Capital Budgeting & Portfolio Theory

I. II. III. IV. How to select projects? How to estimate cash flow? How to measure Risk? How to integrate risk in the Capital Budgeting process? V. How to determine the cost of capital to be used in the capital budgeting process?

Capital Budgeting & Portfolio Theory

I. Capital Budgeting Techniques 1- Payback No. of years to recover initial investment. [We can use the discounted rather than the raw CFs] 2- NPV =
t=1

CFt (1+r)t

- CF0

(NPV > 0) (IRR > WACC)

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3- IRR =
t=0

CFt =0 (1+IRR)t

4- MIRR =
t=1

TVIF - CF0 (1+MIRR)t

(MIRR > WACC)

5- CAPM

^ Expected Rate (ri) vs. Required Rate (ri) ^ >r) Using Market beta as a measure of risk (ri i [Refer to the hand-out case Portfolio Selection which applies to stocks and real assets]

II. Cash Flow Estimation

1- Relevant Cash Flows: a) Incremental Cash Flows; [Cash flows with the project vs. cash flows without the project] b) Future Cash Flows; [including opportunity cost and externalities]

2- Refer to the handout case on Replacement Decisions

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III. Measuring Risk

1- Stand alone Risk*
Measured by or cv of NPV, IRR, or MIRR n ^ 1- r = ri pi
i=1

2- = Variance = 2
^ = (ri r )2 Pi i=1

3- CV = ^ r
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* Another Interpretation: Stand alone Risk = Market Risk + Diversifiable Risk Can not be eliminated Construct a Portfolio

J 2 = J2 2n + eJ2
Where ej2 is the variance of stock Js regression error term.

2- Corporate Risk
Reflects the projects effect on corporate earnings stability, and considers diversification within the firm. Measured by the projects () and its correlation () with returns on firms other assets. Could also be measured by the Projects Corporate beta r = wArA + (1-wA) rB =
_________________________________________________ w2A2A + (1-wA)22B + 2wA (1-wA)ABAB
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3- Market Risk Reflects the projects effect on a well diversified stock market portfolio. Depends on projects and correlation with the stock market. Measured by the projects market beta i = Cov (ri, mi) m2
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IV. How to Integrate Risk in the Capital Budgeting Process?

1- Risk Adjusted Discount rate; Use higher discount rate for higher risk projects. 2- Certainty Equivalent Method; Discounting risk free CF by a risk free rate. Determining the required rate of return (i.e the WACC, or the discount rate is a must in the above two cases).
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3- Sensitivity Analysis ^ 4- Decision Tree Use r and npv 5- Monte Carlo Simulation 6- The Capital Asset Pricing Model (CAPM); using (for one factor). ri = rRF + (r^m rRF) 7- The Arbitrage Pricing Theory (APT); using (for more than one factor) ri = rRF + (r1 rRF) 1 + (r2 rRF) 2 .. + + (ri rRF) i
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8- Fama, French 3-factor Model; using for 3 specific factors (i.e excess market return, excess return associated with size and excess return associated with book-to-market ratios.
ri = rRF + (rm rRF) 1i + (rSMB )2i .. + (rHMB )3i

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V. Cost of Capital
Cost of Capital is the discount rate used in the capital budgeting process. It is the weighted average of the cost of the components of the optimal capital structure.

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1) Cost of debt (long term)

rdat = rdbt (1 T) Where rdbt is determined by one of the following methods:
1- The coupon rate on new debt 2- The yield on other bonds with a similar rating 3- The yield on the companys debt

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2) Cost of Preferred Stock rps = Dps Pn = Dividends . Price Flotation Cost

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3) Cost of Equity: (Three Methods)

1- Growth Model
rs = D1 + g = D0 (1 + 9) + g P0 P0 2- CAPM Model (on a historical base) rs = rRF + ( rM rRF ) (refer to handout case) 3- Own Bond Yield plus Risk Premium rs = rd + Bond RP

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 Example:
The bond yield for a 15-year, 12% semiannual bond which sells for $1,153.72
0 -1,153.72 1 60 2 60 30 60+1000

|----rd=?----|-------|-- - - ---------|

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