ECO359S-3 - ECO359 Lecture 3 Risk and Capital Budgeting Ata...

Info iconThis preview shows pages 1–9. Sign up to view the full content.

View Full Document Right Arrow Icon
1 ECO359 – Lecture 3 Risk and Capital Budgeting Ata Mazaheri
Background image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
2 Lecture Outline Objective: Capital Budgeting Long Term Finance
Background image of page 2
3 Invest in project The Cost of Equity Capital 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
Background image of page 3

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
4 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 three things: 1. The risk-free rate, r F F M r r - 2. The market risk premium 2 , ) ( ) , ( : ta company Be The 3. M i M M i M r Var r r Cov σ =
Background image of page 4
5 Using the SML to Estimate the Risk- Adjusted 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 projects Bad projects 30% 2.5 A B C
Background image of page 5

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
6 Using an Industry Beta Theoretically, the calculation of beta is straightforward…in practice, finding a company’s beta with good accuracy may be complicated It is frequently argued that one can better estimate a firm’s beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firm’s beta. Don’t forget about adjustments for financial leverage.
Background image of page 6
7 Cyclicality of Revenues and Beta Highly cyclical stocks have high betas. Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle. Transportation firms and utilities are less dependent upon the business cycle. Note that cyclicality is not the same as variability — stocks with high standard deviations need not have high betas . Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops,” but their revenues are not especially dependent upon the business cycle.
Background image of page 7

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
Operating Leverage and Beta The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs. Operating leverage increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicity on beta. The degree of operating leverage is given by:
Background image of page 8
Image of page 9
This is the end of the preview. Sign up to access the rest of the document.

Page1 / 39

ECO359S-3 - ECO359 Lecture 3 Risk and Capital Budgeting Ata...

This preview shows document pages 1 - 9. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online