CHAPTER 9

Capital Budgeting and Risk

Answers to Practice Questions
1. It is true that the cost of capital depends on the risk of the project being
evaluated. However, if the risk of the project is similar to the risk of the other
assets of the company, then the appropriate rate of return is the company cost of
capital.
2. Internet exercise answers will vary.
!. Internet exercise answers will vary.
". a. #oth #ritish $etroleum and #ritish %irways had &
2
values of '.2(, which
means that, for both stocks 2() of total risk comes from movements in
the market *i.e., market risk+. ,herefore, -() of total risk is [Link] risk.
b. ,he variance of #ritish $etroleum is/ *2(+
2
0 12(
[Link] variance for #ritish $etroleum is/ *'.-( 12(+ 0 "13.-(
c. ,he t4statistic for
#%
is/ *'.5'6'.1-+ 0 (.25
,his is significant at the 1) level, so that the confidence level is 55).
d. r
#$
0 r
f
7
#$
*r
m
4 r
f
+ 0 '.'( 7 *1.!-+*'.12 8 '.'(+ 0 '.1"(5 0 1".(5)
e. r
#$
0 r
f
7
#$
*r
m
4 r
f
+ 0 '.'( 7 *1.!-+*' 8 '.'(+ 0 4'.'13( 0 41.3()
(. Internet exercise answers will vary.
1. If we don9t know a project9s , we should use our best estimate. If 9s are uncertain,
the [Link] return depends on the expected . If we know nothing about a
project9s risk, our best estimate of is 1.', but we usually have some information
on the project that allows us to modify this prior belief and make a better
estimate.
32
-. a. ,he total market value of outstanding debt is !'',''' euros. ,he cost of
debt capital is 3 percent. :or the common stock, the outstanding market
value is/ *(' euros 1','''+ 0 ('',''' euros. ,he cost of [Link] capital
is 1( percent. ,hus, ;orelei9s weighted4average cost of capital is/
) *'.1(
('',''' !'','''
('','''
*'.'3+
('',''' !'','''
!'','''
r
assets

+
+

+
=
r
assets
0 '.12" 0 12.")
b. #ecause business risk is unchanged, the company9s weighted4average
cost of capital will not change. ,he financial structure, however, has
changed. <ommon stock is now worth 2(',''' euros. %ssuming that the
market value of debt and the cost of debt capital are unchanged, we can
use the same [Link] as in $art *a+ to calculate the new [Link] cost of
capital, r
[Link]
/
)
[Link]
r *
2(',''' !'','''
2(','''
*'.'3+
2(',''' !'','''
!'','''
'.12"

+
+

+
=
r
[Link]
0 '.1-- 0 1-.-)
3. a. r
#=
0 r
f
7
#=
*r
m
4 r
f
+ 0 '.'!( 7 *'.1" '.'3+ 0 '.'312 0 3.12)
r
I=>
0 r
f
7
I=>
*r
m
4 r
f
+ 0 '.'!( 7 *'.(' '.'3+ 0 '.'-( 0 -.(')
b. =o, we can not be confident that #urlington9s true beta is not the industry
average. ,he difference between
#=
and
I=>
*'.1"+ is less than one
standard error *'.2'+, so we cannot reject the hypothesis that
#=
0
I=>
.

c. #urlington9s beta might be different from the industry beta for a variety of
reasons. :or example, #urlington9s business might be more cyclical than
is the case for the typical firm in the industry. ?r #urlington might have
more fixed operating costs, so that operating leverage is higher. %nother
possibility is that #urlington has more debt than is typical for the industry
so that it has higher financial leverage.
d. <ompany cost of capital 0 *>6@+*r
debt
+ 7 *A6@+*r
[Link]
+
<ompany cost of capital 0 *'." '.'1+ 7 *'.1 '.'-(+ 0 '.'15 0 1.5)
3!
5. a. Bith risk4free debt/
assets
0 A6@
[Link]
,herefore/

food
0 '.- '.3 0 '.(1

elec
0 '.3 1.1 0 1.23

chem
0 '.1 1.2 0 '.-2
b.
assets
0 *'.( '.(1+ 7 *'.! 1.23+ 7 *'.2 '.-2+ 0 '.31
Ctill assuming risk4free debt/

assets
0 *A6@+ *
[Link]
+
'.31 0 *'.1+ *
[Link]
+

[Link]
0 1.!(
c. 2se the Cecurity Darket ;ine/
r
assets
0 r
f
7
assets
*r
m
4 r
f
+
Be have/
r
food
0 '.'- 7 *'.(1+*'.1( 4 '.'-+ 0'.11( 0 11.()
r
elec
0 '.'- 7 *1.23+*'.1( 4 '.'-+ 0'.1-2 0 1-.2)
r
chem
0 '.'- 7 *'.-2+*'.1( 4 '.'-+ 0'.123 0 12.3)
d. Bith risky debt/

food
0 *'.! '.2+ 7 *'.- '.3+ 0 '.12 r
food
0 12.')

elec
0 *'.2 '.2+ 7 *'.3 1.1+ 0 1.!2 r
elec
0 1-.1)

chem
0 *'." '.2+ 7 *'.1 1.2+ 0 '.3' r
chem
01!.")
1'.
&atio of 9s <orrelation #eta
Agypt !.11 '.( 1.(1
$oland 1.5! '.( '.5-
,hailand 2.51 '.( 1."1
@eneEuela 2.(3 '.( 1.25
,he betas increase compared to those reported in ,able 5.2 because the returns
for these markets are now more highly correlated with the 2.C. market. ,hus,
the contribution to overall market risk becomes greater.
11. :oreign capital investment projects will be evaluated on the basis of the amount of
market risk the project brings to the portfolio. :urther, the decrease in
diversifiable country bias may result in higher overall correlations.
3"
12. ,he information could be helpful to a 2.C. company considering international
capital investment projects. #y examining the beta estimates, such companies
can evaluate the contribution to risk of the potential cash flows.
% Ferman company would not find this information useful. ,he relevant risk
depends on the beta of the country relative to the portfolio held by investors.
Ferman investors do not invest exclusively, or even primarily, in 2.C. company
stocks. ,hey invest the major portion of their portfolios in Ferman company
stocks.
1!. a. ,he threat of a coup d9Gtat means that the expected cash flow is less than
H2(','''. ,he threat could also increase the discount rate, but only if it
increases market risk.
b. ,he expected cash flow is/ I*'.2( '+ 7 *'.-( 2(','''+J 0 H13-,(''
%ssuming that the cash flow is about as risky as the rest of the company9s
business/
$@ 0 H13-,(''61.12 0 H11-,"11
1". a. Axpected daily production 0
*'.2 '+ 7 *'.3+ I*'." x 1,'''+ 7 *'.1 x (,'''+J 0 2,-2' barrels
Axpected annual cash revenues 0 2,-2' x !1( x H1( 0 H1",352,'''
b. ,he possibility of a dry hole is a diversifiable risk and should not affect the
discount rate. ,his possibility should affect forecasted cash flows,
however. Cee $art *a+.
1(. ,he opportunity cost of capital is given by/
r 0 r
f
7 *r
m
4 r
f
+ 0 '.'( 7 *1.2+*'.'1+ 0 '.122 0 12.2)
,herefore/
<AK
1
0 1('*1.'(61.122+ 0 1"'.!-
<AK
2
0 1('*1.'(61.122+
2
0 1!1.!-
<AK
!
0 1('*1.'(61.122+
!
0 122.5"
<AK
"
0 1('*1.'(61.122+
"
0 11(.'(
<AK
(
0 1('*1.'(61.122+
(
0 1'-.1-
3(
a
1
0 1"'.!-61(' 0 '.5!(3
a
2
0 1!1.!-61(' 0 '.3-(3
a
!
0 122.5"61(' 0 '.3151
a
"
0 11(.'(61(' 0 '.-1-'
a
(
0 1'-.1-61(' 0 '.-1-3
:rom this, we can see that the a
t
values decline by a constant proportion each
year/
a
2
6a
1
0 '.3-(36'.5!(3 0 '.5!(3
a
!
6a
2
0 '.31516'.3-(3 0 '.5!(3
a
"
6a
!
0 '.-1-'6'.3151 0 '.5!(3
a
(
6a
"
0 '.-1-36'.-1-' 0 '.5!(3
11. a. 2sing the Cecurity Darket ;ine, we find the cost of capital/
r 0 '.'- 7 1.(*'.11 4 '.'-+ 0 '.2'( 0 2'.()
,herefore/
b.
<AK
1
0 "'*1.'-61.2'(+ 0 !(.(2
<AK
2
0 1'*1.'-61.2'(+
2
0 "-.!1
<AK
!
0 ('*1.'-+61.2'(+
!
0!(.'1
c.
a
1
0 !(.(26"' 0'.333'
a
2
0 "-.!161' 0'.-33(
a
!
0 !(.'16(' 0'.-''1
d. 2sing a constant risk4adjusted discount rate is [Link] to assuming that
a
t
decreases at a constant compounded rate.
31
1'!.'5
1.2'(
('
1.2'(
1'
1.2'(
"'
$@
! 2
= + + =
1-. %t t 0 2, there are two possible values for the project9s =$@/
,herefore, at t 0 '/
3-
' + successful not is test if * =$@
2
=
H3!!,!!!
'.12
-'','''
(,''',''' + successful is test if * =$@
2
= + =
H2"",353
1."'
3!!,!!!+ .1' *' '+ *'."'
('',''' =$@
2
'
=
+
+ =
Challenge Questions
1. It is correct that, for a high beta project, you should discount all cash flows at a
high rate. ,hus, the higher the risk of the cash outflows, the less you should
worry about them because, the higher the discount rate, the closer the present
value of these cash flows is to Eero. ,his result does make sense. It is better to
have a series of payments that are high when the market is booming and low
when it is slumping *i.e., a high beta+ than the reverse.
,he beta of an investment is independent of the sign of the cash flows. If an
investment has a high beta for anyone paying out the cash flows, it must have a
high beta for anyone receiving them. If the sign of the cash flows affected the
discount rate, each asset would have one value for the buyer and one for the
seller, which is clearly an impossible situation.
2. a. ,he real issue is the degree of risk relative to the investor9s portfolio. If
Ferman investors hold a stock portfolio comprised largely of Ferman
[Link], then they are likely to find that 2.C. pharmaceutical stocks are
less highly correlated with their portfolios than they are with 2.C. stocks,
and will therefore have lower betas. ,his suggests that Ferman investors
might [Link] a lower return for investing in 2.C. pharmaceutical
companies than 2.C. investors [Link]. ,hat does not necessarily imply
that they should move their &L> and production facilities to the 2.C.
however. :irst, there might be extra costs involved in managing the
business in a foreign country. %lso, &L> that simply serves a Ferman
parent company may be more highly correlated with the Ferman market.
b. ,he answer here depends on the reason that Ferman investors keep
much of their money at home. If there are high costs for shareholders to
invest overseas, then the Ferman company may well provide its
shareholders with a service by providing them with cheap international
diversification.
c. =ot necessarily. ,he Ferman company needs to be remunerated only for
the risk it is taking relative to its Ferman portfolio. If the Ferman company
holds a portfolio comprised primarily of 2.C. holdings, then 1!) is the
appropriate rate.
33
!. a. Cince the risk of a dry hole is unlikely to be market4related, we can use the
same discount rate as for producing wells. ,hus, using the Cecurity
Darket ;ine/
r
nominal
0 '.'1 7 *'.5+*.'3+ 0 '.1!2 0 1!.2)
Be know that/
*1 7 r
nominal
+ 0 *1 7 r
real
+ *1 7 r
inflation
+
,herefore/
3.3() '.'33( 1
1.'"
1.1!2
r
real
= = =
b.
d. Axpected income from Bell 1/ I*'.2 '+ 7 *'.3 ! million+J 0 H2." million
Axpected income from Bell 2/ I*'.2 '+ 7 *'.3 2 million+J 0 H1.1 million
>iscounting at 3.3( percent gives.
e. :or Bell 1, one can certainly find a discount rate *and hence a Mfudge
factorN+ that, when applied to cash flows of H! million per year for 1'
years, will yield the correct =$@ of H(,('",1''. Cimilarly, for Bell 2, one
can find the appropriate discount rate. However, these two Mfudge factorsN
will be different. Cpecifically, Bell 2 will have a smaller Mfudge factorN
because its cash flows are more distant. Bith more distant cash flows, a
smaller addition to the discount rate has a larger impact on present value.
". Internet exercise answers will vary.
35
*!.151"+J *!million+ million 1'
1.233(
!million
million 1' =$@
1'
1 t
t
1
+ = + =

=
[
H"2(,3'' =$@
1
=
*!.!333+J *2million+ I 1'million
1.233(
2million
million 1' =$@
1(
1 t
t
2
+ = + =

=
H!,222,!'' =$@
2
=
*1."1'2+J n+ *2."millio I million 1'
1.'33(
2."million
million 1' =$@
1'
1 t
t
1
+ = + =

=
H(,('",1'' =$@
1
=
*3.1!21+J n+ *1.1millio I 1'million
1.'33(
1.1million
million 1' =$@
1(
1 t
t
2
+ = + =

=
H!,'12,1'' =$@
2
=
5'