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Unformatted text preview: 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: What would happen if we used the WACC to evaluate ALL projects (both high and low risk)?Answer: We would accept more high risk projects…they tend to produce higher cash flows, and would therefore be more likely to be + NPV. (Risky produces higher cfs. If we discounted all projects by same discount rate, the discount rate of firm over time would go up and up and up. Would be more likely to accept risker projects less likely to accept lower 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 10% nology known tech t, improvemen Cost COC) (Company 15% business existing of Expansion 20% products New 30% Ventures e Speculativ Rate Discount Category 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 2 • A company’s cost of capital can be compared to the CAPM required return (SML) Internal rate of return is what the project is expected to earn. Pick the projects earnings well relative to risk MARKET RISK VS. BUSINESS RISK: Two Examples Measuring beta due regression of stock returns on market returns. Want to compute beta it will be slope of regression line. You will feel more confident of regression line if they scatter plots are close to line. The more scattered they are the less confident you will be about your regression line. There are steps you can take to get a more reliable beta…(not going there today) Starting with CAPM equation: Ri= Rf +Bi(RmRf), computing this CAPM beta. = Rf+ BiRmBiRf =RfBiRf+BiRm =Rf(1Bi)+BiRm Y intercept = whatever is left that is being multiplied by what’s on x axis. Most people could care less what y intercept is. If beta equaled 1 you expect it to be 0. You could have neg or pos y intercept, you can not expect that Y intercept will be risk free rate. Points represent points in time. 3 Company Cost of Capital (using the SML) Required return Project Beta 1.26 Company Cost of Capital 13 5.5 SML R 2 = .27 (prop of variance explained by Xvaraible) β = 1.61 95% confidence interval= beta +/ (2* standard errors) Market risk: can determine how much. Compute measure of total risk....
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 Spring '11
 KellyBrunarski
 Finance, Net Present Value

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