A risky dollar is worth more than a riskless dollar Application of NPV to risky cash flows. Discount rate computed from CAPM or APT Value a risky project: determined required return (rS) using SML rS = Cost of equity capital When use both debt and equity use rWACC 1. Cost of Equity Capital: Pay dividend with cash or invest in a project paying out future CFs of project as divs. Which do stockholders prefer? If holder can reinvest div in a financial assets with the same risk as that of the project, the stockholders would desire the alternative with the highest expected return. Thus … Project only undertaken if expected return is greater than that of a financial asset of comparable risk. RULE: Discount rate of project should be the expected return of a financial asset of comparable risk. But choose the project with the highest return Determine rs on a project by using SML. Rs = Equity Cost of Capital. From firm’s perspective: Expeted return is cost of equity capital. Using CAPM Expected return = Rbar = Rf + Beta x (RbarM – Rf) Rf = Risk-free rate RbarM - Rf = Market Risk Premium Bi = Co. Beta EX. Beta = 1.3 risk-free rate = Rf = .05 RbarM – Rf = .084 (Market Risk Premium) ***100% Equity Fianced B/c new projects are similar to the firm’s existing ones, Avg Beta on new projs = existing Beta What is the appropriate discount rate? Should be rate of return for a comparable asset.
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