Chapter 13
Risk, Return and Capital Budgeting
Lecture Notes for Actsc 372  Fall 2011
Ken Seng Tan
Department of Statistics and Actuarial Science
University of Waterloo
K.S. Tan/Actsc 372 F11
Chapter 13Risk, Return and Capital Budgeting – p. 1/28
Introduction
Recall (actsc 371):
Net Present Value:
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 F11
Chapter 13Risk, Return and Capital Budgeting – p. 2/28
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:
riskadjusted discounting rate
company cost of capital
the role of SML and capital budgeting
capital structure (levered vs unlevered firm)
flotation cost
Throughout the chapter, we assume CAPM
K.S. Tan/Actsc 372 F11
Chapter 13Risk, Return and Capital Budgeting – p. 3/28
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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 cutoff 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 F11
Chapter 13Risk, Return and Capital Budgeting – p. 4/28
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 capitalbudgeting project should be at least as
great as the expected return on a financial asset of comparable risk.
Cost of Equity Capital:
r
S
=
r
f
+
β
S
(
r
M

r
f
)
above assumes CAPM (with slight change in notation)
K.S. Tan/Actsc 372 F11
Chapter 13Risk, Return and Capital Budgeting – p. 5/28
Example
Suppose the stock of ABC has a beta of 1.6. The firm is 100% equity
financed. Given
riskfree rate
5%
, and
(expected) market risk premium
10%
.
What is the appropriate discounting rate for an expansion of this firm?
Evaluate the following independent projects (
C
0
=

$100
)
Project
Project’s Beta
C
1
IRR
NPV
Decision
X
1.6
122
22%
Y
1.6
115
15%
What if there’s another project (say
Z
) with
C
1
= 124
and project’s
beta 2?
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 Fall '09
 MARYHARDY
 ModiglianiMiller theorem, Weighted average cost of capital, Equity Capital

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