Lecture14 - LECTURE 14 CAPITAL BUDGETING WITH RISK AND THE...

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152 L ECTURE 14 C APITAL B UDGETING WITH R ISK AND THE T AXES Reading: Finish Chapter 12 Homework: Online Objectives: Understand how leverage affects taxes Learn How to Adjust the Discount Rate for the Effect of Taxes Value a whole businesses
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153 R EVIEW OF L AST C ALSS To figure out a project discount rate, we have to figure out its beta. We use betas of companies in the same business as the project Typically we take the average of a few If the project is a scale expansion of the firm, use the firm’s beta But what happens if the comparable companies you are using have debt? Their betas are going to be equity betas But we want an asset beta; that is, a beta that measures the risk of the underlying business or project, not the equity risk We thus have to delever their betas before taking their average Last time we learned to delever betas as follows: Debt = 0 Which allows us to simplify the above equation: Assets Equity Debt Assets Equity Equity Debt Debt Equity Debt Equity Equity Debt Equity ββ β =⋅ + ++ + For firms with relatively safe debt, we assume:
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154 E AMPLE Suppose you work for an integrated oil company and you are considering whether or not to drill an oil & gas well somewhere in Texas. Do you want to use your own firm’s beta? There are a few companies that specialize in drilling wells and extracting oil and gas in the US. Two examples are United Heritage Corporation (UHCP) and New Fronetier Energy (NFEI.OB).: Company Equity Beta Mkt. Equty Debt E/(D+E) Delevered Beta UHCP 0.42 11.47 0.753 NFEI.OB 1.11 10.95 1.18 Averages Source: Yahoo Finance Okay, so we can use the average delevered beta to figure out the expected return investors demand for assets with the same risk as the project: () [ ] asset f asset m f E rr E r r β =+ Suppose the well is projected to last 10 years. What treasury yield should we use as our risk-free rate? What should we use as the market risk premium? Lets now plug in the numbers and get the expected return for assets with the project’s level of risk: I F OUR PROJECT WAS 100% E QUITY FINANCED , THIS WOULD BE OUR DISCOUNT RATE
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155 WEIGHTED AVERAGE COST OF CAPITAL (WACC) For sake of brevity, I will drop the expectations operator E for the rest of the lecture. Every return I talk about from now on is an expected return. The market expected return on an asset with the same risk at the project can be decomposed into the weighted average of the expected returns on the debt and equity claims against the asset: () asset f asset m f Equity Debt Equity Debt rr r r r r Debt Equity Debt Equity β =+ = + ++ Compare this to the formula for beta: ββ Assets Equity Debt =⋅ + +⋅ + In a world without taxes, or if the project were financed with all equity, r asset
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This note was uploaded on 12/02/2009 for the course FIN 350 taught by Professor Schonlau during the Spring '08 term at University of Washington.

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Lecture14 - LECTURE 14 CAPITAL BUDGETING WITH RISK AND THE...

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