2504c_1122 - BUSI 2504c - Essentials of Business Finance...

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Unformatted text preview: BUSI 2504c - Essentials of Business Finance Monday, November 22, 2010 18:15-18:45 quiz #5 14 cost of capital chapter 13 - review: measuring systematic risk How do we measure systematic risk? We use the beta coefficient ( ) to measure systematic risk What does beta tell us? = 1 - the asset has the same systematic risk as the overall market < 1 - the asset has less systematic risk than the overall market > 1 - the asset has more systematic risk than the overall market BUSI 2504c Monday, November 22, 2010 2 / 42 chapter 13 - review: graphic representation of beta (fig 13.10, p.396) on company 20 10 10 BUSI 2504c Monday, November 22, 2010 3 / 42 chapter 13 - review: volatility (figure 13.7, p.388) E(R) Time = 1 = 0 > 1 BUSI 2504c Monday, November 22, 2010 4 / 42 chapter 13 - review: capital asset pricing model (capm) The capital asset pricing model defines the relationship between risk and return CAPM E ( R asset ) | {z } expected return = R f |{z} risk-free rate + asset ( E ( R market )- R f ) | {z } risk premium If we know an assets systematic risk, we can use the CAPM to determine its expected return This is true whether we are talking about financial assets or physical assets BUSI 2504c Monday, November 22, 2010 5 / 42 chapter 13 - review: capm - example The stock of Martin Industries has a beta of 1.43. The risk-free rate of return is 3.6% and the market risk premium is 9%. What is the expected rate of return on Martin Industries stock? answer : 16.5% BUSI 2504c Monday, November 22, 2010 6 / 42 chapter 14: weighted average cost of capital (wacc) 14.1 - Cost of Capital: Preliminaries 14.2 - Cost of Equity 14.3 - Costs of Debt and Preferred Stock 14.4 - Weighted Average Cost of Capital 14.6 - Flotation Costs and WACC BUSI 2504c Monday, November 22, 2010 7 / 42 14.1: why cost of capital is important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects BUSI 2504c Monday, November 22, 2010 8 / 42 14.1: required return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided BUSI 2504c Monday, November 22, 2010 9 / 42 14.2: cost of equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm There are two major methods for determining the cost of equity Dividend growth model (DGM) SML or CAPM BUSI 2504c Monday, November 22, 2010 10 / 42 14.2:14....
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2504c_1122 - BUSI 2504c - Essentials of Business Finance...

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