to investors at that time. If prices always reflect all information, they will only change when new "information" arrives. But by definition we don't know whether new information will be good or bad.  By denying that future market movements can be predicted from past movements, we are denying the profitability of technical analysis.  See the Summary on textbook pg. 339. 6 II. We Always Come Back to NPV The decision to sell a share of stock, and the decision to purchase an electromechanical capital good are basically similar. Both involve the "valuation" of a risky asset, and the comparison of the value of a risky future stream with a present sum. The fact that one asset is "real" and the other "financial" shouldn't bother you.  The present value of borrowing. Suppose the government agrees to lend your firm $100,000 for 10 years at an interest rate of 3%: ( 3,000) t t 1 (1  r ) 10 NPV  100,000   If the appropriate discount rate is 10%, what is NPV? When the appropriate discount rate is 10%, an offer to loan you money for 10 years at 3% is truly an amazing deal... In financial markets, you are facing a nearly perfect, competitive market If selling a security has a positive NPV to you, it probably has a negative NPV to the purchaser. You probably will not find many such purchasers. If capital markets are efficient, then purchase or sale of any security at the prevailing market price is never a positive (or negative) NPV transaction... III. No Theory Is Perfect: Anomalies:  Small firm effect  small firm estimated betas are not high enough to account for their high returns  January effect  small firms earn high returns in January (people wait until after the end of the tax year to dump losing positions in big stocks?)  P/E Effect.  B/M Effect. [Book to Market Value] 7 B. CAPITAL STRUCTURE AND BETA  The beta of portfolio [i.e., asset beta] is just a weighted average of the debt and equity betas:  A   portfolio  D E  D   E D E D E  The asset beta for unlevered firm ?  What will happen after the refinancing [i.e., decrease in debt and increase in equity]?  The risk of the total package is unaffected, but both the debt and the equity are now less risky  Calculation of Asset Beta key   of firm's assets ( A) = weighted avg.  of all securities issued by firm.  B   S   A =  B + S  B +  B + S  S (1) where: A = beta of firm’s assets B = beta of firm’s debt S = beta of firm’s equity B = market value of firm’s debt S = market value of firm’s stock Ex. Politeasans Inc. has $900,000 in debt and $600,000 in equity. The beta of Politeasans’ debt is 0.1 and the beta of Politeasans’ equity is 1.4. What is the beta of the firm’s assets? A  8