Risk and Capital Budgeting
Answer to Concept Review Questions
1. Why is using the cost of equity to discount project cash flows inappropriate when
a firm uses both debt and equity in its capital structure?
2. The firms in the same industry have very different equity betas. Offer two reasons
why this could occur.
3. For a firm considering expansion of its existing line of business, why is the
WACC rather than the cost of equity the preferred discount rate if the firm has
both debt and equity in its capital structure?
4. The cost of debt, rd, is generally less than the cost of equity re, because debt is a
less risky security. A naïve application of the WACC formula might suggest that a
firm could lower its cost of capital (thereby raising the NPV of its current and
future investments) by using more debt and less equity in its capital structure.
Give one reason why using more debt might not lower a firm’s WACC even if rd
< re
5. Why would a project that reaches the breakeven point in terms of net income
potentially be bad for shareholders?
6. Which variable do you think would be more valuable to examine in a project
sensitivity analysis – the growth rate of sales or the allowable depreciation
deductions each year? Explain.
7. You work for an airline that is considering a proposal to offer a new, nonstop
flight betwenn Atlanta and Tokyo. Senior management asks a team of analysts to
run a Monte Carlo simulation of the project. Your job is to advise the group on
what assumptions they should put in the simulation regarding the distribution of
the ticket price your airline will be able to charge. How would you go about this
task?
8. Why might the discount rate vary as you move through a decision tree?
9. Given a real world example of an expansion option and abandonment option.
10. We know that riskier firms must pay higher interest rates when they borrow
money. Explain this using the language of real options.
11. Why must manager intuition be part of the investment decision process regardless
of a project’s NPV or IRR? Why is it helpful to think about real options when
making an investment decision?
Answers to Self Test Problems
1. A financial analyst for Quality Investment, a diversified investment fund, has
gathered the following information for the years 2005 and 2006 on two firms – A
and B – that it is considering adding to its portfolio. Of particular concern are the
operating and financial risks of each firm.
Sales ($ million)
2005
Firm A
Firm B
10.7
13.9
2006
Firm A
11.6
Firm B
14.6
EBIT ($ million)
Assets ($ million)
Debt ($ million)
Interest ($ million)
Equity ($ million)
5.7
7.4
6.2
10.7
5.8
0.6
4.9
8.1
15.6
9.3
1.0
6.3
a. Use the data provided to assess the operating leverage of each firm (using
2005 as the point of reference). Which firm has more operating leverage?
b. Use the data provided to assess the firms ROE (Cash to equity/Equity)
assuming the firm’s Return on Assets is 10% and 20% in each case.
Which firm has more financial leverage?
c. Use your findings in parts a and b to compare, contrast the operating and
financial risks of Firms A and B. Which firm is more risky? Explain.
2. Sierra Vista Industries (SVI) wishes to estimate its cost of capital for use in
analyzing projects that are similar to those that already exist. The firm’s current
capital structure in terms of market value includes 40 % debt, 10 % preferred
stock, and 50 % common stock. The firm’s debt has an avearge yield to maturity
of 8.3 %. Its preferred stock has a $ 70 par value, an 8% dividend, and is currently
selling for $ 76 per share. SVI’s beta is 1.05 the risk free rate is 4 % and the return
on the S&P 500 (the market proxy) is 11.4 %. CVI is in the 40 % marginal tax
bracket.
a. What are SVI’s pretax costs of debt, preferred stock, and common stock ?
b. Calculate SVI;s weighted average cost of capital (WACC) on both a pretax and
after tax basis. Which WACC should SVI use when making investment
decisions?
c. SVI is contemplating a major investment that is expected to increase both its
operating and financial leverage. Its new capital structure will contain 50 % debt,
10 % preferred stock, and 40 % common stock. As a result of the proposed
investment, the firm’s average yield to maturity on debt is expected to increase to
9 %, the market value of preferred stock is expected to fall to its $ 70 par value
and its beta is expected to rise to 1.15. What effect will this investment have on
SVI’’s WACC? Explain your finding.