Chapter 13(1).ppt

# Chapter 13(1).ppt - CHAPTER 13 Risk Cost of Capital and...

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Risk, Cost of Capital, and Valuation CORPORATE FINANCE 1 (Prof. GOHAR G. STEPANYAN) CHAPTER 13 CHAPTER 13

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Chapter Outline Chapter Outline 13.1 The Cost of Capital 13.2 Estimating the Cost of Equity Capital with the CAPM 13.3 Estimation of Beta 13.4 Determinants of Beta 13.5 The Dividend Discount Model Approach 13.6 Cost of Capital for Divisions and Projects 13.7 The Weighted Average Cost of Capital 13.8 Valuation with R WACC 13.9 Estimating Bombardier’s Cost of Capital 2
What is the appropriate discount rate at which cash flows of risky projects and firms are to be discounted? The discount rate of a project should be the expected return on a financial asset of comparable risk. Also called: o Required return o Cost of capital What’s the Big Idea? What’s the Big Idea? 3

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Invest in project Firm with excess cash Shareholder’s Terminal Value Pay cash dividend Shareholder invests in financial asset 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. A firm with excess cash can either pay a dividend or make a capital investment 13.1 The Cost of Equity 13.1 The Cost of Equity Capital Capital 4
From the firm’s perspective, the expected return is the Cost of Equity Capital: ) ( F M i F i R R β R R 1. The risk-free rate, R F F M R R 2. The market risk premium, 2 , ) ( ) , ( M M i M M i i σ σ R Var R R Cov β 3. The company beta, 13.2 Cost of Equity with 13.2 Cost of Equity with CAPM CAPM To estimate a firm’s cost of equity capital, we need to know three things: 5

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Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for an expansion of this firm? % 10 5 . 2 % 5 R % 30 R The Cost of Equity: The Cost of Equity: Example Example ) ( F M i F i R R β R R 6
Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects. Each costs \$100 and lasts one year. Project Project 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 Example (cont’d) Example (cont’d) 7

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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 projects Bad projects 30% 2.5 A B C Using the SML to Estimate Using the SML to Estimate the Risk-Adjusted Discount the Risk-Adjusted Discount Rate for Projects Rate for Projects 8
Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P 500 index, is used to represent the market.

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• Fall '16
• Jose Alexandre

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