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- Risk, Return & Capital Budgeting
- Munk_2008_Financial Asset Pricing Theory
- Fama Decomposition of Return
- Corporate Finance Ch. 12
- An Investigation of the Relationship Between Business and Financial Risk Using Accounting Data
- Lecture 1L
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- sdfdsf
- Betting Against Beta (Frazzini + Pedersen, 2014).pdf
- Exam Financial management
- The Capm Theory
- 111-620-1-PB.pdf
- Estimating Inputs for Valuation
- Ch010
- Financial Ratio
- Assignment 5 Answers
- Ch 6 - Cost of Capital.pdf
- Parrino 2e PowerPoint Review Ch13

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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

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

3

Cost of Capital

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%.

4

Calculating Returns

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

investor would get when holding an

investment over a period of n years, when the

return during year i is given as ri:

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

6

The Future Value of an Investment of $1 in

1957: Evidence from Canada

$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?

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

from mean. A measure of volatility.

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

( 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

60% 0% 17

+ 60%

Risk Statistics

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%

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

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%

Variance 0.0205 0.0067 0.0010

Standard Deviation 14.31% 8.16% 3.08%

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%

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

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

Expected

stock

return

beta

+10%

-10%

market

-10% return

Companies, Ic 27

Beta and Unique Risk

economy. In practice a broad stock market

index, such as the S&P Composite, is used to

represent the market.

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

Risk and Return Relationship

Validity and the Role of the CAPM

30

Markowitz Portfolio Theory

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

different weighted combinations of the stocks

Expected Return (%)

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

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%

35

Efficient Frontier

Example Correlation Coefficient = .3

Stocks % of Portfolio Avg Return

Portfolio 28.1 50% 17.4%

New Corp 30 50% 19%

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

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

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

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

value of its various assets

55

Company Cost of Capital

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

of the assets

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

57

Company Cost of Capital

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

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.

Estimated Cash 30%

Flows Next

Year

A 2.5 $150 50% $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

R = rf + B ( r m - rf )

becomes

Requity = rf + B ( rm - rf )

62

Capital Structure & COC (company

cost of capital)

COC = rportfolio = rassets

(V) (V)

(V) (V)

IMPORTANT

requity = rf + Bequity ( rm - rf ) E, D, and V are

all market values

63

Capital Structure & COC

Expected

return (%)

Requity=15

Rassets=12.2

Rrdebt=8

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%]

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

drives or auto retailing

17%

should have higher

10% discount rates.

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

68

Measuring Betas

Dell Computer

R2 = .10

B = 1.87

line of best fit.

69

Measuring Betas

Dell Computer

R2 = .27

B = 1.61

line of best fit.

70

Measuring Betas

General Motors

R2 = .07

B = 0.72

line of best fit.

71

Measuring Betas

General Motors

GM return (%)

Price data: Dec 97 - Apr 04

R2 = .29

B = 1.21

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

74

Using an Industry Beta

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

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

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

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

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:

DOL

EBIT Change in Sales

80

Operating Leverage

EBIT

Total

$ costs

Fixed costs

Volume

Fixed costs

Volume

and variable costs fall.

81

Chapter 9: Q5

risk of two well-known Canadian Stocks

STD R^2 Beta STD Beta

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

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?

(94.6) is 5.7%this % can be considered the annual

premium on a 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

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 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

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

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

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.

receipt of information

e.g., a test score in this

Study class.

Pay B

wizard

finance

$1000?

C

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

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

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.

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

at empty hole:

$300 PV = $0.

Failure

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:

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

117

The Option to Delay: Example

$7,900

$6,529

(1.10) 2

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

Cost of the testing

Expected future cash flows given the outcome

of the test

Probability of success of the testing

Discount rate

119

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