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

Cash Flow = with project - 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
Year 0 Years 1 - 12
Investment - 5,400
Sales 16,000
Variable Costs 13,000
Fixed Costs 2,000
Depreciation 450
Pretax profit 550
. Taxes @ 40% 220
Profit after tax 330
Operating cash flow 780
Net Cash Flow - 5,400 780
NPV= $478
 Sensitivity Analysis
Example - continued

Possible Outcomes
Range
Variable Pessimistic Expected Optimistic
Investment(000s) 6,200 5,400 5,000
Sales(000s) 14,000 16,000 18,000
Var Cost (% of sales) 83% 81.25% 80%
Fixed Costs(000s) 2,100 2,000 1,900
 Sensitivity Analysis
Example - continued
NPV Calculations for Pessimistic Investment Scenario
Year 0 Years 1 - 12
Investment - 6,200
Sales 16,000
Variable Costs 13,000
Fixed Costs 2,000
Depreciation 450
Pretax profit 550
. Taxes @ 40% 220
Profit after tax 330
Operating cash flow 780
Net Cash Flow - 6,200 780
NPV= ($121)
 Sensitivity Analysis
Example - continued

NPV Possibilities
NPV (000s)
Variable Pessimistic Expected Optimistic
Investment(000s) - 121 478 778
Sales(000s) - 1,218 478 2,174
Var Cost (% of sales) - 788 478 1,382
Fixed Costs(000s) 26 478 930
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 company’s cost
of capital is 10%.
 Break Even Analysis

Year 0 Years 1 - 6
Investment $900
Sales 15.5xPlanes Sold
Var. Cost 8.5xPlanes Sold
Fixed Costs 175
Depreciation 900 / 6 = 150
Pretax Profit (7xPlanes Sold) - 325
Taxes (50%) (3.5xPlanes Sold) - 162.5
Net Profit (3.5xPlanes Sold) - 162.5
Net Cash Flow - 900 (3.5xPlanes Sold) - 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 + 43553
. ( .5xPlanes Sold - 12.5)
 Break Even Analysis

Answer
Solving for “Planes Sold”
0 = -900 + 4355
. (3.5xPlanes Sold - 12.5)

Planes Sold = 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 Pursue project
$200,000) NPV=$2million

Failure

Stop project

Don’t test NPV=0

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

1000
Index

10

Common Stocks
Long T-Bonds
T-Bills
0.1
30

40

50

60

70

80

90
98
19

19

19

19

19

19

19
19
Source: Ibbotson Associates Year End
 Rates of Return
60

40
Percentage Return

20

-20

Common Stocks
-40 Long T-Bonds
T-Bills

-60 26 30 35 40 45 50 55 60 65 70 75 80 85 90 95

Source: Ibbotson Associates Year

 Expected Return

Expected market interest rate on normal risk

= +
return Treasury bills 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 0 0
+ 10 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 Squared

Year Rate of Return Average Return Deviation
1994 1.31 -23.44 549.43
1995 37.43 12.68 160.78
1996 23.07 -1.6 2.82
1997 33.36 8.61 74.13
1998 25.58 3.83 14.67
Total 123.75 801.84
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%
 Risk and Diversification
Portfolio standard deviation

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 stock’s 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
Market Return %
0.2
0
-0.2-0.8 -0.6 -0.4 -0.2 0 0.2 0.4 0.6 0.8 1
-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
12
Market
Expected Return (%) .

10
8
Portfolio
6
4
2
0
0 0.2 0.4 0.6 0.8 1
Beta
 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.

20
Expected Return (%) .

Rm Security Market Line

Rf

0
0 1
Beta
 Problems with CAPM
• Plotting average return vs. Beta, a zero Beta
beats Risk-free rate.
• Short term doesn’t 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
company’s 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
company’s 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 project’s 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 shouldn’t
the company invest even if the cost of
capital is 10% because of a beta?
• Shouldn’t a project that is risky but has
Beta=0 be considered worse than a project
that is safe and has Beta=0?