Chapter 12

Review Item
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Yahoo is considering building a cafeteria for its employees.
At a high discount rate appropriate to Yahoo’s risk, the
NPV of the cafeteria is negative.
At a low discount rate appropriate to a Wendy’s, the
NPV of the cafeteria is positive.
Should Yahoo build the cafeteria?
Explain briefly.

Answer
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Build the cafeteria.
The project is safe like a Wendy’s, not risky like an internet service.
NPV is market value.
The market it not deceived but sees the project for the safe investment that it is.

Example of beta and NPV
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Wingmar Inc. has a beta of 2.
The Market risk premium is 8.5%
The risk-free rate is 4%.
Wingmar has a project with cash flows -100, 60, 80.
The project is typical of Wingmar’s core business.
Should the project be undertaken?

Answer
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Part 1. Cost of equity financing. The appropriate discount rate for projects of Wingmar is
.04+.085(2)=.21.
Part 2. The NPV of the project is 4.2278533.
Take the project.

Chapter 12 Risk, Return, and Capital
Budgeting
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Determinants of the Cost of Equity
Capital
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Estimation of Beta
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Financial leverage.

Cyclicality
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Capital goods, consumer durables, construction are cyclical and synchronized with general economic conditions.

Operating leverage
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Fixed cost of debt service, leases, employment contracts versus variable costs.
High operating leverage means high fixed costs. MRI labs.
Low leverage, low fixed cost. Fast food, services.
EBIT = earnings before interest and taxes. Assume depreciation = loss of market value.
EBITDA = earnings before interest, taxes, depreciation, or amortization, i.e., nearly cash flow.

Beta Estimation
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Problems
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 Betas may vary over time.
 The sample size may be inadequate.
Solutions
 More sophisticated statistical techniques.

Beta Estimation
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Problem: Beta for a firm is overly influenced by random factors peculiar to the firm.
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Solution: Look at average beta estimates of several comparable firms in the industry.
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Problem: Firms have financial leverage, which shouldn’t matter in NPV.
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Solution: Adjust as follows.

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Equity beta for the firm’s shares.
Debt beta for the firm’s debt.
Asset beta for the physical firm.

The asset is equivalent to a portfolio
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S = market value of equity (stock)
B = “ “ “ debt (bonds)
A = “ “ “ asset (firm)
Portfolio weights are
X
S

S
S

B
, X
B

S
B

B

Beta of the asset (the physical firm)
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Beta of a portfolio is the weighted sum of the betas of the components.

A

S
S

B

S

S
B

B

B

Normally
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Stock is risky
Debt is less risky
Asset is in between.

Weighted Average Cost of Capital r
W ACC

S
S

B r
S

S
B

B
( 1

T
C
) r
B

Chapter 13 Corporate-Financing Decisions and Efficient Capital Markets
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13.1 Can Financing Decisions Create Value?
13.2 A Description of Efficient Capital Markets
13.3 The Different Types of Efficiency

Reaction of Stock Price to New Information in Efficient and Inefficient Markets
Stock
Price
Overreaction to “good news” with reversion
Delayed response to
“good news”
Efficient market response to “good news”
-30 -20 -10 0 +10 +20 +30
Days before (-) and after (+) announcement

Sets of Information relevant to a stock
All information
Publicly available information
Past prices

Forms of the Efficient Market Hypothesis
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Weak
 Prices reflect information in past prices
 Random Walk
Semi-strong
 Prices reflect publicly available information
Strong
 Prices reflect all information

Implications for Corporate Financial
Managers
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Can financial managers “fool” investors?
Can financial managers “time” security sales?
Are there price pressure effects?

Some anomalies
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Monday effects
Weekend effects
January effects
Small firm effects
Pre acquisition run-ups

Some explanations
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Closing positions over the weekend.
ditto
Tax timing, annual reporting, data mining.
Trading with better informed quasi-insiders.
Information leaking out bit by bit.