Risk and

Capital Budgeting
Chapter 10

© 2009 Cengage Learning/South-Western

 Choosing the Right Discount Rate

The numerators focus on project cash flows covered

in Chapter 9.

CF1 CF2 CF3 CFN

NPV  CF0     ... 
(1  r ) (1  r ) 2
(1  r ) 3
(1  r ) N

The denominators are the discount rates, the focus

of chapter 10.

Reflect opportunity costs to firm’s investors

The
denominator Reflect the project’s risk
should:
2 Be derived from market data
 Cost of Equity
Beta plays a central role in determining whether a
firm’s cost of equity is high or low.

What factors influence a firm’s beta?

The mix of fixed and variable costs

Operating
leverage EBIT Sales
Operating Leverage  
EBIT Sales

The extent to which a firm finances operations

Financial by borrowing
Leverage
The fixed costs of repaying debt increase a
firm’s beta in the same way that operating
3 leverage does.
 A Simple Case

Project discount rate is easy to determine if we

assume :

Firm is financed with 100% Project is similar to the firm’s

equity existing assets

In this case, the appropriate discount rate equals

the cost of equity.

Cost of equity can be estimated using the CAPM

E ( Ri )  RF  βi ( E ( Rm )  RF )
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 Carbonlite Inc.: Cost of Equity

Carbonlite Inc., an all-equity firm, is evaluating a

proposal to build a new manufacturing facility.

• Firm manufactures bicycle frames.

• As a luxury good producer, firm is very sensitive
to the economy (product demand is elastic).
• Carbonlite’s stock has a beta of 1.5.
• Managers note Rf = 5%, expect the market return
will be 11%.

E(Re ) = Rf + (E(Rm) - Rf) = 5% + 1.5(11%-5%)

= 14% cost of equity
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 Table 10.1 Financial Data for Carbonlite Inc.
and Fiberspeed Corp.

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 Figure 10.1 Operating Leverage for
Carbonlite and Fiberspeed

The higher operating leverage of Carbonlite is reflected in its steeper

slope, demonstrating that its EBIT is more responsive to changes in
7 sales than is the EBIT of Fiberspeed.
 Carbonlite Inc. vs. Fiberspeed Corp.

The two firms are in the same industry.

Carbonlite Inc Fiberspeed Corp
Sales volume 11,000
10,000frames
sofas 11,000
10,000frames
sofas

Price $1,000 $1,000

Total Revenue $10,000,000

$11,000,000 $10,000,000
$11,000,000

Fixed costs per year $5,000,000 $2,000,000

Variable costs per frame $400 $700

Total cost $9,000,000

$9,400,000 $9,000,000
$9,700,000
EBIT $1,600,000
$1,000,000 $1,300,000
$1,000,000

What if sales volume increases by 10% ?

Carbonlite’s EBIT increases faster because it has high

8 operating leverage.
 The Effect of Financial Leverage on
Shareholder Returns
Firm 1 Firm 2
Assets $100 million $100 million
Debt (interest rate 8%) $0 $50 million
Equity $100 million $50 million
Case #1: Gross Return on Assets Equals 20 Percent
EBIT $20 million $20 million
Interest $0 $4 million
Cash to equity $20 million $16 million
ROE 20 ÷ 100 = 20% 16 ÷ 50 = 32%
Case #2: Gross Return on Assets Equals 5 Percent
EBIT $5 million $5 million
Interest $0 $4 million
Cash to equity $5 million $1 million
ROE 5 ÷ 100 = 5% 1 ÷ 50 = 2%

Financial leverage makes Firm 2’s ROE more volatile, so its

9 beta will be higher .
 Weighted Average Cost of Capital (WACC)

Cost of equity applies to projects of an all-equity

firm.
• But what if firm has both debt and equity?
• Problem is akin to finding expected return of portfolio.

Use weighted average cost of capital (WACC) as

discount rate.
• Lox-in-a-Box is a chain of fast food stores.
• Firm has $100 million equity (E), with cost of equity re = 15%;
• Also has bonds (D) worth $50 million, with rd = 9%.
• Assume that the investment considered will not change the cost
structure or financial structure.
 D   E   50   100 
WACC   rd   re   9%   15%  13%
1 DE DE  50  100   50  100 
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 Finding WACC
For Firms with Complex Capital Structures
How do we calculate WACC if firm has long-term (D) debt as
well as preferred (P) and common stock (E)?

 D   E   P 
WACC   d 
r  e 
r  rp
DEP DEP DEP
1 million common shares; $50/share; re = 15%.
An example....
200,000 preferred shares, 8% coupon, $80/share,
S.D. Williams
10% rate of return, $16 million value.
Total value =
$50 million $47.1 million (par value) long term debt, fixed rate
notes with 8% coupon rate, but 7% YTM.
Notes sell at premium and worth $49 million.

 50   49   16 
WACC   15%   7%   10%  10.9%
1  115   115   115 
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 Rules for Finding the Right Discount Rate

1. When an all-equity firm invests in an asset

similar to its existing assets, the cost of equity is
the appropriate discount rate.
2. When a firm with both debt and equity invests in
an asset similar to its existing assets, the WACC
is the appropriate discount rate.
3. When the investment is more risky than the
firm’s average investment, a higher discount
rate than the WACC is required, and vice versa.

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 Accounting for Taxes in Finding WACC

We have thus far assumed away taxes, which are

often important in financing decisions.

• Tax deductibility of interest payments favors use

of debt.
• The opportunity to deduct interest payments
reduces the after-tax cost of debt and changes the
WACC formula:
 D   E 
WACC   (1  Tc )rd   re
DE DE

Accounting for taxes doesn’t change the rules for

selecting the discount rate.
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 A Closer Look at Risk: Break-Even Analysis

Managers often want to assess business’ value

drivers.

Finding the break-even point is often useful for

assessing operating risk.

Break-even point (BEP) is level of output where all

operating costs (fixed and variable) are covered.

 Fixed Costs   Fixed Costs 

BEP      
 Contribution margin   Price/unit  Variable Cost/unit 
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 Fig. 10-2a Break-Even Point for
Carbonlite
Costs & Total revenue
Revenues

Total costs

Fixed costs
$5,000,000

8,333 units Units

Carbonlite has high fixed costs and high contribution margin

($600/bike). High BEP, but once FC are covered, profits grow rapidly.
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 Fig. 10-2b Break-Even Point for
Fiberspeed
Costs & Total revenue
Revenues

Total costs

Fixed costs
$2,000,000

6,667 units Units

Fiberspeed has low fixed costs and low contribution margin

1
($300/bike). Low BEP, but profits grow slowly after FC are covered.
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 Sensitivity Analysis

Sensitivity analysis allows mangers to test the

impact of each assumption underlying a forecast.

• Sensitivity analysis involves calculating the NPVs for

various deviations from a “base case” set of assumptions.

GTI has developed a new skateboard. Base case

assumptions yield NPV = $236,000.

1. The project’s life is five years.

2. The project requires an up-front investment of $7 million.
3. GTI will depreciate initial investment on straight line basis for five
years.
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 Sensitivity Analysis
GTI has developed a new skateboard. Base case
assumptions yield NPV = $236,000.

4. One year from now, the skateboard industry will sell 500,000 units.
5. Total industry unit volume will increase by 5% per year.
6. GTI expects to capture 5% of the market in the first year.
7. GTI expects to increase its market share by one percentage point
each year after year one.
8. The selling price will be $200 in year one.
9. Selling price will decline by 10% per year after year one.
10. All production costs are variable and equal 60% of the selling price.
11. GTI’s marginal tax rate is 30%.
12. The appropriate discount rate is 14%.
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 Table 10-4 Sensitivity Analysis of Skateboard
Project

Dollar values in thousands except price

NPV Pessimistic Assumption Optimistic NPV

-$558 $8,000,000 2. Initial investment $6,000,000 $1,030

-343 450,000 units 4. Market size in year 1 550,000 units 815

-73 2% per year 5. Growth in market size 8% per year 563
-1,512 3% 6. Initial market share 7% 1,984
-1,189 0% 7. Growth in market share 2% per year 1,661
-488 $175 8. Initial selling price $225 960
-54 62% of sales 9. costs 58% of sales 526
-873 -20% per year 10. Annual price change 0% per year 1,612
-115 16% 12. Discount rate 12% 617

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 Scenario Analysis

• Scenario analysis is a more complex form of sensitivity

analysis.
• Rather than adjust one assumption up or down, analysts
calculate the project NPV when a whole set of
assumptions changes in a particular way.
• For example, if consumer interest in GTI’s new
skateboard is low, the project may achieve a lower
market share and a lower selling price than originally
anticipated.

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 Monte Carlo Simulation

• In a Monte Carlo simulation, analysts specify a

range or a probability distribution of potential
outcomes for each of the model’s assumptions.
• It is even possible to specify the degree of correlation
between key variables.
• A simulation software package is then used to take
random “draws” from these distributions, calculating the
project’s cash flows (and NPV) over and over again.
• The simulation produces the probability distribution of
project cash flows (and NPVs) as well as sensitivity
figures for each of the model’s assumptions.
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 Monte Carlo Simulation

• The use of Monte Carlo simulation has grown

dramatically in the last decade because of steep declines
in the costs of computer power and simulation software.
• The bottom line is that simulation is a powerful, effective
tool when used properly.
• Simulation’s fundamental appeal is that it provides
decision makers with a probability distribution of NPVs
rather than a single point estimate of the expected NPV.

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 Decision Trees

• A decision tree is a visual representation

of the sequential choices that managers
face over time with regard to a particular
investment.

• The value of decision trees is that they force analysts to

think through a series of “if-then” statements that
describe how they will react as the future unfolds.

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 Decision Trees for Odessa Investment
Trinkle Foods Limited of Canada has invented a new salt
substitute, branded Odessa.

• Trinkle is deciding whether to spend 5-million Canadian dollars (C$)

to test-market a new line of potato chips flavored with Odessa in
Vancouver.
• Depending on the outcome, Trinkle may spend an additional C$50
million 1 year later to launch a full line of snack foods across Canada.
• If consumer acceptance in Vancouver is high, the company predicts
that its full product line will generate net cash inflows of C$12 million
per year for 10 years.
• If consumers respond less favorably, cash inflows from a nationwide
launch is expected to be just C$2 million per year for 10 years.
• Trinkle’s cost of capital equals 15 percent.
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 Fig. 10-3 Decision Trees for Odessa
Investment

If the test market is successful, the NPV of launching the product is C$10.23
million; if the initial test results are negative, and it launches the product, it will
have an NPV of – C$39.96 million.
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 Decision Trees for Odessa Investment
• To work through a decision tree, begin at the end and then work
backward to the initial decision.
• Suppose one year from now, Trinkle learns that the Vancouver
market test was successful:

• If the initial test results are unfavorable and it launches the product:

• We then evaluate today’s decision about whether to spend the C$5

million. The expected NPV of conducting the market test is:

2 • Spending the money for market testing does not appear worthwhile.
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 Real Options in Capital Budgeting

Option pricing analysis is helpful in examining

multi-stage projects.

Embedded options arise naturally from investment.

Called real options to distinguish from financial
options.

Value of a project equals value captured by NPV,

plus option.

Options can transform negative NPV projects into

positive NPV!
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 Types of Real Options

Expansion • If a product is a hit, expand production.

options

• Firm can abandon a project if not

Abandonment
successful.
options • Shareholders have valuable option to
default on debt.
Follow-on
investment • Similar to expansion options, but more
complex (Ex: movie rights to sequel)
options

• Ability to use multiple production inputs

Flexibility (example: dual-fuel industrial boiler) or
options produce multiple outputs
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 Strategy and Capital Budgeting

• Competition and NPV

– Advocates of a positive NPV project should be
able to articulate the project’s competitive
advantage before running the numbers
• Strategic thinking and real options
– Managers must articulate their strategy for a
given investment

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 Risk and Capital Budgeting

• All-equity firms can discount their standard

investment projects at cost of equity.
• Firms with debt and equity can discount their
standard investment projects using WACC.
• A variety of tools exist to assist managers in
understanding the sources of uncertainty of a
project’s cash flows.

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