Principles of cororate finance 6th brealey myers chapter 09
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Principles of Corporate Finance
Brealey and Myers
Sixth Edition
Capital Budgeting and Risk
Slides by
Matthew Will
Irwin/McGraw Hill
Chapter 9
©The McGraw-Hill Companies, Inc., 200
9- 2
Topics Covered
Measuring Betas
Capital Structure and COC
Discount Rates for Intl. Projects
Estimating Discount Rates
Risk and DCF
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
9- 3
Company Cost of Capital
A firm’s value can be stated as the sum of the
value of its various assets.
Firm value PV(AB) PV(A) PV(B)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
9- 4
Company Cost of Capital
A company’s cost of capital can be compared
to the CAPM required return.
SML
Required
return
13
Company Cost
of Capital
5.5
0
1.26
Irwin/McGraw Hill
Project Beta
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9- 5
Measuring Betas
The SML shows the relationship between
return and risk.
CAPM uses Beta as a proxy for risk.
Beta is the slope of the SML, using CAPM
terminology.
Other methods can be employed to determine
the slope of the SML and thus Beta.
Regression analysis can be used to find Beta.
Irwin/McGraw Hill
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9- 6
Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 78 - Dec 82
R2 = .53
B = 1.35
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 7
Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 83 - Dec 87
R2 = .49
B = 1.33
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 8
Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 88 - Dec 92
R2 = .45
B = 1.70
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 9
Measuring Betas
Hewlett Packard Beta
Hewlett-Packard return (%)
Price data - Jan 93 - Dec 97
R2 = .35
B = 1.69
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 10
Measuring Betas
A T & T Beta
Price data - Jan 78 - Dec 82
A T & T (%)
R2 = .28
B = 0.21
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 11
Measuring Betas
A T & T Beta
Price data - Jan 83 - Dec 87
A T & T (%)
R2 = .23
B = 0.64
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 12
Measuring Betas
A T & T Beta
Price data - Jan 88 - Dec 92
A T & T (%)
R2 = .28
B = 0.90
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 13
Measuring Betas
A T & T Beta
Price data - Jan 93 - Dec 97
A T & T (%)
R2 = ..17
B = .90
Slope determined from 60 months of
prices and plotting the line of best
fit.
Irwin/McGraw Hill
Market return (%)
©The McGraw-Hill Companies, Inc., 200
9- 14
Beta Stability
RISK
CLASS
% IN SAME
CLASS 5
YEARS LATER
% WITHIN ONE
CLASS 5
YEARS LATER
10 (High betas)
35
69
9
18
54
8
16
45
7
13
41
6
14
39
5
14
42
4
13
40
3
16
45
2
21
61
1 (Low betas)
40
62
Source: Sharpe and Cooper (1972)
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
9- 15
Capital Budgeting & Risk
Modify CAPM
(account for proper risk)
• Use COC unique to project,
rather than Company COC
• Take into account Capital Structure
Irwin/McGraw Hill
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Company Cost of Capital
9- 16
simple approach
Company Cost of Capital (COC) is based on
the average beta of the assets.
The average Beta of the assets is based on the
% of funds in each asset.
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
Company Cost of Capital
9- 17
simple approach
Company Cost of Capital (COC) is based on the average beta of the
assets.
The average Beta of the assets is based on the % of funds in each
asset.
Example
1/3 New Ventures B=2.0
1/3 Expand existing business B=1.3
1/3 Plant efficiency B=0.6
AVG B of assets = 1.3
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9- 18
Capital Structure
Capital Structure - the mix of debt & equity within a company
Expand CAPM to include CS
R = r f + B ( rm - r f )
becomes
Requity = rf + B ( rm - rf )
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9- 19
Capital Structure & COC
COC = rportfolio = rassets
Irwin/McGraw Hill
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9- 20
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
Irwin/McGraw Hill
(V)
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9- 21
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (D) + Bequity (E)
(V)
Irwin/McGraw Hill
(V)
©The McGraw-Hill Companies, Inc., 200
9- 22
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (D) + Bequity (E)
(V)
(V)
requity = rf + Bequity ( rm - rf )
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
9- 23
Capital Structure & COC
COC = rportfolio = rassets
rassets = WACC = rdebt (D) + requity (E)
(V)
(V)
Bassets = Bdebt (D) + Bequity (E)
(V)
requity = rf + Bequity ( rm - rf )
Irwin/McGraw Hill
(V)
IMPORTANT
E, D, and V are
all market values
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9- 24
Capital Structure & COC
Expected Returns and Betas prior to refinancing
20
Expected
return (%)
Requity=15
Rassets=12.2
Rrdebt=8
0
0
Irwin/McGraw Hill
0.2
0.8
Bdebt
Bassets
1.2
Bequity
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9- 25
Pinnacle West Corp.
Requity = rf + B ( rm - rf )
= .045 + .51(.08) = .0858 or 8.6%
Rdebt = YTM on bonds
= 6.9 %
Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 200
