fin11b - Investing in Risky Projects (Continued) Econ 333...

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Econ 333 Spring 08 1 Investing in Risky Projects (Continued)
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Econ 333 Spring 08 2 Investing in Risky Projects Our goals: Estimate the cost of capital with the CAPM, APT and dividend discount models Learn how to implement the comparison approach with the risk-adjusted discount rate method and know its shortcomings Understand when to use comparison firms and when to use scenarios to obtain present values Learn how to discount expected future cash flows at a risk-adjusted rate and know when to discount the certainty equivalent at a risk-free rate Be able to identify the certainty equivalent of a risky cash flow, using equilibrium models, risk-free scenarios, and forward prices.
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Econ 333 Spring 08 3 Pitfalls in using the comparison method Project betas are not the same as firm betas Most firms use their own cost of capital discount rate for evaluating specific investment projects. In most cases using the firm’s cost of capital as the discount rate for a new project is inappropriate. For instance new projects may have higher beta risk than the firm’s mature projects (tend to occur when the project has more R&D investment in early years, more operating leverage, or more options associated to it). Growth opportunities are generally source of high betas. When a firm’s value is largely generated by its perceived ability to develop new profitable projects, i.e. growth opportunities, one must be cautious about using it as a comparison firm for a project, even one of its own. However, there is no rule of thumb for adjusting the risk of comparison firms for growth opportunities. Multiperiod risk-adjusted discount rates
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This note was uploaded on 05/21/2008 for the course ECON 3330 taught by Professor Mbiekop during the Spring '08 term at Cornell University (Engineering School).

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fin11b - Investing in Risky Projects (Continued) Econ 333...

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