Chapter 12Chapter 12

Risk, Return, and

Capital Budgeting

Review ItemReview Item

Yahoo is considering building a cafeteria for its employees.

At a high discount rate appropriate to Yahoo’s risk, the NPV of the cafeteria is negative.

At a low discount rate appropriate to a Wendy’s, the NPV of the cafeteria is positive.

Should Yahoo build the cafeteria? Explain briefly.

AnswerAnswer

Build the cafeteria. The project is safe like a Wendy’s, not risky like an

internet service. NPV is market value. The market it not deceived but sees the project for the

safe investment that it is.

Example of beta and NPVExample of beta and NPV

Wingmar Inc. has a beta of 2. The Market risk premium is 8.5% The risk-free rate is 4%. Wingmar has a project with cash flows -100, 60, 80. The project is typical of Wingmar’s core business. Should the project be undertaken?

AnswerAnswer

Part 1. Cost of equity financing. The appropriate discount rate for projects of Wingmar is .04+.085(2)=.21.

Part 2. The NPV of the project is 4.2278533. Take the project.

Chapter 12 Risk, Return, and Capital Budgeting

Chapter 12 Risk, Return, and Capital Budgeting

Determinants of the Cost of Equity Capital

Estimation of Beta Financial leverage.

The Cost of EquityThe Cost of Equity

E(rs) = RF + s x [E(RM) - RF]

Business risk 1: Cyclicality of revenues Business risk 2: Operating leverage. Financial Leverage

CyclicalityCyclicality

Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.

Operating leverageOperating leverage

Fixed cost of debt service, leases, employment contractsversus variable costs.

High operating leverage means high fixed costs. MRI labs.

Low leverage, low fixed cost. Fast food, services. EBIT = earnings before interest and taxes. Assume

depreciation = loss of market value. EBITDA = earnings before interest, taxes, depreciation,

or amortization, i.e., nearly cash flow.

Beta EstimationBeta Estimation

Problems Betas may vary over time. The sample size may be inadequate.

Solutions More sophisticated statistical techniques.

Beta EstimationBeta Estimation

Problem: Beta for a firm is overly influenced by random factors peculiar to the firm.

Solution: Look at average beta estimates of several comparable firms in the industry.

Problem: Firms have financial leverage, which shouldn’t matter in NPV.

Solution: Adjust as follows.

Financial leverage means debt

Financial leverage means debt

Equity beta for the firm’s shares. Debt beta for the firm’s debt. Asset beta for the physical firm.

The asset is equivalent to a portfolioThe asset is equivalent to a portfolio

S = market value of equity (stock) B = “ “ “ debt (bonds) A = “ “ “ asset (firm) Portfolio weights are

BS

BX

BS

SX BS

,

Beta of the asset (the physical firm)Beta of the asset (the physical firm)

Beta of a portfolio is the weighted sum of the betas of the components.

BSA BS

B

BS

S

NormallyNormally

Stock is risky Debt is less risky Asset is in between.

Weighted Average Cost of CapitalWeighted Average Cost of Capital

BCSWACC rTBS

Br

BS

Sr )1(

Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets

Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets

13.1 Can Financing Decisions Create Value?

13.2 A Description of Efficient Capital Markets

13.3 The Different Types of Efficiency

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price

-30 -20 -10 0 +10 +20 +30

Days before (-) and after (+)

announcement

Efficient market response to “good news”

Overreaction to “good news” with reversion

Delayed response to

“good news”

Sets of Information relevant to a stockSets of Information relevant to a stock

Past prices

Publicly availableinformation

All information

Forms of the Efficient Market HypothesisForms of the Efficient Market Hypothesis

Weak Prices reflect information in past prices Random Walk

Semi-strong Prices reflect publicly available information

Strong Prices reflect all information

Implications for Corporate Financial Managers

Implications for Corporate Financial Managers

Can financial managers “fool” investors? Can financial managers “time” security sales? Are there price pressure effects?

Some anomaliesSome anomalies

Monday effects Weekend effects January effects Small firm effects Pre acquisition run-ups

Some explanationsSome explanations

Closing positions over the weekend. ditto Tax timing, annual reporting, data mining. Trading with better informed quasi-insiders. Information leaking out bit by bit.