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Chapter 12 Risk, Cost of capital and capital budgeting

# Chapter 12 Risk, Cost of capital and capital budgeting -...

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Chapter 12 Risk, Cost of Capital, and Capital Budgeting 12.1 The Cost of Equity Capital The discount rate of a project should be the expected return on a financial asset of comparable risk Stated differently, we use a financial security with the same risk as our project as a benchmark in order to evaluate our project If we get a higher return (positive NPV) we accept the project discount rate used to determine the NPV of a risky project can be computed from the CAPM (or APT) Ř = R F + β(Ř M - R F ) Two assumptions: (1) Beta risk of new projects is same as risk of firm; (2) firm is all- equity financed Firms cost of capital: P = s N s s r Div r Div r Div + + + + + + 1 ....... 1 1 2 1 r s = required return of shareholders and firm’s cost of equity capital Diagonal line represents relationship between cost of equity capital and firm’s beta. All-equity firm should accept projects whose internal rate of return is > than cost of equity capital 12.2 Estimation of Beta Beta of security j = ) ( ) , ( M M i R Var R R Cov = 2 , M m i σ Beta is covariance of a security with market, divided by variance of the market. 1. Calculate average return on each asset 2. calculate deviations from their average returns 3. multiply deviation of the market with the deviations of the security (= cov) 4. calculate the squared deviation of the market return’s (= var) 5. Divide sum of 3 by sum of 4 Problems with betas Betas may vary over time Sample size may be inadequate Betas are influenced by changing financial leverage and business risk Real-World Betas 1 SML Accept region Reject region NPV < 0 Firm’s risk (beta) Project internal rate of return (%)

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Chapter 12 Risk, Cost of Capital, and Capital Budgeting Slope of characteristic line is beta, an estimation using above technique (= regression) Plot security return (y-axis) against the market return (x-axis) data being used determines the accuracy of beta → suspect when too few observations are used → since firms may change their industry over time, observations from the distant past are out-of-date Stability of Beta
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Chapter 12 Risk, Cost of capital and capital budgeting -...

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