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RSM333 lecture2

# RSM333 lecture2 - Risk Return and capital budgeting Outline...

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Risk, Return and capital budgeting 2 Outline I. The correct discount rate II. The beta coefficient III. Project vs. company beta IV. Operational and financial leverage

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How do we find the discount rate? 1 Sabrina Buti, Rotman School of Management, RSM 333 s Suppose that we are considering a project that costs \$1,000 today, lasts for 3 years and has expected cash flows of \$100 in year 1, \$400 in year 2, and \$800 in year 3. s We know that the NPV is: NPV = -1,000 + \$100/(1+r) + \$400/(1+r) 2 + \$800/(1+r) 3 Once we know r, we can compute the NPV. Before we just assumed r was given, but in reality we have to estimate it!!! The CAPM can provide the required rate of return that the project needs to yield, based on its beta, to be acceptable to investors.
CAPM: Relationship between Risk and Expected Return 2 Sabrina Buti, Rotman School of Management, RSM 333 s Expected Return on the Market: s Expected return on an individual security: Market Risk Premium M F R r = + β ( ) i M F i F R r R r = + × - Expected return on a security = Risk-free rate + Beta of the security × Market risk premium

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The Security Market Line 3 Sabrina Buti, Rotman School of Management, RSM 333 β F r 1.0 M R Security Market Line (SML) ) ( F M i F i r R β r R - + = Expected return
Risk, return and capital budgeting 4 Sabrina Buti, Rotman School of Management, RSM 333 s From the firm’s perspective, the expected return is the cost of equity capital. s To estimate a firm’s cost of equity capital, we need to know three things ) ( F M i F i r R β r R - + = s The risk-free rate: F M r R - s The market risk premium: 2 , ) var( ) , cov( M M i M M i i σ σ R R R β = = s The company beta: F r

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5 Sabrina Buti, Rotman School of Management, RSM 333 Example: Using the CAPM to estimate the risk adjusted discount-rate for projects s Suppose the stock of firm A has a beta of 2.5. The firm is 100% equity financed. s Assume a risk-free rate of 5% and a market risk premium of 10%. s What is the appropriate discount rate for an expansion of this firm? % 10 5 . 2 % 5 × + = R % 30 = R ) ( F M i F i r R β r R - + =
Sabrina Buti, Rotman School of Management, RSM 333 6 s An all-equity firm should – Accept a project when its IRR exceeds the cost of equity capital – Reject a project when its IRR falls short of the cost of capital Project IRR Firm’s risk ( β ) 5% Good projects Bad projects 30% 2.5 A B C SML Example: Using the CAPM to estimate the risk adjusted discount-rate for projects

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Sabrina Buti, Rotman School of Management, RSM 333 7 Example 2 You consider a project that is in the same risk class as previous operations of the firm: β =1.5. The initial investment is \$60,000 and the payoff is \$15,000 each year for 7 years
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RSM333 lecture2 - Risk Return and capital budgeting Outline...

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