Valuation of Risky Real Assets

Financial Market and Corporate

Strategy – Mark Grinblatt and
Sheridan Titman

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 Valuation of Real Assets
• Two approaches for risky project valuation
1. Forecast the expected CFs for the project and
discount with a risk adjusted discount rate.

2. Forecast certainty equivalent CFs and discount it

with risk free discount rate.

Procedure: Identify a tracking portfolio and use its

value as an estimate of the value of the asset’s
future CFs.

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 What is a tracking portfolio?
• A tracking portfolio is a portfolio of assets with returns
that track a variable. Monthly returns on stocks and
bonds are useful in forecasting post-war US output,
consumption, labor income, inflation, stock returns,
bond returns, and Treasury bill returns.

• These forecasting relationships define portfolios that

track market expectations about future economic
variables. Using tracking portfolio returns as
instruments for future economic variables substantially
raises the estimated sensitivity of asset prices to news
about future economic variables.

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 Tracking Portfolio and Real Asset
Valuation
• Here discounted CF formula is a statement that the market
price of a combination of financial investments that track
the future CFs of the real project should be same as the
value of real project’s CF.

• Perfect tracking exist only in special circumstances, thus,

tracking error exists in most of the cases.

• Objective is to minimize tracking error…..

• For example : in case of oil well project, CFs can be

perfectly tracked by a portfolio of oil forward contracts.

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How to generate a Tracking Portfolio whose PV
of Tracking Error should be zero?
• Asset Pricing Models and Tracking Portfolio
Approach – Whenever tracking error exists,
analyst usually turn to asset pricing model
such as APT and CAPM to derive project’s
present value. Imperfect tracking portfolio can
be used only when tracking error consists of
unsystematic or firm specific risk.

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 Example of how to use tracking
portfolio for valuation
Cash Flow Next Year

State Probability Hilton Market Portfolio

Good 0.4 12.3 1.4

Average 0.4 11.3 1.2

Bad 0.2 9.3 0.80

Hence, we assume initially that the investment can be perfectly

tracked with a mix of the market portfolio and risk free assets.
RFR = 6%
A portfolio of financial assets worth $10 million ($5 million in
market portfolio and $5 million in risk free asset) tracks the CFs
of the real project of Hilton 7
 Continue…
• Note that we are discounting the expected CFs to
calculate the present value, the appropriate
discount rate must be equal to discount rate for
the tracking portfolio’s expected CF.

• This is the weighted average of the expected

return of the market portfolio and risk free rate,
where weights corresponds to the portfolio
weights on the market and risk free asset. Bm =
0.5 and weight of risk free asset = 1-Bm = 0.5
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 Tracking Error and PV
• The perfect tracking seen above arises
because we constructed a portfolio that
perfectly track the CFs of Hilton.

• With imperfect tracking, the mix of market

portfolio and rfr that best tracks Hiltons Cfs is
one that minimize the tracking error.

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Implementing the Tracking portfolio Approach

• When we identified a tracking portfolio that is

mean-variance efficient, valuation of real
assets is equal to its initial investment i.e. $10
million.

• When variance is large, we turn to asset

pricing models that specify a tangency
portfolio as the critical tracking instrument.

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Linking Financial Asset Tracking to
Real Asset Valuation with SML

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 Continue….
• It is very imp to determine the proper mix of assets in the tracking
portfolio, especially when there is tracking error.

• We will use SML to determine why careless about estimating tracking

portfolio can be costly

• The SML is drawn to depict the expected return based on the

tangency portfolio.

• The key is to correctly know project’s beta in order to have +ve NPV.
If beta is overestimated, for example, if the project at point A is
assumed to have a beta at point C, and erroneously interpreted at
point A***, a positive NPV project can mistakenly appear to have
negative NPV. It is also possible to underestimate beta, which leads
to adoption of bad projects.

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 Risk Adjusted Discount Rate
Defining and implementing RADR given beta
• The method of discounting expected CFs at a risk adjusted discount rate.

• This method is employed when there is a comparison firm or set of firm in

the same business.

• Manager who uses this valuation method are assuming that the return of
the traded equity of the comparison firm have the same beta as the
returns of the project.

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 Steps to find out PV using risk
adjusted discount rates
1. Compute the expected CFs for the next period.

2. Compute beta of the return of the project

3. Compute expected return of the project by substituting the beta (as in

step 2) into the tangency portfolio risk expected return equation.

4. Divide the expected future CFs by the expected return as calculated in

step 3.

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 Example:
• ABC co has a beta of 1.2 when computed
against the tangency portfolio. One year from
now this company has 90% probability of being
worth $10 per share and 10% probability of
being worth $20 per share.
Risk free rate = 9%
The tangency portfolio has a expected return of
19%. What is the PV of the equity of ABC
assuming no dividend is paid?
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 Continue…
• The hallmark of risk adjusted discount rate method is
that it is implemented with a comparison approach,
which provides an estimate of betas for the project
by analyzing the beta of the traded securities.

• The beta value identified in the previous example

(beta 1.2) is calculated by estimating beta
comparison firm trading in the industry.

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Tracking Portfolio Method is implicit in the Risk
Adjusted Discount Rate Method
• Hilton expected CFs E( C) = 0.4*12.3 + 0.4*11.3 + 0.2*9.3 = 11.3

• In case of tracking portfolio, we calculated the expected return of tracking

portfolio which is nothing but the weighted average return of market portfolio and
risk free asset.

• Assuming market return is 20% and risk free rate = 6%, expected return = 0.5(20%)
+ 0.5(6%) = 13%

• Average Beta of traded equity for a group of firm in the industry is 0.5. Hence,
Tracking Portfolio implies 50% to be invested in the market portfolio and
remaining 50% in the risk free asset.

• Using CAPM, appropriate risk adjusted discount rate = 6% + 0.5(20 -6) = 13%

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 Effects of Leverage
• Since the RADR method uses the traded stocks
of the comparison firms to estimate the beta of
the project, it is important that the beta risk of
the comparison firm is truly comparable.

• Since the amt of debt financing affect the equity

beta, it is necessary to adjust for differing
amount of debt financing in order to make
appropriate beta comparisons.
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 Continue…
• The Balance Sheet for a firm partially financed
with Equity and Debt => A = D+ E

• The market value of the assets = MV of debt +

MV of equity

• B (Asset) = [D/D+E ]B(debt) +[E/D+E] B(equity)

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 Continue…
• With risk free bonds, all the risk are borne by
the equity holders. So, σ D and Beta D would
be zero.
• σ A = (D/D+E) 0 + (E/E+D) σ E and
• Beta A = (D/D+E) 0 + (E/E+D) Beta E

• Inverting the equation, Beta E ???

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 Beta E

• Beta E = (1+D/E) Beta A

• σ E = (1+D/E) σ A

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 Continue…
• Increasing the firm’s debt, increases the beta
and SD of equity. It will increase linearly in the
D/E ratio if the debt is risk free.

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 What happens in case of risky debt

The Cost of Equity increases as the firm’s

leverage (D/E) increases and the firm Ra
does not change as leverage increases.

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 Valuation of Real Assets - APT
• The Multifactor APT version of the Risk Adjusted Discounted rate.
• PV = E(CF) / (1+rfr+ factor1*B1 + factor2*B2+..

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 Valuation of Real Assets: DDM
• A number of financial analyst estimate the
required rate of return using analysts’ forecast
of future earning with DDM.

• As per GGM Po = D1/ke-g

• Re = D1/Po + g

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 Certainty Equivalent Method
• In real world project, financial managers face a
significant challenge whenever projects are mutually
exclusive and it is difficult to identify a comparison
tracking portfolio.

• Finding correct beta of the project is also a challenge.

• The Certainty Equivalent Method suggests a way out.

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 Continue…
• Under certainty equivalent approach, instead
of discounted expected CFs at risk adjusted
discount rate, certainty CFs are discounted at
risk free rate.

• How to calculate certainty equivalent CFs?

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 Certainty Equivalent CFs
• CE (CF) = E(CF) – CF beta (Rm – Rfr)

• Beta used in the above formula is Cash Flow Beta.

The CF beta is the covariance of future CF with the
return of the tangency portfolio, divided by the
variance of return of tangency portfolio.

• CF beta = Covariance (expected CF, market ret) /

variance of market

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 Example
• ABC co has a CF beta of 10.91 when computed
against the tangency portfolio. One year from
now this company has 90% probability of being
worth $10 per share and 10% probability of
being worth $20 per share.
Risk free rate = 9%
The tangency portfolio has a expected return of
19%. What is the PV of the equity of ABC
assuming no dividend is paid?
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