# Chapter 12 - Chapter 12 Risk, Return, and Capital Budgeting...

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Chapter 12 Risk, Return, and Capital Budgeting

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12.1 The Cost of Equity Capital For safe projects, calculate Net-Present-Value as: NPV = For risky projects: NPV = Where: Ct = project cash flows in period t = expected project cash flows in period t r = cost of capital = + + T t t r t C C f 1 1 0 ( 29 = + + T t t r t C C 1 1 0 t C
Big Question : What is the correct discount rate (r) to calculate NPV? All Equity Case- Assume the company only uses equity finance If project has same risk as firm’s existing assets  cost of capital = expected return on firm’s stock How do we calculate expected return on a firm’s stock? - CAPM Expected return = Risk free return + Risk premium r  rf + (rM  rf)

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To calculate expected return we need: (1) risk free rate (rf) this reflects the pure time value of money- reward for waiting for your money without any risk (2) market risk premium (rM  rf) this reflects the reward the market offers for bearing an average amount of systematic risk (3) beta for firm’s stock () this reflects the amount of systematic risk a firm has relative to the average
Example - All equity firm: Firm considers an expansion plan that will double its size. What is the appropriate discount rate? -risk-free rate = 7% -estimated beta on firm’s stock = 1.3 -estimated market risk premium = 8.5% Answer: rE= 7 + 1.3 x 8.5 = 18.05% Key assumptions: 1. beta of new project is the same as the beta of the company 2. firm is entirely equity financed.

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12.2 Estimation of Beta Recall : What is the  of a risk-free asset? Example: Given the following data, estimate the  of General Tool ) ( ) , ( M r Var M r i r Cov i = β Year General Tool, R GT M 1 -10% -40% 2 3 -30 3 20 10 4 15 20
Calculation of Beta: Year Rate of Return on General Tool

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## This note was uploaded on 10/17/2011 for the course ECON 101 taught by Professor Thompson during the Spring '11 term at Michigan State University.

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Chapter 12 - Chapter 12 Risk, Return, and Capital Budgeting...

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