Risk and Capital Budgeting

(Part 2)

(Pages 184-195, 249-262, 267-268, 284-291)

1
 What are the determinants of
stock beta (equity beta)?
Beta - Sensitivity of a common stock’s return (or
change in value) to the return (or change in value) of
S&P 500
• Value of common stock depends on future cash
flows to stockholders, which depend on NCF
generated from the firm’s assets
▪ PV(NCF from assets) = value of assets = D + E
• NCF includes EBIT as its main component
• Sensitivity of change in EBIT to change in S&P 500
will affect equity beta, βequity
▪ EBIT includes operating revenue and operating
costs 2
 What are the determinants of
stock beta (equity beta)?
• βrevenue : the starting point
• Operating leverage: fixed operating cost
– Changes in revenue will result in greater than
proportionate changes in EBIT
• βAsset : the result

3
Operating leverage

4
Betas & Operating leverage

𝛽𝑃 = ෍ 𝑤𝑗 𝛽𝑗
𝑗=1

5
Betas & Operating leverage

PV(revenue)−PV(variable cost)
𝛽asset = 𝛽revenue
PV(asset)
PV(fixed cost)
= 𝛽revenue 1 +
PV(asset)

6
 βasset

• Asset beta: sensitivity of assets’ return (or change

in value) to the return (or change in value) of S&P
500
• It is hard to get monthly or weekly data of assets’
value, so hard to estimate asset beta
• If the firm’s assets (including NWC) are financed by
equity only, then βasset = βequity
• For brevity, E(rA) is written as rA, E(rM) is written as
rM , and βasset is written as βA
rA = 𝑟𝑓 + 𝛽𝐴 rm − 𝑟𝑓

• WACC = rA
7
 If there is financial leverage

• PV(NCF from assets) = value of assets

(including NWC) = D + E, where D is long-
term liabilities
• Given assets, if D increases, then E
decreases
• NCF is then shared by
▪ debtholders (who receive a fixed amount of cash flow,
so debt beta is small)
▪ stockholders (who then receive a more variable amount
of cash flow than if there is no debt; see Notes6)

8
 βA and financial leverage
determine βE
• βrevenue : the starting point
• Operating leverage: fixed operating cost
– Changes in revenue will result in greater than
proportionate changes in EBIT.
• the intermediate result: βAsset
• Financial leverage: fixed financial cost
– Changes in EBIT will result in greater than
proportionate changes in NI (see Notes6).
• βEquity : the final result
9
 The company’s balance sheet

• If the firm’s assets are financed by debt

and equity, then (LHS=RHS of the balance sheet):
𝐷 𝐸 𝑉 =𝐷+𝐸
𝑟A = 𝑟𝐷 × + 𝑟𝐸 × 𝐷 = market value of debt
𝑉 𝑉
𝐸 = market value of equity
𝐷 𝐸 𝑉 = market value of assets
β𝐴 = β𝐷 × + β 𝐸 ×
𝑉 𝑉

𝐷 rA = 𝑟𝑓 + 𝛽𝐴 rm − 𝑟𝑓
𝛽𝐸 = 𝛽𝐴 + 𝛽 − 𝛽𝐷
𝐸 𝐴
rD = 𝑟𝑓 + 𝛽𝐷 rm − 𝑟𝑓
𝐷
𝑟𝐸 = 𝑟𝐴 + 𝑟𝐴 − 𝑟𝐷 rE = 𝑟𝑓 + 𝛽𝐸 rm − 𝑟𝑓
𝐸

10
 What are the determinants of
stock beta (equity beta)?
• βrevenue : the starting point
• Operating leverage
• βAsset : A revenue PV(asset)
𝛽 = 𝛽 1 +
PV(fixed cost)

• Financial leverage
• βEquity : 𝛽 = 𝛽 + 𝐸 𝛽 − 𝛽
𝐸 𝐴
𝐷
𝐴 𝐷

11
 How to estimate betas?
1. Estimate βEquity of the company using regression
2. Observe financial leverage of the company
3. Calculate βAsset of the company
4. Observe operating leverage of the company
5. Calculate βrevenue of the company (existing
projects)
6. Estimate βrevenue of the new project
7. Decide on operating leverage of the new project
8. Calculate βAsset of the new project
9. Decide on financial leverage of the new project
10. Calculate βEquity of the new project 12
 r in FINA 2010
• The new project may be financed by new
debt and new equity
▪ the cost of debt: the required or expected return
of debt, E(rdebt), per annum
▪ the cost of equity: the required or expected return
of equity, E(requity), per annum
• Use (1-TC)E(rdebt) & E(requity) to calculate
after-tax WACC, where TC is corporate tax
rate
• r = after-tax WACC (or, simply, WACC)
• Should we always use after-tax WACC? 13
 𝑟A = Company Cost of Capital
𝐷 𝐸
= × 𝑟𝐷 + × 𝑟𝐸 = CCC
𝑉 𝑉

• CCC is the opportunity cost of capital for an

investment in the firm’s assets (existing projects).
• The value of the firm = PV(NCF from assets),
which may be calculated using either one of the
following methods:
1. = PV(NCF, using the discount rate = after-tax WACC
or, simply called, WACC): the approach in FINA 2010
𝐷 𝐸
After-tax 𝑊𝐴𝐶𝐶 = × 𝑟𝐷 (1 − 𝑇𝐶 ) + × 𝑟𝐸
𝑉 𝑉

2. = PV(NCF, using the discount rate = CCC) +

PV(tax-shields of interest expense): the adjusted
PV approach in Chapter 18
14
 May we use WACC for every project?

• If the firm has more than one type of assets

(existing projects), then CCC is based on the
average asset beta
• If a new project is like the average-risk
existing project, then WACC is the correct
discount rate
▪ if not, we need to estimate the new project’s
betas

15
 A new project’s betas
1. Estimate βEquity of the company using regression
2. Observe financial leverage of the company
3. Calculate βAsset of the company
4. Observe operating leverage of the company
5. Calculate βrevenue of the company (existing
projects)
6. Estimate βrevenue of the new project
7. Decide on operating leverage of the new project
8. Calculate βAsset of the new project
9. Decide on financial leverage of the new project
10. Calculate βEquity of the new project 16
 A new project’s r
• We may estimate the new project’s revenue
beta by comparing the new project with the
average existing project for:
– Cyclicality
▪ The higher sensitivity of cash flows or revenue to the
economy, the higher the revenue beta
▪ E.g., …
• Using the operating leverage formula, we
calculate the new project’s asset beta
• Observe cost of new debt, and use the
financial leverage formulae to calculate the
new project’s rE
• Then, calculate the new project’s WACC
17
 A project may use
two discount rates
• Chapter 6: Use a discount rate to discount
net cash flows
– So, costs and revenues are discounted using
the same rate
• If operating costs have lower systematic
risk than revenues, then it’s better to use
different discount rates for costs and
revenues
– See Problem 9.16 (in Homework Set 2)

18
 Changing Risk over Time
• Decisions may be made in the future
– Chapter 6 assumes that there is only 1
decision: whether to invest in the new project
today.
– If the new project involves some future
opportunities for decision making, then the
NPV calculation in Chapter 6 will lead to a
wrong answer.
▪ Changing Risk over Time

19
 Changing Risk over Time

Chapter 6 uses a constant discount rate for each

period of compounding (a year)
• Assumption: same risk per year throughout the project
life
▪ Net Cash Flow behaves like a random walk each year
Be careful about cases where risk per year may
change
• For example, a testing phase and then a normal phase
▪ Testing phase: high total risk (“high systematic + normal
diversifiable” or “normal systematic + high diversifiable”)
▪ Normal phase: normal total risk (normal systematic + normal
diversifiable)
• May then need to have a time-varying discount rate 20
 A Simple Example
• phase 1
– 1-year development phase: $625,000 cost
– 50% probability of success, 50% probability of failure; thus, high risk
• phase 2
– if phase 1 is successful: build plant --- $1 million (expected cost)
– generates expected NCF of $250,000 each year forever
– NCF : normal risk
• The whole project (phase 1 and phase 2) is very risky (50% probability of
success)
– The company has a policy that for high-risk projects, 20% as the discount
rate; for normal-risk projects, 10% as the discount rate
– According to Chapter 6, should the constant r be 20% or 10% or other
number (say, 15%, the average) for every future year of this new project?

21
 DECISION
TREES Pursue project:
DECISION POINT NPV = -1000 + 250/.10 = +$1,500

FATE Don't
invest
Success
STOP: NPV = 0
( 1/2)

Test
Failure
( invest Pursue project:
$625) ( 1/2)
NPV < 0

Don't
test
STOP: NPV = 0 Don't
invest
STOP: NPV = 0

22
 Decision Tree Analysis

• By investing $625,000 at t=0, expected

payoff for the 1st phase:
0.5(1,500) + 0.5(0) = 750 or $750,000
• Let 20% be the suitable discount rate if the
high risk is systematic risk during the 1st
phase (e.g.,…)
▪ NPV = (750 / 1.2) – 625 = 0
• A normal discount rate for phase 1 if the high
total risk in phase 1 is due to high non-
systematic risk (e.g., …)
▪ Then, the main effect of such a high total
risk is on the expected cash flow only, but
not on the discount rate. 23
 A more complicated example:
Problem 10.29

• executive flying service

– 40% chance of low demand in first year
– if low demand in first year, 60% chance it will remain low in
subsequent years
– if initial demand is high, 80% chance it will remain high
• initial decision:
– buy turboprop for $550,000, or
– piston-engine for $250,000 with less capacity, and buy another
next year (for $150,000) if desirable

24
Decision Tree
Hi demand (.8)
Continue $960

Hi demand (.6) Lo demand (.2)

$150 $220

Hi demand (.4)
Continue $930

Lo demand (.4) Lo demand (.6)

Turbo $30 $140
-$550
Hi demand (.8)
Expand $800
-$150 Lo demand (.2)
Piston $100
-$250 Hi demand (.8)
Hi demand (.6) Continue $410
$100 Lo demand (.2)
$180

Hi demand (.4)
Continue $220

Lo demand (.4) Lo demand (.6)

$50 $100
25
 Decision Trees
960 (.8)
Turboprop 150(.6)
220(.2)
-550 930(.4)
NPV= ? 30(.4)
140(.6)
800(.8)
-150
100(.2)
100(.6) or 410(.8)
Piston 0
180(.2)
-250
220(.4)
NPV= ? 50(.4)
100(.6)
26
 Decision Trees
960 (.8)
150(.6) 812
Turboprop 220(.2)
-550 930(.4)
30(.4) 456
NPV= ? 140(.6)
800(.8)
-150 660
100(.2)
100(.6) or 410(.8)
Piston 0 364
180(.2)
-250
220(.4)
NPV= ? 50(.4) 148
100(.6)
27
 Decision Trees
660
− 150 = 450
1.10
960 (.8)
+150(.6) 812
Turboprop 220(.2)
-550 930(.4)
+30(.4) 456
NPV= ? 140(.6)
*450 800(.8)
-150 660
100(.2)
+100(.6) or
410(.8)
Piston 0 364
180(.2)
331
-250
220(.4)
NPV= ? +50(.4) 148
100(.6)
28
 812
+ 150 = 888.18
1.10

NPV=888.18 960 (.8)

150(.6) 812
Turboprop 220(.2)
-550 930(.4)
30(.4) 456
NPV= ? 140(.6)
NPV=444.55
*450 800(.8)
-150 660
NPV=550.00 100(.2)
100(.6) or 410(.8)
Piston 0 364
180(.2)
331
-250
220(.4)
NPV= ? 50(.4) 148
NPV=184.55 100(.6)
29
 Decision Trees
NPV=888.18 960 (.8)
+150(.6) 812
Turboprop 220(.2)
-550 710.73
930(.4)
+30(.4) 456
NPV= ? 140(.6)
NPV=444.55
*450 800(.8)
-150 660
NPV=550.00 100(.2)
+100(.6) or
410(.8)
Piston 0 364
180(.2)
331
-250 403.82
220(.4)
NPV= ? +50(.4) 148
NPV=184.55 100(.6)
30
 Decision Trees
960 (.8)
+150(.6) 812
Turboprop 220(.2)
-550 710.73
930(.4)
+30(.4) 456
NPV=87.43 140(.6)
710.73
− 550 = 87.43 *450 800(.8)
1.115 -150 660
100(.2)
First year may use r > 10% +100(.6) or
410(.8)
Piston 0 364
180(.2)
331
-250 403.82
220(.4)
NPV=112.17 +50(.4) 148
100(.6)
31
 “Option to expand” not considered
NPV=888.18 960 (.8)
+150(.6) 812
Turboprop 220(.2)
-550 710.73
930(.4)
+30(.4) 456
NPV= 87.43 140(.6)
NPV=444.55

NPV=431.00
+100(.6)
410(.8)
Piston 0 364
331 180(.2)
-250 332.42
220(.4)
NPV= 48.13 +50(.4) 148
NPV=184.55 100(.6)
32
 Option to abandon
• If you may purchase a second-hand piston for $150 at the end of
the first year, then your own piston may be liquidated for $150
– When will you exercise this option?
– How will you recalculate the value of piston?
• Assume that the turbo may be sold at the end of the first year at the
expected price of $500
– When will you exercise this option?
– How will you recalculate the value of turbo?
• Two different ways to calculate the value of “real option”
– Decision tree analysis: simple, still popular
– Binomial option pricing model: less people understand, more
accurate

33
 Options to abandon & expand
*812/1.1
Turboprop +150(.6) or
500
-550 ?
456/1.1
Value=? +30(.4) or
*500
NPV=?
*450
+100(.6) or 331
Piston or 150
-250 ? 148/1.1
+50(.4) or
Value=? *150
NPV=? 34
 Options to abandon & expand
*812/1.1
Turboprop +150(.6) or
500
-550 745
456/1.1
Value=668.2 +30(.4) or
*500
NPV=118.2
*450
+100(.6) or 331
Piston or 150
-250 410 148/1.1
+50(.4) or
Value=367.7 *150
NPV=117.7 35