THE UNIVERSITY OF ZAMBIA

DEPARTMENT OF ECONOMICS

ECN 3422
Lecture 5: Capital Budgeting and Risk

Extracted from Brealey & Myers (2003)

 Topics Covered

• Company and Project Costs of Capital

• Capital Structure and COC
• Estimating Discount Rates
• Risk and DCF
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)

Company Cost of Capital
Firms requires different returns from different categories of
investments.
Example

Category Discount Rate

Speculative ventures 30%
New products 20%
Expansion of existing business 15%
Cost improvement, known technology 10%
Company Cost of Capital
• A company’s cost of capital can be compared to the
CAPM required return

SML=Security Market Line

Required
return
13
Company Cost
of Capital
5.5

0
Project Beta
1.26
Measuring Betas
• The SML shows the relationship between return and risk
• CAPM uses Beta as a proxy for risk
• Other methods can be employed to determine the slope of the SML
and thus Beta
• Regression analysis can be used to find Beta
Company Cost of Capital
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
Company Cost of Capital
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

Capital Structure
Capital Structure - the mix of debt & equity within a company

Expand CAPM to include Common Stock

R = rf + B ( rm - rf )
becomes

Requity = rf + B ( rm - rf )
Capital Structure & Cost of Capital (COC)
COC = rportfolio = rassets

rassets = rdebt (D) + requity (E)

(V) (V)

Bassets = Bdebt (D) + Bequity (E)

(V) (V)
requity = rf + Bequity ( rm - rf )
Capital Structure & COC
Expected Returns and Betas prior to refinancing
Expected 20
return (%)

Requity=15
Rassets=12.2

Rrdebt=8

0
0 0.2 0.8 1.2
Bdebt Bassets Bequity
Union Pacific Corp.

Requity = Return on Stock

= 15%

Rdebt = Yield to Maturity on bonds

= 7.5 %
Union Pacific Corp.
Example

Assets 100 Debt value 30

Equity value 70
Total Assets Firm value 100

debt equity
Rassets  rdebt  requity
debt  equity debt  equity
30 70
Rassets  7.5%  15%  12.75%
30  70 30  70
Risk, Discounted Cash Flow (DCF) and
Certainty Equivalency (CEQ)

Ct CEQt
PV  
(1  r ) (1  rf )
t t
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three
years. Given a risk free rate of 6%, a market premium of 8%, and beta
of .75, what is the PV of the project?
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?

r  rf  B( rm  rf )
 6  .75(8)
 12%
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3
2 100 79.7
r  rf  B( rm  rf )
 6  .75(8) 3 100 71.2
 12% Total PV 240.2
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?

Project A
Year Cash Flow PV @ 12%
1 100 89.3 Now assume that the
2
3
100
100
79.7
71.2
cash flows change, but
Total PV 240.2 are RISK FREE. What is
r  rf  B( rm  rf ) the new PV?
 6  .75(8)
 12%
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?.. Now assume that the cash flows change,
but are RISK FREE. What is the new PV?
Project B
Project A Year Cash Flow PV @ 6%
Year Cash Flow PV @ 12%
1 94.6 89.3
1 100 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?.. Now assume that the cash flows change,
but are RISK FREE. What is the new PV?

Project A Project B
Year Cash Flow PV @ 12% Year Cash Flow PV @ 6%
1 100 89.3 1 94.6 89.3
2 100 79.7 2 89.6 79.7
3 100 71.2 3 84.8 71.2
Total PV 240.2 Total PV 240.2

Since the 94.6 is risk free, we call it a Certainty Equivalent of the 100.
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project? DEDUCTION FOR RISK

Deduction
Year Cash Flow CEQ
for risk
1 100 94.6 5.4
2 100 89.6 10.4
3 100 84.8 15.2
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?.. Now assume that the cash flows change,
but are RISK FREE. What is the new PV?

The difference between the 100 and the certainty equivalent (94.6) is 5.4%…this
% can be considered the annual premium on a risky cash flow

Risky cash flow

 certainty equivalent cash flow
1.054
Risk,DCF and CEQ
Example
Project A is expected to produce CF = $100 mil for each of three years.
Given a risk free rate of 6%, a market premium of 8%, and beta of .75,
what is the PV of the project?.. Now assume that the cash flows change,
but are RISK FREE. What is the new PV?

100
Year 1   94.6
1.054

100
Year 2  2
 89.6
1.054

100
Year 3  3
 84.8
1.054