© 2009 Cengage Learning/South-Western
Risk and
Capital Budgeting
Chapter 10

2
N
N
r
CF
r
CF
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CF
r
CF
CFNPV
)(
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++
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1111 3
3
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21
0
The numerators focus on project cash flows
covered in Chapter 9.
The denominators are the discount rates, the focus
of chapter 10.
The
denominator
should:
Reflect opportunity costs to firm’s investors
Reflect the project’s risk
Be derived from market data
Choosing the Right Discount Rate

3
Beta plays a central role in determining whether a
firm’s cost of equity is high or low.
What factors influence a firm’s beta?
Operating
leverage
The mix of fixed and variable costs
Sales
Sales
EBIT
EBIT
LeverageOperating
∆
÷
∆
=
Financial
Leverage
The extent to which a firm finances
operations by borrowing
The fixed costs of repaying debt increase a
firm’s beta in the same way that operating
leverage does.
Cost of Equity

4
Firm is financed with 100%
equity
Project is similar to the
firm’s existing assets
Project discount rate is easy to determine if we
assume :
In this case, the appropriate discount rate equals
the cost of equity.
Cost of equity can be estimated using the CAPM
))(()( FmiFi RREβRRE −+=
A Simple Case

5
E(Re ) = Rf + β(E(Rm) - Rf) = 5% + 1.5(11%-5%)
= 14% cost of equity
Carbonlite Inc., an all-equity firm, is evaluating a
proposal to build a new manufacturing facility.
• Firm manufactures bicycle frames.
• As a luxury good producer, firm is very
sensitive to the economy (product demand is
elastic).
• Carbonlite’s stock has a beta of 1.5.
• Managers note Rf = 5%, expect the market
return will be 11%.
Carbonlite Inc.: Cost of Equity

6
Table 10.1 Financial Data for Carbonlite Inc.
and Fiberspeed Corp.

7
Figure 10.1 Operating Leverage for
Carbonlite and Fiberspeed
The higher operating leverage of Carbonlite is reflected in its
steeper slope, demonstrating that its EBIT is more responsive to
changes in sales than is the EBIT of Fiberspeed.

8
Carbonlite Inc Fiberspeed Corp
Sales volume 10,000 sofas 10,000 sofas
Price $1,000 $1,000
Total Revenue $10,000,000 $10,000,000
Fixed costs per year $5,000,000 $2,000,000
Variable costs per frame $400 $700
Total cost $9,000,000 $9,000,000
EBIT $1,000,000 $1,000,000
What if sales volume increases by 10% ?
11,000 frames11,000 frames
$11,000,000$11,000,000
$9,700,000$9,400,000
$1,300,000$1,600,000
The two firms are in the same industry.
Carbonlite’s EBIT increases faster because it has high
operating leverage.
Carbonlite Inc. vs. Fiberspeed Corp.

9
Firm 1 Firm 2
Assets $100 million $100 million
Debt (interest rate 8%) $0 $50 million
Equity $100 million $50 million
Case #1: Gross Return on Assets Equals 20 Percent
EBIT $20 million $20 million
Interest $0 $4 million
Cash to equity $20 million $16 million
ROE 20 ÷ 100 = 20% 16 ÷ 50 = 32%
Case #2: Gross Return on Assets Equals 5 Percent
EBIT $5 million $5 million
Interest $0 $4 million
Cash to equity $5 million $1 million
ROE 5 ÷ 100 = 5% 1 ÷ 50 = 2%
Financial leverage makes Firm 2’s ROE more volatile, so
its beta will be higher .
The Effect of Financial Leverage on
Shareholder Returns

10
Cost of equity applies to projects of an all-equity
firm.
• But what if firm has both debt and equity?
• Problem is akin to finding expected return of portfolio.
Use weighted average cost of capital (WACC)
as discount rate.
%13%15
10050
100
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10050
50
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ED
E
r
ED
D
WACC
• Lox-in-a-Box is a chain of fast food stores.
• Firm has $100 million equity (E), with cost of equity re = 15%;
• Also has bonds (D) worth $50 million, with rd = 9%.
• Assume that the investment considered will not change the cost
structure or financial structure.
Weighted Average Cost of Capital (WACC)

11
ped r
PED
P
r
PED
E
r
PED
D
WACC 





++
+
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
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
++
+



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++
=
%9.10%10
115
16
%7
115
49
%15
115
50
=

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




+





=WACC
How do we calculate WACC if firm has long-term (D) debt
as well as preferred (P) and common stock (E)?
An example....
S.D. Williams
Total value =
$50 million
1 million common shares; $50/share; re = 15%.
200,000 preferred shares, 8% coupon, $80/share, 10%
rate of return, $16 million value.
$47.1 million (par value) long term debt, fixed rate
notes with 8% coupon rate, but 7% YTM.
Notes sell at premium and worth $49 million.
Finding WACC
For Firms with Complex Capital Structures

12
Rules for Finding the Right Discount Rate
1. When an all-equity firm invests in an asset
similar to its existing assets, the cost of equity
is the appropriate discount rate.
2. When a firm with both debt and equity invests
in an asset similar to its existing assets, the
WACC is the appropriate discount rate.
3. When the investment is more risky than the
firm’s average investment, a higher discount
rate than the WACC is required, and vice
versa.

13
edc r
ED
E
rT
ED
D
WACC 





+
+−





+
= )1(
We have thus far assumed away taxes, which are
often important in financing decisions.
• Tax deductibility of interest payments favors use
of debt.
• The opportunity to deduct interest payments
reduces the after-tax cost of debt and changes
the WACC formula:
Accounting for taxes doesn’t change the rules
for selecting the discount rate.
Accounting for Taxes in Finding WACC

14
Managers often want to assess business’ value
drivers.
Finding the break-even point is often useful for
assessing operating risk.
Break-even point (BEP) is level of output where
all operating costs (fixed and variable) are
covered.




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=
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=
Cost/unitVariablePrice/unit
CostsFixed
marginonContributi
CostsFixed
BEP
A Closer Look at Risk: Break-Even Analysis

15
$5,000,000
Total revenue
Total
costs
Fixed costs
Units8,333 units
Costs &
Revenues
Carbonlite has high fixed costs and high contribution margin
($600/bike). High BEP, but once FC are covered, profits grow rapidly.
Fig. 10-2a Break-Even Point for
Carbonlite

16
$2,000,000
Total revenue
Total costs
Fixed costs
Units6,667 units
Costs &
Revenues
Fiberspeed has low fixed costs and low contribution margin
($300/bike). Low BEP, but profits grow slowly after FC are covered.
Fig. 10-2b Break-Even Point for
Fiberspeed

17
Sensitivity analysis allows mangers to test the
impact of each assumption underlying a forecast.
• Sensitivity analysis involves calculating the NPVs for
various deviations from a “base case” set of assumptions.
GTI has developed a new skateboard. Base case
assumptions yield NPV = $236,000.
1. The project’s life is five years.
2. The project requires an up-front investment of $7 million.
3. GTI will depreciate initial investment on straight line basis for five
years.
Sensitivity Analysis

18
4. One year from now, the skateboard industry will sell 500,000 units.
5. Total industry unit volume will increase by 5% per year.
6. GTI expects to capture 5% of the market in the first year.
7. GTI expects to increase its market share by one percentage point
each year after year one.
8. The selling price will be $200 in year one.
9. Selling price will decline by 10% per year after year one.
10. All production costs are variable and equal 60% of the selling price.
11. GTI’s marginal tax rate is 30%.
12. The appropriate discount rate is 14%.
Sensitivity Analysis
GTI has developed a new skateboard. Base case
assumptions yield NPV = $236,000.

19
NPV Pessimistic Assumption Optimistic NPV
-$558 $8,000,000 2. Initial investment $6,000,000 $1,030
-343 450,000 units 4. Market size in year 1 550,000 units 815
-73 2% per year 5. Growth in market size 8% per year 563
-1,512 3% 6. Initial market share 7% 1,984
-1,189 0% 7. Growth in market share 2% per year 1,661
-488 $175 8. Initial selling price $225 960
-54 62% of sales 9. costs 58% of sales 526
-873 -20% per year 10. Annual price change 0% per year 1,612
-115 16% 12. Discount rate 12% 617
Dollar values in thousands except price
Table 10-4 Sensitivity Analysis of
Skateboard Project

20
Scenario Analysis
• Scenario analysis is a more complex form of sensitivity
analysis.
• Rather than adjust one assumption up or down, analysts
calculate the project NPV when a whole set of
assumptions changes in a particular way.
• For example, if consumer interest in GTI’s new
skateboard is low, the project may achieve a lower
market share and a lower selling price than originally
anticipated.

21
Monte Carlo Simulation
• In a Monte Carlo simulation, analysts specify a
range or a probability distribution of potential
outcomes for each of the model’s assumptions.
• It is even possible to specify the degree of correlation
between key variables.
• A simulation software package is then used to take
random “draws” from these distributions, calculating the
project’s cash flows (and NPV) over and over again.
• The simulation produces the probability distribution of
project cash flows (and NPVs) as well as sensitivity
figures for each of the model’s assumptions.

22
Monte Carlo Simulation
• The use of Monte Carlo simulation has grown
dramatically in the last decade because of steep
declines in the costs of computer power and simulation
software.
• The bottom line is that simulation is a powerful, effective
tool when used properly.
• Simulation’s fundamental appeal is that it provides
decision makers with a probability distribution of NPVs
rather than a single point estimate of the expected NPV.

23
Decision Trees
• A decision tree is a visual representation
of the sequential choices that managers
face over time with regard to a particular
investment.
• The value of decision trees is that they force analysts to
think through a series of “if-then” statements that
describe how they will react as the future unfolds.

24
• Trinkle is deciding whether to spend 5-million Canadian dollars (C$)
to test-market a new line of potato chips flavored with Odessa in
Vancouver.
• Depending on the outcome, Trinkle may spend an additional C$50
million 1 year later to launch a full line of snack foods across
Canada.
• If consumer acceptance in Vancouver is high, the company predicts
that its full product line will generate net cash inflows of C$12 million
per year for 10 years.
• If consumers respond less favorably, cash inflows from a nationwide
launch is expected to be just C$2 million per year for 10 years.
• Trinkle’s cost of capital equals 15 percent.
Decision Trees for Odessa Investment
Trinkle Foods Limited of Canada has invented a new salt
substitute, branded Odessa.

25
If the test market is successful, the NPV of launching the product is C$10.23
million; if the initial test results are negative, and it launches the product, it will
have an NPV of – C$39.96 million.
Fig. 10-3 Decision Trees for Odessa
Investment

26
• To work through a decision tree, begin at the end and then work
backward to the initial decision.
• Suppose one year from now, Trinkle learns that the Vancouver
market test was successful:
• If the initial test results are unfavorable and it launches the product:
• We then evaluate today’s decision about whether to spend the C$5
million. The expected NPV of conducting the market test is:
• Spending the money for market testing does not appear worthwhile.
Decision Trees for Odessa Investment

27
Embedded options arise naturally from
investment.
Called real options to distinguish from financial
options.
Option pricing analysis is helpful in examining
multi-stage projects.
Options can transform negative NPV projects into
positive NPV!
Value of a project equals value captured by NPV,
plus option.
Real Options in Capital Budgeting

28
Expansion
options
• If a product is a hit, expand production.
Abandonment
options
• Firm can abandon a project if not
successful.
• Shareholders have valuable option to
default on debt.
Follow-on
investment
options
• Similar to expansion options, but more
complex (Ex: movie rights to sequel)
Flexibility
options
• Ability to use multiple production inputs
(example: dual-fuel industrial boiler) or
produce multiple outputs
Types of Real Options

29
Strategy and Capital Budgeting
• Competition and NPV
– Advocates of a positive NPV project should be
able to articulate the project’s competitive
advantage before running the numbers
• Strategic thinking and real options
– Managers must articulate their strategy for a
given investment

30
• All-equity firms can discount their standard
investment projects at cost of equity.
• Firms with debt and equity can discount their
standard investment projects using WACC.
• A variety of tools exist to assist managers in
understanding the sources of uncertainty of a
project’s cash flows.
Risk and Capital Budgeting