Using the NPV Rule to Choose among Projects

Almost all real-world investment decisions entail either-or choices. Such choices are said to be mutually exclusive. We came across an example of mutually exclusive investments in Chapter 2. There we looked at whether it was better to build an office block for immediate sale or to rent it out and sell it at the

Over a Century of Capital Market History in One Easy Lesson

Financial analysts are blessed with an enormous quantity of data. There are comprehensive databases of the prices of U.S. stocks, bonds, options, and commodities, as well as huge amounts of data for securities in other countries. We focus on a study by Dimson, Marsh, and Staunton that measures the historical performance of three portfolios

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Diversification and Portfolio Risk

You now have a couple of benchmarks. You know the discount rate for safe projects, and you have an estimate of the rate for average-risk projects. But you don’t know yet how to estimate discount rates for assets that do not fit these simple cases. To do that, you have to learn (1) how

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Calculating Portfolio Risk

We have given you an intuitive idea of how diversification reduces risk, but to understand fully the effect of diversification, you need to know how the risk of a portfolio depends on the risk of the individual shares. Suppose that 60% of your portfolio is invested in Southwest Airlines and the remainder is invested

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How Individual Securities Affect Portfolio Risk

This brings us to our next major takeaway: The risk of a well-diversified portfolio depends on the market risk of the securities included in the portfolio. Tattoo that statement on your forehead if you can’t remember it any other way. It is one of the most important ideas in this book. 1. Market Risk

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Diversification and Value Additivity

We have seen that diversification reduces risk and, therefore, makes sense for investors. But does it also make sense for the firm? Is a diversified firm more attractive to investors than an undiversified one? If it is, we have an extremely disturbing result. If diversification is an appropriate corporate objective, each project has to

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Harry Markowitz and the Birth of Portfolio Theory

Most of the ideas in Chapter 7 date back to an article written in 1952 by Harry Markowitz.[1] Markowitz drew attention to the common practice of portfolio diversification and showed exactly how an investor can reduce the standard deviation of portfolio returns by choosing stocks that do not move exactly together. But Markowitz did

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The Relationship between Risk and Return

In Chapter 7, we looked at the returns on selected investments. The least risky investment was U.S. Treasury bills. Since the return on Treasury bills is fixed, it is unaffected by what hap­pens to the market. In other words, Treasury bills have a beta of 0. We also considered a much riskier investment, the

Validity and Role of the Capital Asset Pricing Model

Any economic model is a simplified statement of reality. We need to simplify in order to interpret what is going on around us. But we also need to know how much faith we can place in our model. Let us begin with some matters about which there is broad agreement. First, few people quarrel

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Some Alternative Theories of Portfolio Theory and the Capital Asset Pricing Model

The capital asset pricing model pictures investors as solely concerned with the level and uncertainty of their future wealth. But this could be too simplistic. For example, investors may become accustomed to a particular standard of living, so that poverty tomorrow may be particularly difficult to bear if you were wealthy yesterday. Behavioral psychologists

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Company and Project Costs of Capital

The company cost of capital is defined as the expected return on a portfolio of all the com­pany’s outstanding debt and equity securities. It is the opportunity cost of capital for an invest­ment in all of the firm’s assets, and therefore the appropriate discount rate for the firm’s average-risk projects. If the firm has

Measuring the Cost of Equity

To calculate the weighted-average cost of capital, you need an estimate of the cost of equity. You decide to use the capital asset pricing model (CAPM). Here you are in good company: As we saw in the last chapter, most large U.S. companies do use the CAPM to estimate the cost of equity, which

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Analyzing Project Risk

Suppose that a coal-mining corporation needs to assess the risk of investing in a new com­pany headquarters. The asset beta for coal mining is not helpful. You need to know the beta of real estate. Fortunately, portfolios of commercial real estate are traded. For example, you could estimate asset betas from returns on Real

Certainty Equivalents – Another Way to Adjust for Risk

In practical capital budgeting, a single risk-adjusted rate is used to discount all future cash flows. This assumes that project risk does not change over time, but remains constant year- in and year-out. We know that this cannot be strictly true, for the risks that companies are exposed to are constantly shifting. We are

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Sensitivity and Scenario Analysis

Uncertainty means that more things can happen than will happen. Therefore, whenever managers are given a cash-flow forecast, they try to determine what else may happen and the implications of these possible surprise events. This is called sensitivity analysis. Put yourself in the well-heeled shoes of the financial manager of the Otobai Company in

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Break-Even Analysis and Operating Leverage

1. Break-Even Analysis When we undertake a sensitivity analysis of a project or when we look at alternative scenarios, we are asking how serious it would be if sales or costs turn out to be worse than we forecasted. Managers sometimes prefer to rephrase this question and ask how bad things can get before

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Monte Carlo Simulation

Sensitivity analysis allows you to consider the effect of changing one variable at a time. By looking at the project under alternative scenarios, you can consider the effect of a limited number of plausible combinations of variables. Monte Carlo simulation is a tool for considering all possible combinations. It therefore enables you to inspect

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Real Options and Decision Trees

When you use discounted cash flow (DCF) to value a project, you implicitly assume that the firm will hold the assets passively. But managers are not paid to be dummies. After they have invested in a new project, they do not simply sit back and watch the future unfold. If things go well, the

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How Firms Organize the Investment Process

1. The Capital Budget Senior management needs some forewarning of future investment outlays. So for most large firms, the investment process starts with the preparation of an annual capital budget, which is a list of investment projects planned for the coming year. Smaller investments are not item­ized separately in the budget. For example, they

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Look First to Market Values

Let us suppose that you have persuaded all your project sponsors to give honest forecasts. Although those forecasts are unbiased, they are still likely to contain errors, some positive and others negative. The average error will be zero, but that is little consolation because you want to accept only projects with truly superior profitability.