Lecture13 - LECTURE 13 CAPITAL BUDGETING WITH RISK AND THE...

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152 L ECTURE 13 C APITAL B UDGETING WITH R ISK AND THE C OST OF C APITAL Reading: Chapter 12 Homework: Online Objectives: Determining the opportunity cost of capital Understanding Project vs financial risk Adjusting Project Risk for Leverage
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153 INCORPORATING RISK INTO CAPITAL BUDGETS Must estimate the β of the project. How do we do this? ± Look at companies that have similar projects. ¾ What β do those companies have. ± Historical returns on various assets. ¾ Compute β directly Example : Suppose you are the financial planning director for U.S. Copper mining. You learn through watching your children that marshmallow covered Cheerios are the next great fad in breakfast cereals. You decide that your company should produce this product. How do you come up with a required rate of return? The risk of the project is relevant— not the risk of the company that is making a decision on the project. For a well diversified company the required rate of return is determined by the project’s β .
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154 INCORPORATING RISK INTO CAPITAL BUDGETS The project’s β tells us how many units of systematic risk a project has. Recall that your investors must be compensated for taking on systematic risk. We’ll use the project’s β to compute an r for it. () n n r CF r CF r CF CF NPV + + + + + + + = 1 ... 1 1 2 2 1 1 0 How do we do this? Method: 1. Estimate the systematic risk of the project. 2. Use the CAPM (or another model) to convert this risk into the required rate of return. 3. Use this rate of return to discount all expected after-tax cash flows from the project. Example: Let's say Apple is thinking about buying Tivo. Apple Computer, Inc. designs, manufactures and markets personal computers (PCs) and related software, peripherals and personal computing accesories, and digital entertainment devices. TiVo Inc. is a provider of technology and services for digital video recorders (DVRs).
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155 INCORPORATING RISK INTO CAPITAL BUDGETS Is buying Tivo simply a scale-expansion of Apple’s current business? What is the correct risk-adjusted return for Apple to use in calculating the value of Tivo?
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Lecture13 - LECTURE 13 CAPITAL BUDGETING WITH RISK AND THE...

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