3Risk and Return5 - Risk and Return Capital Budgeting...

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Unformatted text preview: Risk and Return Capital Budgeting Decision Invest in projects that add value to the firm Value projects using cash flows, reflecting the timing and magnitude of cash flows and all side effects Discount cash flows using a discount rate that reflects the risk of the project and cost of capital Opportunity Cost of Capital Up to now, we have assumed some required rate of return, or opportunity cost of capital, for each project we have analyzed Now, we need to figure out where this actually comes from for each project By the end of the next two lectures, we will understand how the risk of the project and the cost of capital determine the opportunity cost of capital for the firm Our Path to Learning about the Opportunity Cost of Capital Capital is composed of Equity Liabilities Outline General structure of required rate of return Stocks Bonds What return do you require? Suppose you have $1000. You have two alternatives: Spend $1000 now Invest the $1000 in Coca-Cola stock We can think of at least three reasons that you would want to expect to get more than $1000 back (in other words, a positive required return) from the investment in Coca-Cola stock Inflation: cash in the future has less purchasing power than current cash Preferences(Impatience): people typically prefer current consumption to future consumption Risk(Uncertainty): the investment in the stock is risky, you may get back less than $1000 Your investment in Coca-Cola If you are investing in Coca-Cola, you still require returns because of your preferences for current consumption and inflation expectations Current Treasury Bond prices tell us that the combination of these is currently about 3% per year over the next five years In addition to this, you require a risk premium on your investment, since you may lose money on the investment This definition of risk is loose; well develop a better concept of risk Risk The return on any investment Investor preferences over risk Risk-averse: risk implies required return Risk-neutral: risk implies required return Risk-seeking: risk implies required return premium) risk ( + = riskload r r f i Proxies for the Risk-Free Rate Most of the time, we use US Treasury securities as our proxy of risk-free assets They are widely considered to have negligible default risk Short maturity bonds have little interest rate risk But, most of the Treasury securities offer nominal rates The bonds still carry inflation risk To the extent that inflation differs from inflation expectations at the time of purchase, the securities will not be risk free Inflation-Indexed securities still have some basis risk since the CPI is not a perfect measure of inflation Inflation and Preferences US Nominal Treasury Bonds US Inflation Indexed Treasury Bonds 5-year 2.489% 1.04% 10-year 3.41% 1.64% 30-year 4.081% 1.99%1....
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This note was uploaded on 09/22/2011 for the course FINANCE 117 taught by Professor Tingtingque during the Summer '11 term at University of Iowa.

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3Risk and Return5 - Risk and Return Capital Budgeting...

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