Chapter 12

12-1 Fifth Edition

Corporate Finance
Ross Westerfield Jaffe

Risk, Return, and Capital Budgeting

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Review Item
12-2 Fifth Edition

Yahoo is considering building a cafeteria for its

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Ross Westerfield Jaffe

employees. At a high discount rate appropriate to Yahoos risk, the NPV of the cafeteria is negative. At a low discount rate appropriate to a Wendys, the NPV of the cafeteria is positive. Should Yahoo build the cafeteria? Explain briefly.

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Answer
12-3 Fifth Edition

Build the cafeteria. The project is safe like a Wendys, not risky like an

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Ross Westerfield Jaffe

internet service. NPV is market value. The market it not deceived but sees the project for the safe investment that it is.

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Example of beta and NPV

12-4 Fifth Edition

Wingmar Inc. has a beta of 2. The Market risk premium is 8.5% The risk-free rate is 4%. Wingmar has a project with cash flows -100, 60, 80. The project is typical of Wingmars core business. Should the project be undertaken?

Corporate Finance
Ross Westerfield Jaffe

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Answer
12-5 Fifth Edition

Part 1. Cost of equity financing. The appropriate

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Ross Westerfield Jaffe

discount rate for projects of Wingmar is .04+.085(2)=.21. Part 2. The NPV of the project is 4.2278533. Take the project.

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Chapter 12 Risk, Return, and Capital Budgeting

12-6 Fifth Edition

Determinants of the Cost of Equity

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Ross Westerfield Jaffe

Capital Estimation of Beta Financial leverage.

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The Cost of Equity

12-7 Fifth Edition

E(rs) = RF + bs x [E(RM) - RF] Business risk 1: Cyclicality of revenues Business risk 2: Operating leverage. Financial Leverage

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Cyclicality
12-8 Fifth Edition

Capital goods, consumer durables, construction are

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Ross Westerfield Jaffe

cyclical and synchronized with general economic conditions.

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Operating leverage
12-9 Fifth Edition

Fixed cost of debt service, leases, employment contracts

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Ross Westerfield Jaffe

versus variable costs. High operating leverage means high fixed costs. MRI labs. Low leverage, low fixed cost. Fast food, services. EBIT = earnings before interest and taxes. Assume depreciation = loss of market value.

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Beta Estimation
12-10 Fifth Edition

Problems

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Betas may vary over time. The sample size may be inadequate. Solutions

More sophisticated statistical techniques.

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Beta Estimation
12-11 Fifth Edition

Problem: Beta for a firm is overly influenced by

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Ross Westerfield Jaffe

random factors peculiar to the firm.

Solution: Look at average beta estimates of several

comparable firms in the industry.

Problem:

Firms have shouldnt matter in NPV.

financial

leverage,

which

Solution: Adjust as follows.

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12-12 Fifth Edition

Financial leverage means debt

Equity beta for the firms shares. Debt beta for the firms debt. Asset beta for the physical firm.

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The physical firm (the asset) is a portfolio

12-13 Fifth Edition

S = market value of equity (stock) B= debt (bonds) A= asset (firm) Portfolio weights are

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S XS , SB
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B XB SB
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Beta of the (physical) firm

12-14 Fifth Edition

Beta of a portfolio is the weighted sum

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Ross Westerfield Jaffe

of the betas of the components.

S B bA bS bB SB SB
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Normally
12-15 Fifth Edition

Stock is risky Debt is less risky Asset is in between.

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Ross Westerfield Jaffe

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Weighted Average Cost of Capital

12-16 Fifth Edition

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Ross Westerfield Jaffe

rWACC

S B rS (1 TC )rB SB SB

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Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets

12-17 Fifth Edition

13.1 Can Financing Decisions Create Value? 13.2 A Description of Efficient Capital Markets 13.3 The Different Types of Efficiency

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Reaction of Stock Price to New Information in Efficient and Inefficient Markets

12-18 Fifth Edition

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Stock Price

Overreaction to good news with reversion Delayed response to good news

Efficient market response to good news -30 -20 -10 0 +10

+20

+30

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Days before (-) and after (+) announcement

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Reaction of Stock Price to New Information in Efficient and Inefficient Markets

12-19 Fifth Edition

Stock Price

Overreaction and reversion

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Delayed response Efficient-market response to new information

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30 20 10
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+10 +20 +30

Days before (+) and after (-) announcement

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Sets of Information relevant to a stock

12-20 Fifth Edition

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Ross Westerfield Jaffe
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All information

Publicly available information

Past prices

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Three Forms of Market Efficient Hypothesis

12-21 Fifth Edition

Weak

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Prices reflect information in past prices Random Walk Semi-strong Prices reflect publicly available information Strong Prices reflect all information

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Implications for Corporate Financial Managers

12-22 Fifth Edition

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Can financial managers fool investors? Can financial managers time security sales? Are there price pressure effects?

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Some anomalies
12-23 Fifth Edition

Monday effects Weekend effects January effects Small firm effects Pre acquisition run-ups

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Some explanations
12-24 Fifth Edition

Closing positions over the weekend. ditto Tax timing, annual reporting, data mining. Trading with better informed quasi-insiders. Information leaking out bit by bit.

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