Lecture 16: Capital Budgeting,

Beta, and Cash Flows

■ Reading:
– Brealey and Myers, Chapter 9
– Lecture Reader, Chapter 15
■ Topics:
– Final topics on basic CAPM
– Debt, Equity, and Asset Betas
– Leveraged Betas
– Operating Leverage

© M. Spiegel and R. Stanton, 2000 1 U.C. Berkeley

 Calculating the beta of a portfolio

■ Consider a portfolio of n securities, with weights

w1, ..., wn.
■ The beta of the portfolio, βp, is given by
βp = w1β1 + w2β2 + ... + wnβn.
■ The expected return on the portfolio is
rp = w1r1 + w2r2 + ... + wnrn
= rf + βp(rm-rf).

© M. Spiegel and R. Stanton, 2000 2 U.C. Berkeley

 Example
($100 Total Value Portfolio)
$
Asset β w
1 0 -.25 -$25

2 .5 1.5 $150

3 1 -.75 -$75

4 1.5 .5 $50

The portfolio β is:

βp = -.25(0) + 1.5(.5) - .75(1) + .5(1.5) = .75

© M. Spiegel and R. Stanton, 2000 3 U.C. Berkeley

 Beta and the Market Portfolio

■ The market portfolio’s beta equals exactly 1 since:

Cov( ~rm , ~rm ) Var ( ~rm )
βm = ~ = ~ =1
Var ( rm ) Var ( rm )

■ Therefore the weighted sum of all the betas in the

economy equals one.

© M. Spiegel and R. Stanton, 2000 4 U.C. Berkeley

 The CAPM in practice
(BM 199-211)
■ Graham and Harvey (1999) sent a survey to CFOs
of all Fortune 500 companies, plus the 4,440
members of the Financial Executives Institute.
■ Main findings:
– 74.9% of respondents (almost) always use NPV!!
» Compares with 9.8% found by Gitman/Forrester (1977).
– 73.5% set discount rate using CAPM!!
– 58.8% would use a single company-wide discount rate
for all projects, regardless of type..
■ See BM pp. 199-211 for more discussion
© M. Spiegel and R. Stanton, 2000 5 U.C. Berkeley
 Betas and Cash Flows
■ Any cash flow can be an asset with its own β.
■ For example, a company with many divisions may
have a different β for each division’s revenues.
– a division with β = 1.5 will require a higher discount
rate than a division with β = .75.
■ Even individual machine cash flows may have β:
– Further, the machine’s expense cash flows and its
revenue cash flows may have different β.
■ Now, what effect does Debt have on β?

© M. Spiegel and R. Stanton, 2000 6 U.C. Berkeley

 Debt, Equity and Asset Betas

■ The profits generated by a firm's assets are

distributed to its debt and equity holders.
■ Therefore, one can think of a firm's assets as
equivalent to a portfolio of debt and equity.
– A = dollar value of the firm's assets.
– D = dollar value of the firm's debt.
– E = dollar value of the firm's equity.
■ By accounting definition: A = D + E.

© M. Spiegel and R. Stanton, 2000 7 U.C. Berkeley

 The Asset Beta

■ Since A = D+E, we can write the asset beta as a

function of the debt and equity betas:
D E
βA = β D + βE = (d )(β D ) + (e)(β E ),
D+E D+E
D E
where d = ;e= .
D+E D+E
■ We can also write βE = (βA - dβd)/(e)
■ If firm’s debt is risk free, equity beta has form:
βE = βA/e = βAA/E = βAA/(A-D).

© M. Spiegel and R. Stanton, 2000 8 U.C. Berkeley

 The Effect of Risk-Free Debt on Beta

■ A firm’s asset beta depends on the assets alone;

it does not change as the amount of debt changes.
■ But a firm’s equity beta does depend on its risk-
free debt: βE = βA/e = βAA/E = βAA/(A-D).
– The linkage between the firm's equity beta and its debt-
equity mix is often overlooked.
– In fact, we see that βE rises in tandem with debt D.
– What does this tell you about the effect of more debt on
the firm’s riskiness?

© M. Spiegel and R. Stanton, 2000 9 U.C. Berkeley

 Is Debt Less Costly then Equity?
(No!)

■ People often think debt is less costly than equity, since

bond interest rates < expected stock returns.
– This misses point that more debt makes equity riskier.
■ In fact, a firm’s cost of capital is independent of how it
finances a project. Proof follows.
■ Assume firm can issue all the risk free debt it wishes.
■ We know the following:
– rD = rf (since the debt is risk free.)
– βE = βA/e (again, the debt is risk free)
– rE = rf + βE(rm - rf)

© M. Spiegel and R. Stanton, 2000 10 U.C. Berkeley

 Cost of Capital is Independent of
Financing: Proof Continued
■ Define the total financing cost rT:
rT = (e)(rE ) + (d)(rD )
■ Now substitute out rE, rD and use βE=βA/e to get
é βA ù
rT = (e )êrf + ( rm − rf ) + (d )(rf ) .
ë e
■ Finally, with just a bit of algebra:
rT = rf + βA(rm - rf)
■ Total cost of capital is independent of financing!

© M. Spiegel and R. Stanton, 2000 11 U.C. Berkeley

 Example 1:
But Leverage does Raise rEE

■ Suppose: βA = 2, A = 100, rf = .05, rm - rf = .1

■ Let’s see how rE rises as amount of debt, D, rises:
D βE rE
0 2 .25
10 2.22 .272
50 4 .45
90 20 2.05 (Yes, it really is 2.05!)

© M. Spiegel and R. Stanton, 2000 12 U.C. Berkeley

 Sample Problem with
Leveraged Betas

■ You can buy the well diversified mutual fund Get Rich
Yesterday (GRY) containing only stocks.
– The mutual fund beta (βG) = .8. Market portfolio SD = 20%.
– Your portfolio goal is a standard deviation of 12%.
– In what proportions should you mix GRY and the risk free asset?
■ (Step 1) SD(GRY)=.8(20)=16. (All diversified portfolios
with β = .8, must be 80% as risky as the market portfolio.)
■ (Step 2) If you combine GRY with the risk free asset:

SD ( w G ~rG + (1 − w G ) rf ) = w G σ G = w G (16 ) = 12 .
So , w G = 3 / 4 = . 75 .

© M. Spiegel and R. Stanton, 2000 13 U.C. Berkeley

 Sample Problem with
Leveraged Betas, Continued

■ Now let every firm held by GRY change from 60% equity
financing to 40% equity financing.
– All the debt is risk free
– What change is required for wG?
■ Recall that βE=βA/e, so βA= eβE.
– With initial 60% equity financed, firms’ βA = (.6)(.8) =.48.
– With final 40% equity financed,.48 = .4βE, so βE = 1.2.
– If the new βE=1.2, then the S.D. of GRY must be 1.2(20)=24.
– This implies wG(24) = 12, or WG=.5.
– So you reduce your holdings in GRY to 50% of your portfolio

© M. Spiegel and R. Stanton, 2000 14 U.C. Berkeley

 Operating Leverage
■ An asset creates a portfolio of 3 cash flows:
– Revenues from the asset (R)
– Fixed cost to purchase and use the asset (F)
– Variable cost of using the asset (V)
■ Asset cash flow (A) is written as: A = R – F – V
– Rearrange to get: R = A + F + V.
– Treat revenues as a portfolio of asset, fixed cost and
variable cost.
– Then use portfolio formula to get revenues beta:
A F V
βR = βA + βF + βV .
R R R
© M. Spiegel and R. Stanton, 2000 15 U.C. Berkeley
 Operating Leverage, Continued
A F V
■ Now start with: β R = β A + βF + βV .
R R R
– The beta of the fixed costs equals 0.
– Also assume revenue beta equals the variable cost beta.
– So set βF=0 and βV=βR, and we get
A V
βR = βA + βR .
R R
– Now solve for βA, using R-V = A+F from above:
R−V é Fù
βA = βR . βA = β R ê1 + .
A ë A

© M. Spiegel and R. Stanton, 2000 16 U.C. Berkeley

 Operating Leverage, Conclusion

é Fù
βA = β R ê1 + .
ë A
■ Holding the asset value constant, an increase in the
fixed costs increases the asset beta.
■ Thus, projects with large fixed costs have their
cash flows discounted at a higher rate than
projects with low fixed costs.

© M. Spiegel and R. Stanton, 2000 17 U.C. Berkeley