# 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 ( β ) to measure systematic risk • What does beta tell us? • β = 1 - the asset has the same systematic risk as the overall market • β < 1 - the asset has less systematic risk than the overall market • β > 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 ß = 1 ß = 0 ß > 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 + β asset ( E ( R market )- R f ) | {z } risk premium • If we know an asset’s 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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