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Introduction

1. Corporate Finance how decision


making affects value.
2. Corporate finance is not a number
game.
3. Focus: (a) practical issues that arise in
valuation, (b) taxes, (c) incentives of
different stakeholders.

1
Chapter 7
Risk, Return and the Cost of Capital
Final objective: Estimating the opportunity cost of
capital.
Explain and calculate
Expected return
Security risk
Diversification
Portfolio risk
beta.

2
Capital Budgeting Example

Capital Budgeting Decision


Suppose you had the opportunity to buy a
tbill which would be worth $400,000 one
year from today.
Interest rates on tbills are a risk free
7%.
What would you be willing to pay for this
investment? -$400,000
PV today:
0 1 2

$400,000 / (1.07) = $373,832


3
Cost of Capital

Capital Budgeting Decision


Suppose you are offered a construction
deal with similar cost and payoff.
An important concept in finance is that a
risky dollar is worth less than a safe dollar.
You are told that the risk is quantified by
the cost of capital, which is 12%.

NPV= -350,000+400,000/1.12 = $7,142


4
Calculating Returns

Suppose you bought 100 shares of BCE one


year ago today at $25. Over the last year, you
received $20 in dividends (= 20 cents per
share 100 shares). At the end of the year, the
stock sells for $30. How did you do?

5
Holding Period Returns

The holding period return is the return that an


investor would get when holding an
investment over a period of n years, when the
return during year i is given as ri:

holding period return


(1 r1 ) (1 r2 ) (1 rn ) 1

6
The Future Value of an Investment of $1 in
1957: Evidence from Canada

$1 (1 r1957 ) (1 r1958 ) (1 r2003 ) $86.17


$42.91

$20.69
Common Stocks
Long Bonds
T-Bills

7
An Investment of $1 in 1900: US evidence

8
An Investment of $1 in 1900: US evidence
Real
Returns

9
How does this relate to cost of capital?

Suppose there is an investment project which


you know has the same risk as Standard and
Poors Composite Index.
What rate should you use?

10
Rates of Return 1900-2003
Stock Market Index Returns
Percentage Return

Year
Source: Ibbotson Associates
11
Measuring Risk
Histogram of Annual Stock Market Returns
# of Years

Return %

12
Average Stock Returns and Risk-Free
Returns
The Risk Premium is the additional return
(over and above the risk-free rate) resulting
from bearing risk.
One of the most significant observations of
stock (and bond) market data is this long-run
excess of security return over the risk-free
return.
The historical risk premium was 7.6% for the
US.

13
Average Market Risk Premia (by country)

Risk premium, %

14
Country
Measuring Risk

Variance - Average value of squared deviations


from mean. A measure of volatility.

Standard Deviation Square root of variance.


A measure of volatility.

15
Return Statistics
The history of capital market returns can be
summarized by describing the
average return
( R1 RT )
R
T

the standard deviation of those returns

( R1 R ) 2 ( R2 R ) 2 ( RT R ) 2
SD VAR
T 1
16
Canada Returns, 1957-2003
Average Standard
Investment Annual Return Deviation Distribution

Canadian common stocks 10.64% 16.41%

Long Bonds 8.96 10.36

Treasury Bills 6.80 4.11

Inflation 4.29 3.63

60% 0% 17
+ 60%
Risk Statistics

There is no universally agreed-upon definition of risk. A large


enough sample drawn from a normal distribution looks like a
bell-shaped curve.

18
Historically Are Returns Normal?

19
Expected Return, Variance, and covariance

Rate of Return
Scenario Probability Stock fund Bond fund
Recession 33.3% -7% 17%
Normal 33.3% 12% 7%
Boom 33.3% 28% -3%

Consider the following two risky asset worlds.


There is a 1/3 chance of each state of the
economy and the only assets are a stock fund
and a bond fund.

20
Expected Return, Variance, and Covariance

Stock fund Bond Fund


Rate of Squared Rate of Squared
Scenario Return Deviation Return Deviation
Recession -7% 3.24% 17% 1.00%
Normal 12% 0.01% 7% 0.00%
Boom 28% 2.89% -3% 1.00%
Expected return 11.00% 7.00%
Variance 0.0205 0.0067
Standard Deviation 14.3% 8.2%

21
The Return for Portfolios
Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%


Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

The expected rate of return on the


portfolio is a weighted average of the
expected returns on the securities in the
portfolio.
E (rP ) wB E (rB ) wS E (rS )
22
The Variance of a Portfolio

Rate of Return
Scenario Stock fund Bond fund Portfolio squared deviation
Recession -7% 17% 5.0% 0.160%
Normal 12% 7% 9.5% 0.003%
Boom 28% -3% 12.5% 0.123%

Expected return 11.00% 7.00% 9.0%


Variance 0.0205 0.0067 0.0010
Standard Deviation 14.31% 8.16% 3.08%

23
Portfolio Risk

1
2
3
To calculate
STOCK 4
portfolio
5
variance add
6
up the boxes

N
1 2 3 4 5 6 N
STOCK 24
Diversification
The variance (risk) of the securitys return can
be broken down into:
Systematic (Market) Risk
Unsystematic (diversifiable) Risk
The Effect of Diversification:
unsystematic risk will significantly diminish in
large portfolios
systematic risk is not affected by
diversification since it affects all securities in
any large portfolio
25
Portfolio Risk as a Function of the Number
of Stocks in the Portfolio
In a large portfolio the variance terms are effectively
diversified away, but the covariance terms are not.

Diversifiable Risk;
Nonsystematic Risk;
Firm Specific Risk;
Unique Risk
Portfolio risk
Nondiversifiable risk;
Systematic Risk;
Market Risk
n
Thus diversification can eliminate some, but not all of the
risk of individual securities. 26
Beta and Unique Risk

1. Total risk = diversifiable risk + market risk


2. Market risk is measured by beta, the sensitivity to market changes

Expected
stock
return

beta
+10%
-10%

-10% +10% Expected


market
-10% return

Copyright 1996 by The McGraw-Hill


Companies, Ic 27
Beta and Unique 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.

28
Definition of Risk When Investors Hold
the Market Portfolio
Researchers have shown that the best measure
of the risk of a security in a large portfolio is the
beta ()of the security.
Beta measures the responsiveness of a security
to movements in the market portfolio.

Cov ( Ri , RM )
i
( RM )
2

29
Chapter 8
Risk and Return

Markowitz Portfolio Theory


Risk and Return Relationship
Validity and the Role of the CAPM

30
Markowitz Portfolio Theory

Given a certain level of risk, investors prefer


stocks with higher returns.
Given a certain level of return, investors prefer
less risk.
By combining stocks into a portfolio, one can
achieve different combinations of return &
standard deviation.
Correlation coefficients are crucial for ability to
reduce risk in portfolio.

31
Markowitz Portfolio Theory

Expected Returns and Standard Deviations vary given


different weighted combinations of the stocks
Expected Return (%)

Coca Cola

40% in Coca Cola

Exxon Mobil

Standard Deviation

32
Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

33
Efficient Frontier

Each half egg shell represents the possible weighted


combinations for two stocks.
The composite of all stock sets constitutes the efficient frontier
Expected Return (%)

Standard Deviation
34
Efficient Frontier
Example Correlation Coefficient = .4
Stocks % of Portfolio Avg
Return
ABC Corp 28 60% 15%
Big Corp 42 40% 21%

Portfolio 28.1 17.4%

Lets Add stock New Corp to the portfolio

35
Efficient Frontier
Example Correlation Coefficient = .3
Stocks % of Portfolio Avg Return
Portfolio 28.1 50% 17.4%
New Corp 30 50% 19%

New Portfolio 23.43 18.20%

NOTE: Higher return & Lower risk


How did we do that? DIVERSIFICATION

36
Efficient Frontier

Return

B
AB
A

Risk

37
Efficient Frontier

Return

B
N
AB
A

Risk

38
Efficient Frontier

Return

B
ABN AB N

Risk

39
2-Security Portfolios - Various Correlations
return
100%
= -1.0 stocks

= 1.0
100%
= 0.2
bonds

40
Efficient Frontier

return
o nt i er
r
nt f
cie
effi
minimum
variance
portfolio

Individual Assets

41
Riskless Borrowing and Lending

return
L
CM 100%
stocks
Balanced
fund

rf
100%
bonds

Now investors can allocate their money across


the T-bills and a balanced mutual fund
42
Market Equilibrium: CAPM

return
L
CM efficient frontier

rf

43
Changes in Riskfree Rate

return
L 0 CML 1
CM 100%
stocks

1 First Second Optimal


r f Optimal Risky Portfolio
0 Risky
r f Portfolio
100%
bonds

44
Security Market Line
Return

Market Return = rm .
Efficient Portfolio
Risk Free
Return = rf

1.0 BETA

45
Security Market Line
Return

SML

rf
BETA
1.0

SML Equation = rf + B ( rm - rf )
46
Risk & Expected Return

Expected
return
13.5%

3%

1.5
i 1.5 RF 3% R M 10%
R i 3% 1.5 (10% 3%) 13.5%
47
Estimating with regression

Security Returns
i ne
c L
i
r ist
c te
ara
Ch Slope = i
Return on
market %

Ri = i + iRm + ei
48
Estimates of Beta for Selected Stocks
Stock Beta
Research in Motion 3.04
Nortel Networks 3.61
Bank of Nova Scotia 0.28
Bombardier 1.48
Investors Group. 0.36
Maple Leaf Foods 0.25
Roger 1.17
Communications
Canadian Utilities 0.08
49
TransCanada Power 0.08
CAPM versus Reality

1. Do investors care about mean and


variance?
2. Is there a security that is risk-free?
3. Short selling?
4. Transaction costs?
5. Most important: homogeneous
expectations?

50
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-2002

30
SML

20 Investors

10
Market
Portfolio
0
Portfolio Beta
1.0
51
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1931-65 SML
30

20 Investors

10 Market
Portfolio
0
Portfolio Beta
1.0
52
Testing the CAPM
Beta vs. Average Risk Premium
Avg Risk Premium
1966-2002

30

20 SML
Investors

10

Market
0 Portfolio
Portfolio Beta
1.0
53
Chapter 9 (part 1)
Capital Budgeting and Risk
Shareholder
Firm with invests in
excess cash Pay cash dividend financial
asset
A firm with excess cash can either pay a
dividend or make a capital investment

Shareholders
Invest in project Terminal
Value
Because stockholders can reinvest the dividend in risky financial assets,
the expected return on a capital-budgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
54
Company Cost of Capital

A firms value can be stated as the sum of the


value of its various assets

Firm value PV(AB) PV(A) PV(B)

55
Company Cost of Capital

Category Discount Rate


Speculative Ventures 30%
New products 20%
Expansion of existing business 15% (Company COC)
Cost improvement, known technology 10%

56
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

57
Company Cost of Capital

If the firm is all equity financed, A companys cost


of capital can be compared to the CAPM required
return

SML
Required
return
13
Company Cost
of Capital
5.5

0
Project Beta
1.26
58
Example

Suppose the stock of Stansfield Enterprises,


a publisher of PowerPoint presentations,
has a beta of 2.5. The firm is 100-percent
equity financed.
Assume a risk-free rate of 5-percent and a
market risk premium of 10-percent.
What is the appropriate discount rate for an
expansion of this firm?

59
Example (continued)
Suppose Stansfield Enterprises is evaluating the following non-
mutually exclusive projects. Each costs $100 and lasts one year.

Project Project Projects IRR NPV at


Estimated Cash 30%
Flows Next
Year
A 2.5 $150 50% $15.38

B 2.5 $130 30% $0

C 2.5 $110 10% -$15.38

60
Using the SML to Estimate the Risk-
Adjusted Discount Rate for Projects

Good SML
IRR
Project

A
projects

30% B

C Bad projects
5%
Firms risk (beta)
2.5

61
Capital Structure
Capital Structure - the mix of debt & equity
within a company

Expand CAPM to include CS (common shares)

R = rf + B ( r m - rf )
becomes
Requity = rf + B ( rm - rf )

62
Capital Structure & COC (company
cost of capital)
COC = rportfolio = rassets

rassets = rdebt (D) + requity (E)


(V) (V)

Bassets = Bdebt (D) + Bequity (E)


(V) (V)
IMPORTANT
requity = rf + Bequity ( rm - rf ) E, D, and V are
all market values
63
Capital Structure & COC

Expected Returns and Betas prior to refinancing


Expected
return (%)

Requity=15
Rassets=12.2

Rrdebt=8

Bdebt Bassets Bequity


64
The Firm versus the Project
Suppose the Conglomerate Company has a cost of capital,
based on the CAPM, of 17%. The risk-free rate is 4%, the
market risk premium is 10%, and the firms beta is 1.3.
17% = 4% + 1.3 [14% 4%]

This is a breakdown of the companys investment projects:


1/3 Automotive retailer = 2.0
1/3 Computer Hard Drive Mfr. = 1.3
1/3 Electric Utility = 0.6
average of assets = 1.3
When evaluating a new electrical generation investment,
which cost of capital should be used?
65
Capital Budgeting & Project Risk

IRR SML
Project

24% Investments in hard


drives or auto retailing
17%
should have higher
10% discount rates.

Firms risk (beta)


0.6 1.3 2.0
r = 4% + 0.6(14% 4% ) = 10%
10% reflects the opportunity cost of capital on an investment in
electrical generation, given the unique risk of the project. 66
Capital Budgeting & Project Risk

IRR
Project
SML
The SML can tell us why:
Incorrectly accepted
negative NPV projects
Hurdle RF FIRM ( R M RF )
rate
Incorrectly rejected
rf positive NPV projects
Firms risk (beta)
FIRM

67
Measuring Betas
Theoretically, the calculation of beta is straightforward:

Cov ( Ri , RM ) im
2
Var ( RM ) M

Problem 1: Betas may vary over time.

68
Measuring Betas

Dell Computer

Price data: May 91- Nov 97

R2 = .10
B = 1.87

Slope determined from plotting the


line of best fit.
69
Measuring Betas

Dell Computer

Price data: Dec 97 - Apr 04

R2 = .27
B = 1.61

Slope determined from plotting the


line of best fit.
70
Measuring Betas

General Motors

Price data: May 91- Nov 97

R2 = .07
B = 0.72

Slope determined from plotting the


line of best fit.
71
Measuring Betas

General Motors

GM return (%)
Price data: Dec 97 - Apr 04

R2 = .29
B = 1.21

Slope determined from plotting the


line of best fit.
72
Estimated Betas

73
Beta Stability
% IN SAME % WITHIN ONE
RISK CLASS 5 CLASS 5
CLASS YEARS LATER 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)


74
Using an Industry Beta

It is frequently argued that one can better estimate


a firms beta by involving the whole industry.
If you believe that the operations of the firm are
similar to the operations of the rest of the industry,
you should use the industry beta.
If you believe that the operations of the firm are
fundamentally different from the operations of the
rest of the industry, you should use the firms beta.

75
Problems with Industry Beta

One must make sure that the firm is


comparable to other industry both in its
operation and its financing.
Question: Consider Grand Sport, Inc., which is currently all-
equity and has a beta of 0.90. The firm has decided to lever up
to a capital structure of 50% debt and 50% equity. Since the
firm will remain in the same industry, its asset beta should
remain 0.90.
Assuming a zero beta for its debt, what should the equity beta
be?

76
Beware of Fudge Factors

Common practice to make adjustments to


discount rate to offset worries.
Example:
1) A new drug wont get FDA approval and wont
be able to go on the market.
2) Unexpected weather condition would hurt the
crop.

77
Determinants of Beta

Business Risk
Cyclicality of Revenues
Operating Leverage
Financial Risk
Financial Leverage

78
Cyclicality of Revenues

Highly cyclical stocks have high betas.


Empirical evidence suggests that retailers
and automotive firms fluctuate with the
business cycle.
Transportation firms and utilities are less
dependent upon the business cycle.

79
Operating Leverage

The degree of operating leverage measures how


sensitive a firm (or project) is to its fixed costs.
Operating leverage increases as fixed costs rise and
variable costs fall.
Operating leverage magnifies the effect of cyclicality on
beta.
The degree of operating leverage is given by:

Change in EBIT Sales


DOL
EBIT Change in Sales
80
Operating Leverage

EBIT
Total
$ costs

Fixed costs
Volume
Fixed costs
Volume

Operating leverage increases as fixed costs rise


and variable costs fall.
81
Chapter 9: Q5

The following table shows estimates of the


risk of two well-known Canadian Stocks
STD R^2 Beta STD Beta

Alcan 24 0.15 0.69 0.21

Inco 29 0.22 1.04 0.26

a. What proportion was market risk, and what proportion unique risk?
b. What is the variance of market and unique variance of each stock?
c. What is the confidence level of the Incos beta?
d. What is expected return of Alcn if Rf=5% and market return=12%?
e. Suppose next year the market provides a zero return. What return to 82
you expect for each stock?
Chapter 9: Q9
You run a perpetual encabulator machine, which
generates revenues averaging $20 million per year.
Raw material costs are 50 percent of revenues.
These costs are variable they are always
proportional to revenues. There are no other
operating costs. The cost of capital is 9 percent.
Your firms long-term borrowing rate is 6 percent.
Now you are approached by Studebaker Capital
Corp., which proposes a fixed-price contract to
supply raw materials at $10 million per year for 10
years.
a. What happens to the operating leverage and
business risk of the encabulator machine if you
agree to this fixed-price contact?
b. Calculate the present value of the encabulator
machine with and without the fixed-price contract?
83
Chapter 9 (part 2)
Capital Budgeting and Risk

Ct CEQt
PV
(1 r ) t
(1 rf ) t

84
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?

85
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
86
Risk,DCF and CEQ
Example
Project B cash flow is 94.6, 89.6, 84.8 in year 1-3 respectively.
However, these cash flows are RISK FREE. What is Projects B
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
87
Risk,DCF and CEQ

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.
88
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 5.7%this % can be considered the annual
premium on a risky cash flow

Risky cash flow


certainty equivalent cash flow
1.057

89
Long lived assets and discount rates
Example (from text): The scientists at Vegetron have come up
with an electric mop and are ready to go ahead with pilot
production. The preliminary phase will take one year and
costs $125k. Management feels that there is only a 50%
chance that the pilot production will be successful. If the
project fails, the project will be dropped. If the project
succeeds Vegetron will build a $1million plant that would
generate an expected annual cash flow in perpetuity of
$250k.
Rf=7%, Risk Premium=9%. Regular projects of the firm have
a beta of 0.33, however due to the 50% probability of failure
management assumes a beta of 2 for the project.
1. What is NPV?
2. Is management correct about its approach for the NPV
calculation?

90
International Projects

Investment projects abroad may be safer


than similar domestic investments.
Remember: Beta measures risk relative to
investors portfolio (a good question would
be to ask who is the investor of the
company?)
Not clear why home bias persists so
strongly (perhaps information, transaction
costs, etc.)
91
What is Liquidity?

The idea that the expected return on a stock and


the firms cost of capital are positively related to
risk is fundamental.
Recently a number of academics have argued
that the expected return on a stock and the firms
cost of capital are negatively related to the
liquidity of the firms shares as well.
The trading costs of holding a firms shares
include brokerage fees, the bid-ask spread, and
market impact costs.
92
Liquidity, Expected Returns, and the Cost
of Capital
The cost of trading an illiquid stock reduces the
total return that an investor receives.
Investors thus will demand a high expected
return when investing in stocks with high trading
costs.
This high expected return implies a high cost of
capital to the firm.

93
Liquidity and the Cost of Capital

Cost of Capital

Liquidity
An increase in liquidity, i.e., a reduction in trading costs,
lowers a firms cost of capital.
94
Liquidity and Adverse Selection

There are a number of factors that determine the


liquidity of a stock.
One of these factors is adverse selection.
This refers to the notion that traders with better
information can take advantage of specialists
and other traders who have less information.
The greater the heterogeneity of information, the
wider the bid-ask spreads, and the higher the
required return on equity.

95
What the Corporation Can Do

The corporation has an incentive to lower trading


costs since this would result in a lower cost of
capital.
A stock split would increase the liquidity of the
shares.
A stock split would also reduce the adverse
selection costs thereby lowering bid-ask spreads.
This idea is a new one and empirical evidence is
not yet in.

96
What the Corporation Can Do

Companies can also facilitate stock purchases


through the Internet.
Direct stock purchase plans and dividend
reinvestment plans handled on-line allow small
investors the opportunity to buy securities
cheaply.
The companies can also disclose more
information, especially to security analysts, to
narrow the gap between informed and
uninformed traders. This should reduce spreads.
97
Summary and Conclusions
The expected return on any capital budgeting
project should be at least as great as the
expected return on a financial asset of
comparable risk. Otherwise the shareholders
would prefer the firm to pay a dividend.
The expected return on any asset is
dependent upon .
A projects required return depends on the
projects .
A projects can be estimated by considering
comparable industries or the cyclicality of
project revenues and the projects operating
and financial leverage. 98
Jones Family Mini-Case
Executive summary:
The wildcat oil well is going to cost $5 million.
The Jones geologists says theres only 30% chance of a dry hole.
If oil is found, the expectation is for 300 barrels of crude oil per day
(at a price of $25 per barrel)
Sales will start next year.
Production and shipping costs are $10 per barrel (Mr. Jones argues
that they are fixed).
Production will start declining at 5% every year.
Oil prices expected to grow at 2.5% per year, and pumping will
continue for 15 years.
The interest rate is 6%, the beta is 0.8, and the risk premium is 7%.

99
Chapter 10: Decision Trees
A fundamental problem in NPV analysis is
dealing with uncertain future outcomes.
There is usually a sequence of decisions in
NPV project analysis.
Decision trees are used to identify the
sequential decisions in NPV analysis.
Decision trees allow us to graphically represent
the alternatives available to us in each period
and the likely consequences of our actions.
This graphical representation helps to identify
the best course of action.
100
Example of Decision Tree
Open circles represent decisions to be made.

A Filled circles represent


receipt of information
e.g., a test score in this
Study class.
Pay B
wizard
finance
$1000?
C

The lines leading away


Do not D from the circles represent
study the alternatives.

F 101
Stewart Pharmaceuticals
The Stewart Pharmaceuticals Corporation is considering
investing in developing a drug that cures the common cold.
A corporate planning group, including representatives from
production, marketing, and engineering, has recommended
that the firm go ahead with the test and development phase.
This preliminary phase will last one year and cost $1 billion.
Furthermore, the group believes that there is a 60% chance
that tests will prove successful.
If the initial tests are successful, Stewart Pharmaceuticals
can go ahead with full-scale production. This investment
phase will cost $1,600 million. Production will occur over the
next four years.

102
Stewart Pharmaceuticals NPV of Full-Scale Production following
Successful Test
Investment Year 1 Years 2-5
Revenues $7,000
Variable Costs (3,000)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $1,800
Tax (34%) (612)
Net Profit $1,188
Cash Flow -$1,600 $1,588
4
$1,588
NPV $1,600 t
$3,433.75
t 1 (1.10)

Note that the NPV is calculated as of date 1, the date at which the investment of
$1,600 million is made. Later we bring this number back to date 0.
103
Stewart Pharmaceuticals NPV of Full-Scale Production following
Unsuccessful Test
Investment Year 1 Years 2-5
Revenues $4,050
Variable Costs (1,735)
Fixed Costs (1,800)
Depreciation (400)
Pretax profit $115
Tax (34%) (39.10)
Net Profit $75.90
Cash Flow -$1,600 $475
4
$475.90
NPV $1,600 t
$91.461
t 1 (1.10)
Note that the NPV is calculated as of date 1, the date at which the investment of
$1,600 million is made. Later we bring this number back to date 0. 104
Decision Tree for Stewart Pharmaceutical
The firm has two decisions to make: Invest
To test or not to test.
To invest or not to invest. NPV $3,433.75m
Success

Test Do not
NPV = $0
invest

Failure

NPV $91.461m
Do not Invest
NPV $0
test
105
Stewart Pharmaceutical: Decision to Test
Lets move back to the first stage, where the decision boils
down to the simple question: should we invest?
The expected payoff evaluated at date 1 is:
Expected Prob. Payoff Prob. Payoff

payoff sucess given success failure given failure
Expected
.60 $3,433.75 .40 $0 $2,060.25
payoff
The NPV evaluated at date 0 is:
$2,060.25
NPV $1,000 $872.95
1.10
So we should test.
106
Real Options
One of the fundamental insights of modern finance
theory is that options have value.
The phrase We are out of options is surely a sign of
trouble.
Because corporations make decisions in a dynamic
environment, they have options that should be
considered in project valuation.

107
Options

The Option to Expand


Static analysis implicitly assumes that the scale of the
project is fixed.
If we find a positive NPV project, we should consider the
possibility of expanding the project to get a larger NPV.
For example,the option to expand has value if demand
turns out to be higher than expected.
All other things being equal, we underestimate NPV if we
ignore the option to expand.
The Option to Delay
Has value if the underlying variables are changing with a
favourable trend.
108
The Option to Expand: Example
Imagine a start-up firm, Campusteria, Inc. which plans
to open private (for-profit) dining clubs on university
campuses.
The test market will be your campus, and if the concept
proves successful, expansion will follow nationwide.
Nationwide expansion, if it occurs, will occur in year
four.
The start-up cost of the test dining club is only $30,000
(this covers leaseholder improvements and other
expenses for a vacant restaurant near campus).

109
Campusteria pro forma Income Statement
Investment Year 0 Years 1-4 We plan to sell 25 meal
plans at $200 per
Revenues $60,000
month with a 12-month
Variable Costs ($42,000) contract.
Fixed Costs ($18,000)
Variable costs are
Depreciation ($7,500) projected to be
Pretax profit ($7,500) $3,500 per month.
Tax shield 34% $2,550 Fixed costs (the lease
Net Profit $4,950 payment) are
projected to be
Cash Flow $30,000 $2,550 $1,500 per month.

4
$2,550 We can depreciate
NPV $30,000 t
$21,916.84 (straight line) our
t 1 (1.10) capitalized leaseholder
improvements. 110
The Option to Expand: Valuing a Start-Up
Note that while the Campusteria test site has a
negative NPV, its negativity is relatively small.
If we expand, we project opening 20 Campusterias in
year four and the size of the project may grow 20 folds.
The value of the project is in the option to expand.
If we hit it big, we will be in a position to score large.
We wont know if this has value if we do not try. Thus, it
seems that we may want to take on this test project
and see what it delivers.

111
Discounted Cash Flows and Options
We can calculate the market value of a project as the sum of
the NPV of the project without options and the value of the
managerial options implicit in the project.
M = NPV + Opt

A good example would be comparing the


desirability of a specialized machine versus a more
versatile machine. If they both cost about the same
and last the same amount of time the more
versatile machine is more valuable because it
comes with options.
112
The Option to Abandon: Example
The option to abandon a project has value if demand
turns out to be lower than expected.
Suppose that we are drilling an oil well. The drilling rig
costs $300 today and in one year the well is either a
success or a failure.
The outcomes are equally likely. The discount rate is
10%.
The PV of the successful payoff at time one is $575.
The PV of the unsuccessful payoff at time one is $0.

113
The Option to Abandon: Example
(continued)
Traditional NPV analysis would indicate rejection of the project.

Expected = Prob. Successful + Prob. Failure


Payoff Success Payoff Failure Payoff

Expected
= (0.50$575) + (0.50$0) = $287.50
Payoff

$287.50
NPV = $300 + = $38.64
1.10
114
The Option to Abandon: Example
Traditional NPV analysis overlooks the option to abandon.

Success: PV = $575

Drill Sit on rig; stare


at empty hole:
$300 PV = $0.
Failure

Do not Sell the rig;


NPV $0 salvage value
drill
= $250

The firm has two decisions to make: drill or not, abandon or115
stay.
The Option to Abandon: Example
(continued)
When we include the value of the option to abandon, the
drilling project should proceed:

Expected = Prob. Successful + Prob. Failure


Payoff Success Payoff Failure Payoff

Expected
= (0.50$575) + (0.50$250) = $412.50
Payoff

$412.50
NPV = $300 + = $75.00
1.10
116
Valuation of the Option to Abandon
Recall that we can calculate the market value of a project
as the sum of the NPV of the project without options and
the value of the managerial options implicit in the project.
M NPV Opt
$75.00 38.64 Opt

$75.00 38.64 Opt

Opt $113 .64


117
The Option to Delay: Example

$7,900
$6,529
(1.10) 2

Consider the above project, which can be undertaken in


any of the next 4 years. The discount rate is 10 percent.
The present value of the benefits at the time the project is
launched remain constant at $25,000, but since costs are
declining the NPV at the time of launch steadily rises.
The best time to launch the project is in year 2this
schedule yields the highest NPV when judged today.
118
Option issues to consider

Things to remember in these types of analysis:


Cost of the testing
Expected future cash flows given the outcome
of the test
Probability of success of the testing
Discount rate

119