SEC09 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL FNCE...

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UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL FNCE 601 FINANCIAL ANALYSIS LECTURE NOTES Franklin Allen Fall 2003 QUARTER 1 - WEEK 7 Tu: 10/14/03 Copyright ' 2003 by Franklin Allen
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FNCE 601 - Section 9 - Page 1 Section 9: Capital Budgeting and Risk Read Chapter 9 BM Motivation Example 1 Macrosoft is a computer software company. It has no debt. The beta of its equity, which is equal to the beta of its assets since it has no debt, is 1.25. The risk free rate is r F = 5% and the market risk premium is r M F = 8%. Using the CAPM, the opportunity cost of capital for the firm is 5% + 1.25 x 8% = 15% and this is the discount rate they use for evaluating computer software projects. Macrosoft is considering a hardware project. It is considering building PC±s to compete with Dell, Gateway and other PC manufacturers. Suppose the beta of the assets of these companies that engage in activities similar to this hardware project is 1.83. This corresponds to an opportunity cost of capital of 5% + 1.83 x 8% = 20%. Maria Fuentes is the CFO of Macrosoft. She believes that Macrosoft should use 15% as the discount rate. Her argument is that Macrosoft can raise funds from their shareholders at 15% and so this is the relevant rate. Ari Silverberg is her deputy. He argues that Macrosoft should use the rate of 20% since this compensates for the risk that Macrosoft is taking by investing in the hardware industry. Who is correct? In evaluating the hardware project should Macrosoft use a discount rate of 15% or 20%? Finding the discount rate for a project like the firm Suppose that we are considering a ²pure play³ firm like Dell that only invests in one type of project that is the same as its existing assets. All Dell does is produce PC±s. The discount rate we should use for a project is the opportunity cost of capital (or as it is often called the cost of capital). In other words, if the firm didn’t do the project it would invest in the best alternative
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FNCE 601 - Section 9 - Page 2 β σ Equity s Firm 2 M = M) Cov(Y, = b available and we should use the return on this as the discount rate. In Section 2 there was certainty and we simply took the best available alternative. In our initial example this was the rate at the bank. What is the best alternative available when there is uncertainty? This depends on the risk of the project. We should choose the best alternative so that its risk is the same as that of the project. The CAPM provides a way of doing this. It provides the best available alternative in the stock market for a similar risk project. If the CAPM holds, then the opportunity cost of investing in a project with a risk of β is: r = r F + (Project β )(r M - r F ) This is then the discount rate for the project. If the firm doesn’t do the project then it can always invest in a portfolio with the same β as the project and get a return of r. There are a number of studies that give some idea of the market return r
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SEC09 - UNIVERSITY OF PENNSYLVANIA THE WHARTON SCHOOL FNCE...

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