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CorporateFinance

1Corporate Finance

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IDENTIFYING & ESTIMATING PROJECT CASHFLOW

Chapter 8 (Finance for Executives-Hawawini,viallet-3e)

The Cash Flow PrincipleThe with/without Principle

Estimating Relevant Cash FlowsVarious types of CostsSensitivity/Scenario Analysis

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Fundamental principles guiding thedetermination of a projects cash flows and howthey should be appliedActual Cash-Flow Principle- Cash flows must be measured at the time theyactually occur

With/without Principle- Cash flows relevant to an investment decisionare only those that change the firms overall cash

position- Sunlight Manufacturing Companys (SMC)designer desk lamp project used to illustrateapproach

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After reading this chapter, students shouldunderstand:

The actual cash-flow principle and thewith/without principle and how to apply themwhen making capital expenditure decisions.

How to identify a projects relevant andirrelevant cash flows

Sunk costs and opportunity costs

How to estimate a projects relevant cash flows4Corporate Finance

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5Corporate Finance

The Actual Cash-flow Principle

Cash flows must be measured at the time they

actually occurIf inflation is expected to affect future prices andcosts, nominal cash flows should be estimated

Cost of capital must also incorporate theanticipated rate of inflation

If the impact of inflation is difficult to determine,

real cash flows can be employedInflation should also be excluded from thecost of capital

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Corporate Finance 6

A projects expected cash flows must bemeasured in the same currency

Nominal Cash Flow: The Cash Flow thatincorporate anticipated / expected inflation shouldbe estimated.

Real Cash Flow: The values of cash flowscalculated with the assumption that prices and

costs will not be effected by anticipated inflation.

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The With/Without Principle

The relevant cash flows are only those thatchangethe firms overall future cashposition, asa result of the decisionto invest

AKA: incremental, or differential, cash flows Equal to differencebetween firms expected

cash flows if the investment is made (the

firm with the project) and its expected cashflows if the investment is not made(the firmwithout the project)

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To illustrate the definitions of incremental,differential cash flows and those ofrelevant/irrelevant costs, unavoidable costs,

sunk costs and opportunity costs consider thefollowing example

Example: A person must decide whether to driveto work or take public transportation

If he drives his monthly costs are:

Insurance costs $120Rent on garage near apartment $150Parking fees $ 90Gas and car service $110

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If he takes the train his monthly ticket costs are$140

The cash flows with the project are (assuminghe doesnt drive his car)CF(train): = -120 150 140 = -$410

The cash flows without the project are(assuming he drive his car)CF(car): = -120 150 90 110 = -470The incremental cash flows areCF(train) CF(car)= -$410 - -$470 = +$60

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The Designer Desk Lamp Project

Sunlight Manufacturing Company (SMC) is

considering a possible entrance in the designerdesk lamp market

The projects characteristics are reported in

Exhibit 8.1

SMCs financial manager must

Estimate the projects expected cash flows

Determine whether the investment is a value-creatingproposal

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EXHIBIT 8.1a:Data Summary of the Designer Desk Lamp Project.

ITEM CORRESPONDING UNITS OR VALUE TYPE TIMING

1. Expected annual 45,000; 40,000; 30,000; 20,000; 10,000 Revenue End of year 1 to 5unit sales

2. Price per unit $40 first year, then rising annually at 3% Revenue End of year 1 to 5

3. Consulting $30,000 Expense Already incurredcompanys fee

4. Losses on $100,000 Net cash loss End of year 1 to 5standard lamps

5. Rental of building $10,000 Revenue End of year 1 to 5to outsiders

6. Cost of the equipment $2,000,000 Asset Now

7. Straight-line $400,000 ($2,000,000 divided by 5 years) Expense End of year 1 to 5depreciation expenses

8. Resale value of $100,000 Revenue End of year 5equipment

9. Raw material cost/unit $10 the first year, then rising annually at 3% Expense End of year 1 to 5

10. Raw material inventory 7 days of sales Asset Now

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12Corporate Finance

EXHIBIT 8.1b:Data Summary of the Designer Desk Lamp Project.

ITEM CORRESPONDING UNIT OR VALUE TYPE TIMING

11. Accounts payable 4 weeks (or 28 days) of purchases Liability Now

12. Accounts receivable 8 weeks (or 56 days) of sales Asset Now

13. Work in process and 16 days of sales Asset Nowfinished goods inv

14. Direct labor cost $5 the first year, then rising annually at 3% Expense End of year 1 to 5per unit

15. Energy cost $1 the first year, then rising annually at 3% Expense End of year 1 to 5

per unit

16. Overhead charge 1% of sales Expense End of year 1 to 5

17. Financing charge 12% of the net book value of assets Expense End of year 1 to 5

18. Tax expenses on 40% of pretax profits Expense End of year 1 to 5income

19. Tax expenses on 40% of pretax capital gains Expense End of year 5capital gains

20. After tax cost of 9% (see Chapter 10) Not in thecapital cash flow

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13Corporate Finance

Identifying A Projects Relevant Cash FlowsSunk CostCost that has already been paidand for which

there is no alternative use at the time when theaccept/reject decision is being made

With/without principle excludes sunk costs

from the analysis of an investment

Opportunity Costs

Associated with resources that the firm coulduse to generate cash, if it does not undertake theproject

Costs do not involve any movement of cashin or outof the firm

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14Corporate Finance

Costs Implied by Potential Sales ErosionAnother example of an opportunity costSales erosion can be caused by the project, or

by a competing firmRelevant only if they are directly related tothe project

If sales erosion is expected to occuranyway, then it should be ignored

Allocated CostsIrrelevant as long as the firm will have to paythem anyway

Only consider increases in overhead cashex enses resultin from the ro ect

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15Corporate Finance

Depreciation ExpensesDo not involve any cash outflows

Irrelevant to an investment decision

However provides for tax savings by reducingthe firms taxable profit

These tax savings are added to the projects

relevant cash flows

Tax Expenses

If an investment is profitable, the additionaltaxthe firm will have to pay is a relevant cash outflowComputed using the firms marginal corporatetax rate

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16Corporate Finance

Tax savings from the deductibility of interestexpenses are taken into account in a projectsestimated after-tax cost of capital

Financing CostsCash flows to the investors, not cash flows

fromthe projectAre captured in the projects cost of capitalShould not be deducted from the projects

cash flow streamInvestment- and financing-related cash flowsfrom the designer desk lamp project are shownin Exhibit 8.2

EXHIBIT

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Corporate Finance 17

INITIALCASH FLOW

Investment-related cash flows $1,000 +$1,200 +$91

Financing-related cash flows +$1,000 $1,100 Zero

Total Cash Flows Zero +$100 +$91

TERMINALCASH FLOW

NPV at10%

TYPE OF CASH-FLOW STREAM

EXHIBIT 8.2:Investment- and Financing-Related Cash-Flow Streams

InflationIf inflation is incorporated in the cost of capital,then it should also be incorporated in the

calculation of cash flows

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Estimating A Projects Relevant Cash FlowsThe expected cash flows must be estimatedover the economic life of the project

Not necessarily the same as its accountinglifethe period over which the projects fixedassets are depreciated for reporting purposes

Measuring The Cash Flows Generated By A

ProjectClassic formula relating the projects expectedcash flows in period tto its expected contributionto the firms operating margin in period t:CF = EBIT 1-Tax + De - WCR - Ca ex

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Where:CFt =relevant cash flowEBITt = contribution of the project to the Firms

Earnings Before Interest and TaxTaxt = marginal corporate tax rate applicable tothe incremental EBITt

Dept = contribution of the project to the firmsdepreciation expensesWCRt = contribution of the project to the firms

working capital requirementCapext = capital expenditures related to theproject

E i i Th I i i l C h O fl

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Estimating The Projects Initial Cash OutflowProjects initial cash outflow includes the followingitems:

Cost of the assets acquired to launch the projectSet up costs, including shipping and installationcosts

Additional working capital required over the firstyearTax credits provided by the government to

induce firms to investCash inflows resulting from the sale of existingassets, when the project involves a decision toreplace assets, including any taxes related to thatsale

E i i Th P j t I di C h

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Estimating The Projects Intermediate CashFlowsThe projects intermediate cash flows are

calculated using the cash flow formulaEstimating The Projects Terminal Cash FlowThe incremental cash flow for the last year of

any project should include the following items:The last incremental net cash flow the project isexpected to generateRecovery of the projects incremental working capital

requirement, if anyAfter-tax resale value of any physical assets acquired inrelation to the projectCapital expenditure and other costs associated with thetermination of the ro ect

EXHIBIT 8 3a:

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EXHIBIT 8.3a:Estimation of the Cash Flows Generated by the Designer Desk LampProject.Figures in thousandsof dollars; data from Exhibit 8.1

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EXHIBIT 8 3b:

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EXHIBIT 8.3b:

Estimation of the Cash Flows Generated by the DesignerDesk Lamp Project.Figures in thousands of dollars; data from Exhibit 8.1

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EXHIBIT 8 4:

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EXHIBIT 8.4:Calculation of Net Present Value for SMCs Designer Desk Lamp Project.Figures from Exhibit 8.3

Sh ld SMC L h th N P d t?

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Should SMC Launch the New Product?

The project has a positive NPV

Before making the final decision, the firmshould perform a sensitivity analysis on theprojects NPV to account for two importantelements:SMC may notbe able to raise the price of itsnew lamp in steps with the inflationSMC may incur net cash lossesas a result ofa potential reduction in the sales of its

standard desk lamps

S iti it f th P j t NPV t Ch i

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Sensitivity of the Projects NPV to Changes inthe Lamp Price

Even if SMC is unable to raise the price of itslamps by the three percent expected rate ofinflation, the project is still worth undertaking

Because its NPV remains positive

Sensitivity of NPV to Sales Erosion

Before deciding whether to launch the designerdesk lamp project, SMCs managers mustdetermine

The size of the possible annual reduction in

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The size of the possible annual reduction insales and net cash flows through sales erosionWith an estimated $100,000 yearly sales

erosion, the project is no longer a value-creatingproposalHowever, it can withstand some sales erosionand still have a positive NPV

Sensitivity analysis is a useful tool whendealing with project uncertaintyHelps identify those variables that have thegreatest effect on the value of the proposalShows where more information is neededbefore a decision can be made

LONG TERM FINANCIAL PLANNING &

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LONG-TERM FINANCIAL PLANNING &GROWTH

Chapter 4 (Corporate Finance Fundamentals -RWJ-8e)

Financial Planning ModelsExternal Financing and GrowthInternal Growth and Sustainable GrowthOperating leverage/Break-even AnalysisChapter ObjectivesUnderstand how to apply the percentage of salesmethod.

Understand how to compute the external financingneeded to fund a firms growth.Understand the determinants of a firms growth.Understand some of the problems in planning for

growth.

What is Financial Planning?

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What is Financial Planning?

Formulates the way financial goals are to be

achieved.

Requires that decisions be made about an

uncertain future.

Recall that the goal of the firm is to maximize the

market value of the owners equity

The basic policy elements of financial planning

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The basic policy elements of financial planningare:

The firms needed investment in new assets.

The degree of financial leverage the firm

chooses to employ.

The amount of cash the firm thinks it is

necessary and appropriate to pay shareholders.

The amount of liquidity and working capital thefirm needs on an ongoing basis.

Important Questions

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Important QuestionsIt is important to remember that we are workingwith accounting numbers, and we should ask

ourselves some important questions as we gothrough the planning process. For example:

How does our plan affect the timing and risk ofour cash flows?

Does the plan point out inconsistencies in ourgoals?

If we follow this plan, will we maximise ownerswealth?

Dimensions of Financial Planning

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Dimensions of Financial Planning

The planning horizon is the long-range period

that the process focuses on (usually two to fiveyears).

Aggregation is the process by which thesmaller investment proposals of each of a firmsoperational units are added up and treated as

one big project.

Financial planning usually requires threealternative plans: a worst case, a normal case,

and a best case.

Accomplishments of Planning

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Accomplishments of Planning

Optionsfirm can develop, analyse and

compare different scenarios.

Avoiding surprises development of

contingency plans.

Feasibility and internal consistency

develops a structure for reconciling differentobjectives.

Elements of a Financial Plan

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Elements of a Financial Plan

An externally supplied sales forecast (either an

explicit sales figure or growth rate in sales).

Projected financial statements (pro-formas).

Projected capital spending.

Necessary financing arrangements.

Amount of new financing required (plug figure).

Assum tions about the economic environment.

Example A Simple Financial Planning Model

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ExampleA Simple Financial Planning Model

Recent Financial Statements

Income Statement Balance SheetSales $100 Assets $50 Debt $20Costs 90 Equity 30Net Income $ 10Total $50 Total $50

Assume that:

1. Sales are projected to rise by 25 per cent2. The debt/equity ratio stays at 2/33. Costs and assets grow at the same rate as

sales

Pro-Forma Financial Statements

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Pro-FormaFinancial Statements

Income StatementBalance Sheet

Sales $125.00 Assets $ 62.50 Debt $25.00Costs 112.50 Equity 37.50Net $12.50 Total $62.50 Total $62.50

What is the plug?

Notice that projected net income is $12.50, but

equity only increases by $7.50. The difference,$5.00 paid out in cash dividends, is the plug.

Percentage of Sales Approach

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Percentage of Sales ApproachSome items vary directly with sales, while othersdo not:

Income Statement

Costs may vary directly with sales - if this isthe case, then the profit margin is constant.Depreciation and interest expense may not

vary directlywith sales if this is the case, thenthe profit margin is not constant.Dividends are a management decision andgenerally do not vary directly with sales this

influences additions to retained earnin s.

Balance Sheet

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Balance SheetInitially assume all assets, including fixed,vary directlywith sales

Accounts payable will also normally varydirectlywith sales.

Notes payable, long-term debt and equitygenerally do not vary directly with sales

because they depend on management decisionsabout capital structureThe change in the retained earnings portion ofequity will come from the dividend decision.

ExampleIncome Statement

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Example Income StatementSales $1 000Costs 800

Taxable Income 200Tax (30%) 60Net profit $140Retained earnings $112

Dividends $28ExamplePro-Forma Income Statement

Sales (projected) $1 250

Costs (80% of sales) 1 000Taxable Income 250

Tax (30%) 75

Net profit $175

ExampleSteps

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Example StepsUse the original Income Statement to create a pro-forma; some itemswill vary directlywith sales.Calculate the projected addition to retained earnings

and the projected dividends paid to shareholders.Calculate the capital intensity ratio.ExampleBalance SheetAssets

Current assets ($) (% of sales)Cash 160 16Accounts receivable 440 44

Inventory 600 60Total 1 200 120

Non-current assetsNet plant and equipment 1 800 180Total assets 3 000 300

Liabilities and owners equity

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Liabilities and owners equity

Current liabilities ($) (% of sales)Accounts payable 300 30

Notes payable 100 n/aTotal 400 n/aLong-term debt 800 n/aShareholders equity

Issued capital 800 n/aRetained earnings 1 000 n/aTotal 1 800 n/aTotal liabilities & owners equity 3 000 n/a

ExamplePartial Pro-Forma Balance Sheet

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AssetsCurrent assets ($) ChangeCash 200 $40Accounts receivable 550 110

Inventory 750 150Total 1 500 $300Non-current assetsNet plant and equipment 2 250 $450Total assets 3 750 $750

Liabilities and owners equityCurrent liabilities ($) ChangeAccounts payable 375 $ 75Notes payable 100 0Total 475 $ 75Long-term debt 800 0

Shareholders equityIssued capital 800 0Retained earnings 1 140 $140Total 1 940 $140Total liabilities & owners equity 3 215 $215

External financing needed 535 $535

ExampleResults of Model

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Example Results of ModelThe good newsis that sales are projected to increaseby 25 per cent.

The bad news is that $535 of new financing isrequired.

This can be achieved via short-term borrowing, long-term borrowing, and new equity issues.

The planning process points out problems and potentialconflicts.

Assume that $225 is borrowed via notes payable, and

$310 is borrowed via long-term debt.

Plug figure now distributed and recorded within

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Plug figure now distributed and recorded withinthe Balance Sheet.

A new (complete) pro-forma Balance Sheet cannow be derived.

ExamplePro-Forma Balance SheetA

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Assets

Current assets ($) ChangeCash 200 $ 40

Accounts receivable 550 110Inventory 750 150Total 1 500 $300

Non-current assetsNet plant and equipment 2 250 $450

Total assets 3 750 $750Liabilities and owners equity

Current liabilities ($) ChangeAccounts payable 375 $ 75Notes payable 325 $225

Total 700 $300Long-term debt 1 110 $310

Shareholders equityIssued capital 800 0Retained earnings 1 140 $140

Total 1 940 $140Total liabilities & owners equity 3 750 $750

External Financing and Growth

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External Financing and Growth

The higher the rate of growth in sales or assets,

the greater the external financing needed (EFN).Growth is simply a convenient means ofexamining the interactions between investmentand financing decisions. In effect, the use ofgrowth as a basis for planning is just a reflectionof the high level of aggregation used in theplanning process.

Need to establish a relationship between EFNand growth (g).

ExampleIncome Statement

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Example Income Statement

Sales $500

Costs 400Taxable Income $100Tax (30%) 30

Net profit $70Retained earnings $25Dividends $45

ExampleBalance Sheet

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($) (% ofsales)

($) (% ofsales)

Assets Liabilities

Current assets 400 80 Total debt 450 n/a

Non-currentassets

600 120 Owners equity 550 n/a

Total assets 1000 200 Total 1000 n/a

Ratios Calculatedp(profit margin) = 14%

R(retention ratio) = 36%ROA (return on assets) = 7%ROE (return on equity) = 12.7%

D/E(debt/equity ratio) = 0.818

Growth

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GrowthNext years sales forecast to be $600.Percentage increase in sales:

Percentage increase in assets also 20 per cent.

Increase in AssetsWhat level of asset investment is needed to

support a given level of sales growth?For simplicity, assume that the firm is at fullcapacity. in assets be financed?

20%$500$100

The indicated increase in assets required equals:A

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q qAg

where A = ending total assets from the previous period and g =the growth rate in sales

How will the increase

Internal Financing

Given a sales forecast and an estimated profitmargin, what addition to retained earnings can beexpected?

This addition to retained earnings represents thelevel of internal financingthe firm is expected togenerate over the coming period.

The expected addition to retained earnings is:

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The expected addition to retained earnings is:where: S= previous periods sales

g= projected increase in sales

p= profit marginR= retention ratio

External Financing Needed

If the required increase in assets exceeds theinternal funding available (that is, the increase in

retained earnings), then the difference is theexternal financing needed (EFN).

EFN = Increase in Total Assets

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Addition to Retained Earnings

= A(g)p(S)R (1 + g)

Increase in total assets = $1000 20%= $200

Addition to retained earnings= 0.14($500)(36%) 1.20= $30

The firm needs an additional $200 in new financing. $30 can be raised internally. The remainder must be raised externally (external

financing needed).

REoAddition tassetsin totalIncreaseEFN

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170$

201%36500$140)200(1000$

)1()()(

...

gRSpgA

)(

RelationshipTo highlight the relationship between EFN and g:

Setting EFN to zero, gcan be calculated to be2.56 per cent.This means that the firm can grow at 2.56 per

cent with no external financing (debt or equity).

g

g.%.

gRSpARSp

97525

%)36(500$1401000$36500$140EFN

Financial Policy and Growth

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y

So far sees equity increase (via retained

earnings), debt remain constant and D/Edecline.

If D/E declines, the firm has excess debtcapacity.

If the firm borrows up to its debt capacity, whatgrowth can be achieved?

Sustainable Growth Rate (SGR)

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( )

The sustainable growth rateis the growth rate a

firm can maintain given its debt capacity, ROEand retention ratio.

R

R

ROE1

ROE

SGR

ExampleSustainable Growth Rate

Continuing from the previous example:

4.82%

0.360.1271

0.36).1270(SGR

The firm can increase sales and assets at a rate

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of 4.82 percent per year without selling anyadditional equity, and without changing its debt

ratio or payout ratio.

Determinants of Growth

Growth rate depends on four factors:profitability (profit margin)dividend policy (dividend payout)

financial policy (D/Eratio)asset utilisation (total asset turnover).

If a firm does not wish to sell new equity, and its

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q y,profit margin, dividend policy, financial policy andtotal asset turnover (or capital intensity) are all

fixed, then there is only one possible growth rate.Do you see any relationship between the SGRand the Du Pont identity?

ESTIMATING THE COST OF CAPITAL (WACC)

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( )Chapter 10 (Finance for executives-Hawawini,viallet-3e)

Estimating the cost of equityThe dividend discount modelThe CAPM approach

Estimating the cost of capital of a project

Cash is not freeit comes at a priceThe price is the cost to the firm of usinginvestors moneyCost of CapitalReturn expected by the investors for the capital

the su l

Background

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gObjective of ChapterShows how to estimate the cost of capital to be used in

discounted cash flows modelsInvestors do not normally invest directly in projectsThey invest in the firms that undertake projectsChallenge is to identify firms, called proxies or pureplaysExhibit the same risk characteristics as the projectunder consideration.After a proxy has been identified need to estimate thereturn expected by the investors who hold the securities

the proxy has issuedAssume that there are only two types of securitiesStraight bondsCommon shares

Return expected from the assets managed by a firmt b th t t l f th t t d b b dh ld

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must be the total of the returns expected by bondholdersand shareholders, weighted by their respectivecontribution to the financing of these assets

Weighted average cost of capitalor WACCSunlight Manufacturing Companys (SMC) desk lampprojectUsed to illustrate the case when a projects cost of

capital is the same as the firms cost of capitalBuddy's Restaurant ProjectIllustrates how to estimate the projects cost of capitalwhen the project has a risk that differs from the risk of

the firmAfter reading this chapter, students should understand:How to estimate the cost of equity capitalHow to combine the cost of different sources of

financing to obtain a projects weighted average cost of

How to estimate the cost of debtTh diff b t th t f it l f fi

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The difference between the cost of capital for a firmand the cost of capital for a project

Identifying Proxy Or Pure-Play FirmsWhen the projects risk profile is similar to thefirms risk profile, the proxy is the firm itself

Classification systems used to select pure-playsare far from perfect

Often trade-offs need to be made between

possible large measurement errors of a smallsample of closely comparable companies anda larger sample of firms that are only loosely

comparable to the project

Estimating The Cost Of Debt

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gIf a firm takes out a loan, the firms cost of debtis the rate charged by the bank

If we know a sufficient amount of informationthe valuation formula can be solved for theinvestors required rate of return

If the firm has no bonds outstanding, its cost of

debt can be estimated by adding a credit riskspread to the yield on government securities ofthe same maturity

t t+1 t+2 T

t t

D D D

+ +2

D

1 t Tk k

Coupon PMT Coupon PMT Coupon PMT Coupon PMTBond Price = + + + +1+ 1+ 1+ 1+k k

Since interest expenses are tax deductible, thef f d b i h l f

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after tax cost of debt is the relevant cost ofdebt

After-tax cost of debt= Pre-tax cost of debt (1 - marginal corporatetax rate)

However, the after tax cost of debt is a valid

estimator only ifThe firm is profitable enough, orA carry back or carry forward rule applies to

interest expenses

Estimating The Cost Of Equity:

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The Dividend Discount ModelAccording to the dividend discount model, the

price of a share should be equal toPresent value of the stream of future cashdividends discounted at the firms cost of equity

The dividend discount model cannot be use to

solve for the cost of equityUnless simplifying assumptions regarding thedividend growth rate are made

Estimating The Cost Of Equity: DividendsGrow At A Constant RateFirms cost of equity is the sum of its expecteddividend yield and the expected dividend growth

If we assume the dividend that a firm is expected

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to pay next year will grow at a constant rateforever

D0 = 2.00, kE = 13%, g = 6%.

Constant growth model:

P0 = D0 (1 + g)/P0 + g= 2(1 + 0.06)/ (0.13 0.06)

= $2.12/ 0.07 =$30.29

What is the stocks market value one year from now,P1?

D1 will have been paid, so expected dividends are D2,

D3, D4 and so on. Thus,

1

E0

DIV

k = +gP

P1 = D2 / (kE g)D (1 + g)^2/ (kE g)

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= D0 (1 + g)^2/ (kE g)

= $2.247/ 0.07= $32.10

Find the expected dividend yield and capital gains yield during the first

year.Dividend yield = D1 / P0 = $2.12/ $30.29 = 7%

CG Yield = (^P1 - P0 )/ P0 = ($32.10 $30.29) / $30.29 =6%

Estimating The Cost Of Equity: How Reliable

Is The Dividend Discount Model?For the vast majority of companies, the simplisticassumptions underlying the reduced version of

the dividend discount model are unacceptableThus, an alternative valuation approach isneededThe capital asset pricing modelor CAPM

Estimating The Cost Of Equity:

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The Capital Asset Pricing ModelThe greater the risk, the higher the expected

returnWhat is the nature of the risk?How is it measured?

How does it determine the return expected byshareholders from their investment?

Diversification Reduces RiskA major implication of holding a diversifiedportfolio of securities is that the risk of a singlestock can be divided into two components

Unsystematicordiversifiable riskC b li i t d th h tf li

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Can be eliminated through portfoliodiversificationIncludes company-specific events such asthe discovery of a new product (positive effect)

or a labor strike (negative effect)Systematic ornondiversifiable risk

Cannot be eliminated through portfoliodiversificationEvents that affect the entire economy insteadof only one firm, such asChanges in the economys growth rate,inflation rate and interest rates

Diversification Reduces Risk

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Financial markets will not reward unsystematicrisk

Because it can be eliminated throughdiversification at practically no cost

Thus, the only risk that matters in determining therequired return on a financial asset is the assetssystematic risk

In other words, the required rate of return on afinancial asset depends only on its systematicrisk

Measuring Systematic Risk With the Beta

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CoefficientA firms systematic risk is usually measured

relativeto the market portfolioPortfolio that contains all the assets in theworld

Systematic risk of a stock is estimated byMeasuring the sensitivity of its returns tochanges in a broad stock market index

Such as the S&P 500 indexThis sensitivity is called the stocks betacoefficient

The Impact Of Financial Leverage On A

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Stocks BetaA firms risk depends on

Risk of the cash flows generated by the firms assets(business risk)Firms asset (or unlevered) beta captures its businessrisk

The risk resulting from the use of debt (financial risk)Thus, firms beta coefficient is affected by both

Firms equity beta (or levered beta) captures bothbusiness and financial risk

equity

asset

Debt1+ 1 - tax rateEquity

equity assetDebt

1+ 1 - tax rateEquity

EXHIBIT 10.4:

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Average Annual Rate of Return on CommonStocks, Corporate Bonds, U.S. Government

Bonds, and U.S. Treasury Bills, 1926 to 1995.AverageRiskPremium

AverageAnnualReturn

Type ofInvestment

The Capital Asset Pricing Model (CAPM)

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Treasury bills are the safest investment available

Usually used as a proxy for the risk-free rateRisk premium of a security

Difference between the expected return on asecurity and the risk-free rate

Market risk premiumRisk premium of the market portfolio

Since beta measures a securitys risk relative to

the market portfolioA securitys risk premium equals the marketrisk premium the securitys beta.

The CAPM states that the expected return on anyi i h i k f l h k i k

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security is the risk-free rate, plus the market riskpremium multiplied by the securitys beta

Using The CAPM To Estimate SMCs Cost Of

EquityTreasury bill rate is replaced by the rate ongovernment bonds

Since it is difficult to estimate future Treasurybill rates

SMCs cost of equity of12.37% is estimatedfrom the market risk premium of 6.2 percent and

SMCs beta of 1.06

i F M F iR = R + R - R

KE, SMC = 5.8% + (6.2%) x 1.06 = 12.37%E i i Th C Of C i l Of A Fi

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Estimating The Cost Of Capital Of A FirmWhat is the firms cost of capital?

Minimum rate of return the project mustgenerateIn order to meet the return expectations of its

suppliers of capitalAssuming that a project has the same riskas thefirm that would undertake itA firms cost of capital is its weighted averagecost of capital, or WACCAssuming that the firm is financed by debt andequity, its WACC is equal to

Weighted average of the cost of these twof fi i

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means of financingWeights equal to the relative proportions of debt

and equity used in financing the firms assetsWACC= kD (1 TC) E/(E+D) + kE E/(E+D)

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UCP-CF 09,11-03

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