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Topic10_capbud_risk[1]

# Topic10_capbud_risk[1] - Thomas Moeller FINA 30153...

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Thomas Moeller FINA 30153: Financial Management 1 Topic 10 Risk, cost of capital, and capital budgeting Objectives 1. Understand the concept of cost of equity capital 2. Learn how to estimate beta 3. Discuss the determinants of beta 4. Discuss the relation between capital budgeting and project risk 5. Discuss the concept of weighted average cost of capital

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Thomas Moeller FINA 30153: Financial Management 2 1. Cost of equity capital A firm with excess cash can either pay a dividend or make a capital investment. Since stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk. From the firm’s perspective, the expected return is the cost of equity capital: E(r )=r i E(r )-r if m f + β []
Thomas Moeller FINA 30153: Financial Management 3 We can use the security market line (SML) to determine the proper discount rate to use for capital budgeting analysis. Rf IRR E(Rm) 1.0 Beta An all-equity firm should accept projects when IRRs exceed the cost of equity capital and reject projects when IRRs fall short of the cost of capital.

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Thomas Moeller FINA 30153: Financial Management 4 2. Estimation of beta To estimate the cost of equity capital, we need to calculate the equity beta. Theoretically, the calculation of beta is straightforward: ( ) () m m i i r r r var , cov = β Problems: 1. Betas may vary over time. 2. Betas are influenced by changing financial leverage and business risk. 3. The equity of the firm is not publicly traded.
Thomas Moeller FINA 30153: Financial Management 5 Solutions: 1. Problem 1 can be moderated by more sophisticated statistical techniques or ad hoc adjustments.

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Topic10_capbud_risk[1] - Thomas Moeller FINA 30153...

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