Chapter 12 Risk Cost of Capital and Valuation

# Chapter 12 Risk Cost of Capital and Valuation - Cost of...

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Cost of Capital Chapter 12 Finance 357

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Cost of Equity Capital Firms have two choices when they make a profit. They can pay the cash out as a dividend or they can retain the cash and reinvest it. If the money is reinvested within the company, it should make a return higher than what it could receive from an outside investment. Thus, the discount rate of a project should be the expected return on a financial asset of comparable risk. 2
Using CAPM to Find Equity Cost of Capital From the perspective of a firm, its expected return is the cost of equity capital. This formula is often called the Security Market Line formula or SML. About 75% of all companies use CAPM in capital budgeting. Now we can estimate the cost of equity capital for a firm. We need: Risk Free Rate Market Risk Premium Company Beta 3

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Example Microsoft has a Beta of .99. It is 100% equity financed; that is, it has no debt. Microsoft is considering a new project that has a risk profile similar to its other projects; therefore its beta for the new project is the same as its overall beta. If the risk free rate is 2% and the market risk premium is 5.4%, what is the appropriate discount rate for the new project? 4 Note: (R m -R f ) = 5.4%
Project Evaluation and Beta Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21. The market risk premium is 9.5% and the risk free rate is 5%. We calculate the expected return on the common stock by using the SML formula. 5% + (1.21 x 9.5%) = 16.495% Because Alpha is expected to return 16.495% on its stock, Alpha should use this as its discount rate. Alpha is evaluating the non-mutually exclusive projects on the next slide. 5

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Evaluate Each project costs \$100 and all projects have the same risk as the firm as a whole. Do we accept or reject the projects? Project Project Beta Project’s expected cash flow next year Project’s IRR Project’s NPV when CF are discounted by 16.495% Accept or Reject A 1.21 \$140 40% \$20.2 B 1.21 \$120 20% \$3.0 C 1.21 \$110 10% \$ -5.6 6
The Risk Free Rate Most firms use the rate on a US Treasury Bill or Bond as the risk-free rate. Firms often match the length of the project to the length of maturity of the bond that they use to determine the risk-free rate.

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