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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 94)
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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View Full Document 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 1year of daily data.
3
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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 5years 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):
(1T
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 aftertax
cost of debt?
Notes:
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This document was uploaded on 10/26/2011 for the course FIN 302 at Miami University.
 Spring '11
 KellyBrunarski
 Finance

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