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lecture2_finance302

# lecture2_finance302 - Lecture Notes Part II Finance 302...

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Lecture Notes: Part II Finance 302 Spring 2011 Betas, Capital Budgeting and Risk: Chapter 9 (Note: We will not be covering section 9-4) Topics: WACC Asset β When you can (can’t) use the WACC as a discount rate in capital budgeting. A firm’s value can be stated as the sum of the value of the assets; PV of cash flows that accrue (sooner or later) to bondholders and stockholders. I.e.: Firm value = PV of cash flows assets produce for security holders (debt, PS, CS) Example of projects of differing risk: 10% nology known tech t, improvemen Cost COC) (Company 15% business existing of Expansion 20% products New 30% Ventures e Speculativ Rate Discount Category What would happen if we used the WACC to evaluate ALL projects (both high and low risk)? Company Cost of Capital (COC) is based on the average beta of the assets (or their assets AVERAGE market risk). The average beta of the assets is based on the % of Market Value of each asset Example 1/3 New Ventures β =2.0 1/3 Expand existing business β =1.3 1/3 Plant efficiency β =0.6 AVG β of assets = 1.3 1 A company’s cost of capital can be compared to the CAPM required return (SML)

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MARKET RISK VS. BUSINESS RISK: Two Examples R 2 = .27 β = 1.61 Compute the proportion of Dell’s variance due to market risk if the total variance of Dell Computer Company (annualized) is 720. Compute the proportion of Dell’s variance due to business risk. Can we reject the hypothesis that Dell’s stock has less market risk than average? 2 Company Cost of Capital (using the SML) Required return Project Beta 1.26 Company Cost of Capital 13 5.5 0 SML
Compute the Standard Error of the BETA for GM. Can we reasonably reject the hypothesis that GM’s beta is negative? Compute Campbell Soup’s beta using the most recent 5 years of monthly data. Compute the amount of variance due to market risk and the amount of variance due to business risk. Is “0” within a 95% confidence interval of Campbell Soup’s beta? Compute Campbell Soup’s beta and a 95% confidence interval for the beta the most recent 1-year of daily data. 3

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Issue: How stable is beta? What we really want is the beta in the future period for which we are trying to predict returns. Can we estimate the future expected beta using past data ? Evidence of Beta Stability: Chart in text: percentage of stocks in same risk category 5-years later. Notes: What to do if equity beta is not stable. (How would we know this? When would this be an issue for a firm manager?): The Weighted Average Cost of Capital: WACC: for a firm with only bonds (D) & common stock (E): (1-T c )D/(D+E) r D + E/(D+E) r E r is the rate of return on new issues of debt (equity) Query: The WACC measures required rate for projects of: a) All risks b) Average risk c) Some risk (not riskless) Why does the WACC use the after-tax cost of debt?
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