Slide 1Choosing the Right Discount RateDetermining All Leather’s Cost of EquitySlide 4How to Choose Rf in the CAPMSlide 6How to Choose RM in the CAPMSlide 8Slide 9Slide 10Slide 11Slide 12Slide 13Finding All Leather’s Cost of Equity (Cont)Slide 15Financial Data for All Leather Inc. and Microfiber Corp.Slide 17Operating Leverage for All Leather and MicrofiberSlide 19Impact of Operating Leverage on Costs of Debt and EquitySlide 21Slide 22Slide 23Measuring Financial Leverage and its Impact on Firm’s Stock BetaSlide 25Slide 26The Weighted Average Cost of Capital (WACC)Finding the WACC (Cont)Finding WACC for Firms with Complex Capital StructuresSlide 30Connecting the WACC to the CAPMCalculating Asset Betas and Equity BetasFinding Equity Betas from Asset Betas, and Vice Versa (Cont)Slide 34Finding the Discount Rate to Use for Projects Unrelated to Firm’s IndustrySlide 36Data for Berry Petroleum and Forest OilConverting Equity Betas to Asset Betas for Two Pure Play FirmsConverting Equity Betas to Asset Betas for Two Pure Play Firms (Continued)Summarizing Rules for Selecting an Appropriate Project Discount RateAccounting for Taxes in Finding WACCA Closer Look at Risk Break-Even AnalysisSlide 43Break-Even Point for All LeatherBreak-Even Point for MicrofiberSensitivity AnalysisSensitivity Analysis of DVD ProjectUsing Decision Trees to Make Multi-Step Investment DecisionsSlide 49Using Decision Trees (Cont)Decision Tree From Odessa InvestmentSlide 52Slide 53Slide 54Risk And Capital BudgetingRisk And Capital BudgetingChapter 9Chapter 9Dr. Del HawleyFIN 634Fall 2003Dr. Del HawleyFIN 634Fall 2003Choosing the Right Discount RateChoosing the Right Discount Rate•What discount rate should managers use in capital budgeting?–Rate should reflect the opportunity cost of all of the firm’s investors (the cost of capital)–Rate should also reflect the risk of the specific project•To find discount rate, start with simplifying assumptions:–Assume all equity financing, so only have to satisfy S/Hs–Assume firm makes all investments in a single industry•These allow firm to use the cost of equity as discount rate–Know from MBA 611 that the cost of equity is found with the CAPM))(()(FmiFiRREβRRE (Eq 9.1)Determining All Leather’s Cost of EquityDetermining All Leather’s Cost of Equity•All Leather, Inc., an all-equity firm that produces leather sofas, is evaluating a proposal to build a new manufacturing facility.•As a producer of luxury goods, the firm’s performance is very sensitive to economic conditions. This is reflected in the firm’s 1.3 stock beta.–Note: The higher risk must be reflected in the discount rate used to evaluate the new manufacturing facility unless the project’s risk is not average relative to the firm’s other current investments.Determining All Leather’s Cost of EquityDetermining All Leather’s Cost of Equity•Based on current market conditions, the financial manager will use Rf = 4%. Her market analysis provided an expected market return of 9%.•Can use CAPM to find All Leather’s cost of equity: E(Re ) = Rf + (E(Rm) - Rf) = 4% + 1.3 (9% - 4%) = 10.5% cost of equityHow to Choose Rf in the CAPMHow to Choose Rf in the CAPMAny rate on the yield curve for government securities is a risk-free rate. So which one do you use?–Today’s yield curve runs from about 1.5% to 5% on risk-free yields. This is wide spread by historical standards.–Since you will be using the CAPM to set a discount rate for long-term investments, you need the market’s estimate of the inflation premium, but you do not need the other parts of the long-term rate that have to do with liquidity or preferences.E(Re ) = Rf + (E(Rm) - Rf)How to Choose Rf in the CAPMHow to Choose Rf in the CAPMThe Adjusted T-Bond Method uses the current rate on a 20-year T-Bond less the average spread between 20-year and 1-year T-bonds – about 1.2%Current yield on 20-year T-Bond 5.0% Less the average spread -1.2%Adjusted T-Bond Rate 3.8%Current Yield on a 1-year T-Bill 1.5%How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on recent market performance?How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on recent market performance?No. Recent past performance is a very poor predictor of long-term future performance. (See the link on our website for annual stock returns.)How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on past long-term performance? The average annual return on the market over the last 74 years is about 11.6%.How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on past long-term performance? The average annual return on the market over the last 74 years is about 11.6%.If you always use 11.6% as RM, you lock the SML to that point so it decreases slope as Rf rises and increases slope as Rf falls. This is just about opposite of what you would expect to happen.How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to be the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on market risk premium? On average over a long time, this has been about 5.6%.How to Choose RM in the CAPMHow to Choose RM in the CAPMRM needs to the expected rate of return on the market portfolio in the future, on average, over a long time. How do we know that?Base it on market risk premium? On average over a long time, this has been about 5.6%.This method has the best economic basis for what we are doing, and it is very simple.Using this method, the CAPM is used simply as:E(Re ) = Adjusted Rf +  ( 5.6% )Finding All Leather’s Cost of Equity (Cont)Finding All Leather’s Cost of Equity (Cont)•Other operating factors impact beta:–Cost structure and