Remember use:

Incremental Cash Flows

Discount incremental cash flows

Include All Indirect Effects
Forget Sunk Costs
Include Opportunity Costs
Beware of Allocated Overhead Costs

Incremental
Cash Flow

cash flow
with project

cash flow
without project

Sequence of Firm Decisions

Capital Budget - The list of planned
investment projects.
The Decision Process
1 - Develop and rank all investment projects
2 - Authorize projects based on:

Govt regulation
Production efficiency
Capacity requirements
NPV (most important)

Capital Budgeting Process

Capital Budgeting Problems

Consistent forecasts
Conflict of interest
Forecast bias
Selection criteria (NPV and others)

How To Handle Uncertainty

Sensitivity Analysis - Analysis of the effects
of changes in sales, costs, etc. on a project.
Scenario Analysis - Project analysis given a
particular combination of assumptions.
Simulation Analysis - Estimation of the
probabilities of different possible outcomes.
Break Even Analysis - Analysis of the level of
sales (or other variable) at which the
company breaks even.

Sensitivity Analysis
Example
Given the expected cash flow
forecasts listed on the next
slide, determine the NPV of
the project given changes in
the cash flow components
using an 8% cost of capital.
Assume that all variables
remain constant, except the
one you are changing.

Sensitivity Analysis
Example - continued
I nvest ment

Year 0
- 5, 400

Sal es
Var i abl e Cost s

Year s 1 - 12
16, 000
13, 000

Fi xed Cost s
Depr eci at i on

2, 000
450

Pr et ax pr ofi t
. Taxes @ 40%

550
220

Pr ofi t af t er t ax
Oper at i ng cash fl ow

330
780

Net Cash Fl ow

- 5, 400

780

NPV= $478

Sensitivity Analysis
Example - continued
Possible Outcomes
Range
Var i abl e Pessi mi st i c Expect ed Opt i mi st i c
I nvest ment( 000s)
Sal es( 000s)
Var Cost ( % of sal es)
Fi xed Cost s( 000s)

6, 200

5, 400

5, 000

14, 000
83%

16, 000
81. 25%

18, 000
80%

2, 100

2, 000

1, 900

Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Investment Scenario
Year 0
I nvest ment

Year s 1 - 12

- 6, 200

Sal es

16, 000

Var i abl e Cost s

13, 000

Fi xed Cost s

2, 000

Depr eci at i on
Pr et ax pr ofi t

450
550

. Taxes @ 40%

220

Pr ofi t af t er t ax

330

Oper at i ng cash fl ow

780

Net Cash Fl ow

- 6, 200

780

NPV= ($121)

Sensitivity Analysis
Example - continued
NPV Possibilities
NPV (000s)
Var i abl e Pessi mi st i c Expect ed Opt i mi st i c
I nvest ment( 000s)

- 121

478

778

Sal es( 000s)

- 1, 218

478

2, 174

Var Cost ( % of sal es)

Fi xed Cost s( 000s)

- 788
26

478
478

1, 382
930

Break Even Analysis

Example
Given the forecasted data
on the next slide,
determine the number of
planes that the company
must produce in order to
break even, on an NPV
basis. The companys cost
of capital is 10%.

Break Even Analysis

I nvest ment

Year 0 Year s 1 - 6
$900

Sal es
Var . Cost

15. 5xPl anes Sol d

8. 5xPl anes Sol d

Fi xed Cost s
Depr eci at i on

175
900 / 6 = 150

Pr et ax Pr ofi t
Taxes ( 50%)

( 7xPl anes Sol d) - 325

( 3. 5xPl anes Sol d) - 162. 5

Net Pr ofi t

( 3. 5xPl anes Sol d) - 162. 5

Net Cash Fl ow - 900

( 3. 5xPl anes Sol d) - 12. 5

Break Even Analysis

Answer
The break even point, is the # of Planes
Sold that generates a NPV=$0.
The present value annuity factor of a 6
year cash flow at 10% is 4.355
Thus,
NPV = - 900 + 435535
.
( . xPl anes Sol d - 12. 5)

Break Even Analysis

Answer
Solving for Planes Sold
0 = - 900 + 4355
.
(35
. xPl anes Sol d - 12. 5)

Pl anes Sol d = 63

Flexibility & Options

Decision Trees - Diagram of sequential decisions
and possible outcomes.
Decision trees help companies determine their
Options by showing the various choices and
outcomes.
The Option to avoid a loss or produce extra profit
has value.
The ability to create an Option thus has value that
can be bought or sold.

Decision Trees
Success
Test (Invest
$200,000)

Pursue project
NPV=$2million

Failure
Stop project
NPV=0

Dont test
NPV=0

Decision Tree: Example

You invest in a dot com company.
At the start of each year for 3 years, it
requires 1 million to continue.
The future value of a successful dot.com in
at the beginning of the 4th year is 10
million.
Each year it has a 50% of surviving.
What is the NPV of this investment at r=.1?

You want to be a millionaire

You have no life-lines and are risk neutral. For
simplicity assume if you answer wrong you get 0.
If your are at 500,000, at what certainty would you
guess for the million?
Given your previous answer. Before seeing the
question your certainty of answering correctly the
500,000 is either 25% or 75% with equal chance.
At what certainty at 250,000, would you go for it?

Risk

Rates of Return
73 Years of Capital Market History
Measuring Risk
Risk & Diversification
Thinking About Risk

The value of a $1 investment in 19266

Index

1000

10
Common Stocks
Long T-Bonds
T-Bills
0.1

Source: Ibbotson Associates

Year End

Rates of Return
Percentage Return

60

40

20

-20
Common Stocks
Long T-Bonds
T-Bills

-40
-60 26

30

35

40

45

Source: Ibbotson Associates

50

55

60

Year

65

70

75

80

85

90

95

Expected Return
Expected market
return

interest rate on
Treasury bills

normal risk
premium

(1981) 23.3%

14

9.3

(1999) 14.1%

4.8

9.3

Equity Premium Puzzle.

In 1985, a pair of economists, Rajnish Mehra and
Edward Prescott, examined almost a century of returns
for American shares and bonds. After adjusting for
inflation, equities had made average real returns of
around 7 a year, compared with only 1% for Treasury
bonds-a 6% point equity premium. Given that shares
are riskier (in the sense that their prices bounce around
more) there should have been some premium. But
theory suggested it should not have been much more
than 1 point. The extra five points seemed redundant-evidence of some inexplicable market inefficiency

Measuring Risk
Variance - Average value of squared deviations from
mean. A measure of volatility.
Standard Deviation Square-Root of Variance. A
measure of volatility.

Measuring Risk
Coin Toss Game-calculating variance and standard deviation
(1)
(2)
(3)
Percent Rate of Return Deviation from Mean Squared Deviation
+ 40

+ 30

900

+ 10
+ 10

0
0

0
0

- 20

- 30

900

Variance = average of squared deviations = 1800 / 4 = 450

Standard deviation = square of root variance =

450 = 21.2%

Risk and Diversification

Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called diversifiable risk.
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
systematic risk.

Risk and Diversification

Deviation from
Average Return
-23.44
12.68
-1.6
8.61
3.83

Squared
Deviation
549.43
160.78
2.82
74.13
14.67
801.84

Year
Rate of Return
1994
1.31
1995
37.43
1996
23.07
1997
33.36
1998
25.58
Total
123.75
Average rate of return = 123.75/5 = 24.75
Variance = average of squared deviations = 801.84/5=160.37
Standard deviation = squared root of variance = 12.66%

Portfolio standard deviation

Risk and Diversification

Unique
risk
Market risk

0
5

10

15

Number of Securities

What does this tell you about mutual funds (unit trusts)?

Topics Covered

Measuring Beta
Portfolio Betas
CAPM and Expected Return
Security Market Line
Capital Budgeting and Project Risk

Measuring Market Risk

Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.
Beta - Sensitivity of a stocks return to the
return on the market portfolio.

Measuring Market Risk

Example - Turbo Charged Seafood has the
following % returns on its stock, relative to
the listed changes in the % return on the
market portfolio. The beta of Turbo
Charged Seafood can be derived from this
information.

Measuring Market Risk

Example - continued
Month Market Return % Turbo Return %
1
+ 1
+ 0.8
2
+ 1
+ 1.8
3
+ 1
- 0.2
4
-1
- 1.8
5
-1
+ 0.2
6
-1
- 0.8

Measuring Market Risk

Example - continued
When the market was up 1%, Turbo average
% change was +0.8%
When the market was down 1%, Turbo
average % change was -0.8%
The average change of 1.6 % (-0.8 to 0.8)
divided by the 2% (-1.0 to 1.0) change in
the market produces a beta of 0.8.
Beta is a measure of risk with respect to the
market (covariance). Can be additional risk!
Betting on Israel vs. Austria WC game.

Measuring Market Risk

Example - continued
Turbo
return %
1
0.8
0.6
0.4
0.2
0
-0.2-0.8 -0.6 -0.4 -0.2
-0.4
-0.6
-0.8

Market Return %

0.2

0.4

0.6

0.8

Portfolio Betas
Diversification decreases variability from
unique risk, but not from market risk.
The beta of your portfolio will be an
average of the betas of the securities in the
portfolio.
If you owned all of the S&P Composite
Index stocks, you would have an average
beta of 1.0

Measuring Market Risk

Market Risk Premium - Risk premium of market
portfolio. Difference between market return and
return on risk-free Treasury bills.

Measuring Market Risk

Market Risk Premium - Risk premium of market
portfolio. Difference between market return and
return on risk-free Treasury bills.
14
Expected Return (%) .

12

Market
Portfolio

10
8
6
4
2
0
0

0.2

0.4

0.6
Beta

0.8

Measuring Market Risk

CAPM - Theory of the relationship between risk and
return which states that the expected risk premium
on any security equals its beta times the market
risk premium.

Market risk premium = rm - rf

Risk premium on any asset = r - rf
Expected Return = rf + B(rm - rf )

Measuring Market Risk

Security Market Line - The graphic representation
of the CAPM.

Expected Return (%) .

20

Rm

Security Market Line

Rf
0
0

Beta

Problems with CAPM

Plotting average return vs. Beta, a zero Beta
beats Risk-free rate.
Short term doesnt do so well.
Unstable Betas.
Tough to test. Will the real market portfolio
stand up?
Beta is not a very good predictor of future
returns.
However, Jagannathan & Wang do find support with adjustments.

Capital Budgeting & Project Risk

The project cost of capital depends on the
use to which the capital is being put.
Therefore, it depends on the risk of the
project and not the risk of the company.

Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost
of capital of 17%. (4 + 1.3(10)). A breakdown of the
companys investment projects is listed below. When
evaluating a new dog food production investment, which
cost of capital should be used?
1/3 Nuclear Parts Mfr.. B=2.0
1/3 Computer Hard Drive Mfr.. B=1.3
1/3 Dog Food Production B=0.6

Capital Budgeting & Project Risk

Example - Based on the CAPM, ABC Company has a cost
of capital of 17%. (4 + 1.3(10)). A breakdown of the
companys investment projects is listed below. When
evaluating a new dog food production investment, which
cost of capital should be used?
R = 4 + 0.6 (14 - 4 ) = 10%
10% reflects the opportunity cost of capital on an
investment given the unique risk of the project.
You should use this value in computing that projects NPV!!

Wait a second!
A project has a NPV=10,000 when r=.05
and a NPV=-10,000 when r=.1 and the
company can borrow at 5%. Why shouldnt
the company invest even if the cost of
capital is 10% because of a beta?
Shouldnt a project that is risky but has
Beta=0 be considered worse than a project
that is safe and has Beta=0?