Chapter 12: Risk, Return, and Capital Budgetingecon.ucsb.edu/~marshall/134a/134a_99_11… · PPT...
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Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 1999 C o r p o r a t C o r p o r a t e e F i n a n c e F i n a n c e Fifth Edition Ross Jaffe Westerfi eld . . 12- 12-1 Chapter 12 Risk, Return, and Capital Budgeting
Transcript of Chapter 12: Risk, Return, and Capital Budgetingecon.ucsb.edu/~marshall/134a/134a_99_11… · PPT...
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Chapter 12
Risk, Return, and
Capital Budgeting
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Review 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.
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Answer
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.
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Example 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?
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Answer
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.
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Chapter 12 Risk, Return, and Capital Budgeting
Determinants of the Cost of Equity Capital
Estimation of Beta Financial leverage.
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The Cost of Equity
E(rs) = RF + s x [E(RM) - RF]
Business risk 1: Cyclicality of revenues Business risk 2: Operating leverage. Financial Leverage
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Cyclicality
Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.
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Operating 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.
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Beta Estimation
Problems Betas may vary over time. The sample size may be inadequate.
Solutions More sophisticated statistical techniques.
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Beta 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.
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Financial leverage means debt
Equity beta for the firm’s shares. Debt beta for the firm’s debt. Asset beta for the physical firm.
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The physical firm (the asset) is a portfolio
S = market value of equity (stock) B = “ “ “ debt (bonds) A = “ “ “ asset (firm) Portfolio weights are
BSBX
BSSX BS
,
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Beta of the (physical) firm
Beta of a portfolio is the weighted sum of the betas of the components.
BSA BSB
BSS
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Normally
Stock is risky Debt is less risky Asset is in between.
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Weighted Average Cost of Capital
BCSWACC rTBSBr
BSSr )1(
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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
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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”
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Reaction of Stock Price to New Information in Efficient and Inefficient Markets
StockPrice
Days before (+) andafter (-) announcement–30 –20 –10 0 +10 +20 +30
Efficient-marketresponse to new information
Delayed response
Overreaction andreversion
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Sets of Information relevant to a stock
Past prices
Publicly availableinformation
All information
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Three Forms of Market Efficient Hypothesis
Weak Prices reflect information in past prices Random Walk
Semi-strong Prices reflect publicly available information
Strong Prices reflect all information
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Implications for Corporate Financial Managers
Can financial managers “fool” investors? Can financial managers “time” security sales? Are there price pressure effects?
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Some anomalies
Monday effects Weekend effects January effects Small firm effects Pre acquisition run-ups
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Some 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.
