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Unformatted text preview: 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 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: risk-adjusted 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 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) > 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 companys other assets 2. A useful starting point for setting discounting rates for unusually risky or safe projects. It can be easier to estimate projects 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 Shareholders 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. Cost of Equity Capital: r S = r f + 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 risk-free 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 =- $100 ) Project Projects Beta C 1 IRR NPV Decision X 1.6 122 22% Y 1.6 115 15% What if theres another project (say Z ) with C 1 = 124 and projects beta 2?...
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This note was uploaded on 01/04/2012 for the course ACTSC 372 taught by Professor Maryhardy during the Fall '09 term at Waterloo.
- Fall '09