10-8a[1].- Risk, Cost of Capital, and Capital Budgeting

10-8a[1].- Risk, Cost of Capital, and Capital Budgeting -...

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Ramesh Rao 1 Risk , Cost of Capital, and Capital Budgeting
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Ramesh Rao 2 The Cost of Capital and the Discount Rate for Capital Budgeting What is the discount rate for evaluating the NPV of a project that is of similar risk (i.e., just “scale enhancing”)? Broad Answers: If firm has only equity (i.e., it is unlevered) use its cost of equity capital, r s , as the discount rate. In this case, r s =r o . If firm has both equity and debt (i.e., it is levered) use the overall cost of capital, the WACC as the discount rate.
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Ramesh Rao 3 Structure of Ideas A. The Cost of Equity Capital Why does it exist? How do you estimate this? Estimation of Beta Determinants of Beta Financial Leverage and Beta B. Cost of Debt Capital C. The WACC D. Security Liquidity and the Cost of Capital
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Ramesh Rao 4 A. Cost of Equity : Why is there a cost? 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 m ake a capital investment
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Ramesh Rao 5 Implications of this Idea? A project’s cost of capital depends on the use to which the capital is being put—not the source. Depends on how it is used not who is using it The cost of capital for a project is project- specific and not firm-specific. Cost may vary from project to project within same firm It depends on the risk of the project and not the risk of the company .
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Ramesh Rao 6 Estimating Components of Cost of Equity Capital Cost of Equity CAPM APT Dividend Discount Model
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Ramesh Rao 7 The Cost of Equity: CAPM ) ( F M i F i R R β R R - + = 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, From the firm’s perspective, the expected return is the Cost of Equity Capital: To estimate a firm’s cost of equity capital, we need to know :
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8 Estimating beta for an all equity firm Returns for the past 5 years on Douglas Stock and NYSE Index are as follows: Douglas NYSE -0.05 -0.12 0.05 0.01 0.08 0.06 0.15 0.10 0.10 0.15 a. What are average returns on Douglas Stock and on the market? b. Compute beta of Douglas Stock
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This note was uploaded on 01/15/2010 for the course FIN 357 taught by Professor Hadaway during the Fall '06 term at University of Texas at Austin.

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10-8a[1].- Risk, Cost of Capital, and Capital Budgeting -...

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