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# chapter_13 - Chapter 13 Risk Return and Capital Budgeting...

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Chapter 13 Risk, Return, and Capital Budgeting Lecture Notes for Actsc 372 - Fall 2008 Ken Seng Tan Department of Statistics and Actuarial Science University of Waterloo K.S. Tan/Actsc 372 F08 Chapter 13Risk, Return, and Capital Budgeting – p. 1/35 Introduction Recall (actsc 371): NPV ( r ) = t 0 C t (1 + r ) t C t denotes the forecasted cash flow at time t Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows. r is the opportunity cost of capital (OCC) the relevant “discounting" rate should commensurate with the riskiness of the project main topic of this chapter! K.S. Tan/Actsc 372 F08 Chapter 13Risk, Return, and Capital Budgeting – p. 2/35 Outline How to determine the appropriate discounting rate that reflects the riskiness of the project? How do we evaluate (and compare) projects when their risks are different? Topics: risk-adjusted discounting rate company cost of capital the role of SML and capital budgeting capital structure (levered vs unlevered firm) liquidity Throughout the chapter, we assume CAPM K.S. Tan/Actsc 372 F08 Chapter 13Risk, Return, and Capital Budgeting – p. 3/35

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Capital Structure Capital Structure is the composition of a corporation’s securities used to finance its investment activities. also called financial structure Financing options: either through Debt Borrowings (e.g. issuing bonds), B or through Equity Market (e.g. issuing stocks), S Firm Value = V = B + S Asset Value a firm is said to be levered if B > 0 a firm is said to be unlevered if B = 0 (all-equity financed) The Company Cost of Capital is defined as the expected return on the portfolio of all the company’s existing securities r A K.S. Tan/Actsc 372 F08 Chapter 13Risk, Return, and Capital Budgeting – p. 4/35 Company Cost of Capital & Capital Budgeting Some companies treat the company cost of capital as the relevant OCC in capital budgeting Decision Rules: accept if NPV(Company Cost of Capital) > 0 r A is the cut-off rate (or hurdle rate) implicit assumption? Justification? 1. Most projects can be treated as average risk; i.e. no more or no less risky than the average of the company’s other assets 2. A useful starting point for setting discounting rates for unusually risky or safe projects. It can be easier to estimate project’s OCC relative to company cost of capital. How to determine the Company Cost of Capital? K.S. Tan/Actsc 372 F08 Chapter 13Risk, Return, and Capital Budgeting – p. 5/35 The Cost of Equity Capital Firm with Excess Cash Pay Dividend Invest in Project Shareholder invests in Financial Assets Shareholder’s Terminal Value Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk.
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