Chap012(WW-FIN357T)N - Chapter 12 Risk Cost of Capital Capital Budgeting Chapter Outline 12.1 The Cost of Equity Capital 12.2 Estimation of Beta

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Chapter 12 Risk, Cost of Capital, & Capital Budgeting
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12-2 Chapter Outline 12.1 The Cost of Equity Capital 12.2 Estimation of Beta 12.3 Determinants of Beta 12.4 Extensions of the Basic Model 12.5 Estimating IP’s Cost of Capital
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12-3 Key Concepts and Skills Know how to determine a firm’s cost of equity capital Understand the impact of beta in determining the firm’s cost of equity capital Know how to determine the firm’s overall cost of capital
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12-4 Amount, Timing, and  Risk Earlier chapters on capital budgeting focused on the appropriate amount and timing of cash flows. This chapter discusses the appropriate discount rate when cash flows are risky.
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12-5 Amount, Timing, and  Risk ? Because 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.
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12-6 Invest in project 12.1 The Cost of Equity Capital Firm with excess cash Shareholder’s Terminal Value Pay cash dividend Shareholder invests in financial asset A firm with excess cash can either pay a dividend or m ake a capital investment
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12-7 The Cost of Equity From the firm’s perspective, the expected return is the Cost of Equity Capital: ) ( F M i F i R R β R R - + = To estimate a firm’s cost of equity capital, we need to know: 1. The risk-free rate, R F F M R R - 1. The market risk premium, 2 , ) ( ) , ( M M i M M i i σ σ R Var R R Cov β = = 1. The company beta,
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12-8 Example Suppose the stock of Stansfield Enterprises has a beta of 2.5. The firm is 100% equity financed. If the risk-free rate is 5% and the market risk premium is 10%, what is the correct discount rate for an expansion of this firm? ) ( F M i F R R β R R - + = % 10 5 . 2 % 5 × + = R % 30 = R
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12-9 Example (continued) Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects. Each costs $100 and lasts one year. Project Project β Project’s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B 2.5 $130 30% $0 C 2.5 $110 10% -$15.38
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12-10 Risk-Adj. Discount Rate for Projects An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital . Project IRR Firm’s risk (beta) SML 5% Good project Bad project 30% 2.5 A B C
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12-11 12.2 Estimation of Beta Theoretically, the calculation of beta is straightforward: 2 , ) ( ) , ( M M i M M i σ σ R Var R R Cov β = = Potential problems 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk.
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12.2 Estimation of Beta Potential Solutions Problems 1 and 2 can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for
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This note was uploaded on 05/10/2008 for the course FIN 357 taught by Professor Hadaway during the Spring '06 term at University of Texas at Austin.

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Chap012(WW-FIN357T)N - Chapter 12 Risk Cost of Capital Capital Budgeting Chapter Outline 12.1 The Cost of Equity Capital 12.2 Estimation of Beta

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