CORPORATE FINANCE:AN INTRODUCTORY COURSEDISCUSSION NOTESMODULE #171RISK, RETURN, AND CAPITAL BUDGETINGI. A Review:We have learned that the field of corporate finance is preoccupied with two major questions:- In which assets should the firm invest? The investment decision. This questionconcerns the composition of the left-hand side of a firm's balance sheet, the asset side.We use the terms capital budgeting and capital expenditures to describe the process ofmaking and managing expenditures on assets, particularly long-term assets. Theworking capital management decision, i.e., short-term asset levels, is a subset of theinvestment decision.- How should the firm raise capital to finance these capital expenditures, or the financingdecision? This question addresses the design of the firm's financial structure, or theproportion of debt (both short-term and long-term) versus equity securities on theright-hand side of the firm's balance sheet. The dividend decision is a subset of thefinancial structure decision since this decision affects how much equity remains in thefirm.Chapter 12 in RWJ provides another step in our search for an answer to the first of thesequestions. We conclude this search in Chapter 17, where we pull together the discussion of theinvestment and financial structure decisions. In Chapter 13, we begin addressing the second ofthese major questions, or the design of the firm's financial structure.As you also should recall from prior material, we evaluate projects using the Net Present ValueRule, or the NPV Rule. This rule says that you discount a project's after-tax cash flows at the rater, or T NPV = C0 + Σ Ct/(1 + r)t, where t=1C0 = the time = 0 after-tax cash flow, usually negative, Ct = after-tax cash flows from time 1 to time T, either positive or negative,T = the terminal, or the last period of the project's life, andr = the required rate of return.1 This lecture module is designed to complement Chapter 18 in Ross, Westerfield, and Jaffe.1You accept projects with positive NPV's and reject projects with negative NPV's. Projects withpositive NPV's increase shareholder wealth. These projects earn more than the expected returnthat shareholders can earn on securities traded in the capital markets with the same amount of riskas the project, specifically the systematic risk as measured by beta. Projects with negative NPV'sdecrease shareholder wealth for the opposite reason. However, in our development to this point, we concentrated on the after-tax cash flows inassessing projects. You were not given insights into how to determining the required rate ofreturn on a project, or r. It is to this topic that we now turn.II. The Required Rate of Return on Projects:Our efforts in defining risk over the previous three chapters now allow us to return to the topic ofcapital budgeting. As discussed above, the term capital budgeting refers to the process ofevaluating capital investment projects. We ask, should the firm acquire (or divest) particularcapital assets?As you may recall from Chapter 1 in RWJ and in Module #2, the objective of managers should beto maximize the wealth of their shareholders. Remember, shareholders are the residual risk-bearers of the firm; shareholders supplied the capital that allowed the firm to spring into existence.Accordingly, managers work for the shareholders. Shareholders' best interests should underlie allmanagerial decisions.Shareholders have abundant opportunities to invest in the financial markets in bills, bonds, stocks,convertible securities, etc. They do not want managers to retain money in the firm to invest inprojects that do not earn returns at least as high as they can earn for themselves in the financialmarkets, adjusting for the risk of the projects. In this context, think of the Security Market Line(SML). Shareholders want managers to reject projects unless they at least match the risk-adjusted returns on the SML. Another way of making this point is to say, managers should notinvest in projects unless shareholders earn their opportunity cost, i.e., the return they could earnin the financial markets on risk-equivalent financial securities.Risk equivalency is a key part of the above statement. This concept is a major reason why wehave spent so much time developing the notion of the appropriate measure of risk for anindividual asset, or beta. As it turns out, beta is also the appropriate measure of risk for a projectin a firm with public shareholders. We turn this measure of risk into a required rate of return for aproject by using the CAPM pricing equation (SML), or E(rj) = rf + (E(rm) - rf)βj, where E(rj) represents the required rate of return on project j, andβj represents the risk of project j.This return becomes our discount rate in our NPV calculations.II. The One-Asset Firm:2Let's begin our discussion by considering a one-asset firm. Since we want to defer the impact ofthe financial structure decision on the wealth of shareholders till later, we will initially assume thatfirms are all equity financed.Let's begin with a simplified, market value balance sheet with "real" assets (as opposed to financialassets) on the left-hand side and financial assets, here all equity, on the right-hand side. ASSETSEQUITY A1 = Asset S =Stock(Asset Risk = (FinancialSecurity Risk = Business Risk) Financial Risk) Total Assets = Total Equity Asset Beta, βA = Equity Beta, βSGiven the CAPM, the required return for the real asset A1 equals E(rA1) = rf + (E(rm) - rf)βA1, where βA1 is the beta of Asset A1. However, there are some complications in determining the asset's beta, βA1. Therefore, we mustdigress for a moment.What does a financial security (in this example, common stock) represent? A financial security is3just a piece of paper! Intrinsically, this piece of paper has no value. Why, then, do financialsecurities, such as shares of common stock, have value in the marketplace? It is becausefinancial securities represent claims on the cash flows generated by real assets, or the assets that"live" on the left-hand side of the balance sheet! In other words, the source of value of financialsecurities is derived from the cash flows generated by the real assets and the risk of these cashflows.