Lecture15_winter09

Lecture15_winter09 - CAPITAL STRUCTURE AND COST OF CAPITAL...

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CAPITAL STRUCTURE AND COST OF CAPITAL
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CAPITAL STRUCTURE AND COST OF CAPITAL The CAPM will be used to measure the appropriate discount rate of the Cash Flows of a Project and the risk of the Company. The former will be used to Value the Projects the Firm is considering investing in and the latter to evaluate the Stock of the Firm.
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CAPITAL STRUCTURE AND COST OF CAPITAL The CAPM was used to evaluate Assets in a diversified portfolio The money retained by the Firm to invest in a Project could have been distributed as dividends and invested in a stock with the same systematic risk as the project
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CAPITAL STRUCTURE AND COST OF CAPITAL So, the risk that only matters for valuation is the systematic risk of the project. If the all the projects the firm is involved in are not well diversified, that is not important for the investors, because they can diversify the risk with other assets or projects in other firms.
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CAPITAL STRUCTURE AND COST OF CAPITAL So, the appropriate discount rate for a project needs to follow: It is incorrect to use an unique reference discount rate to evaluate projects. Each project must the valued considering its own systematic risk. f M project f project R R E R R
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CAPITAL STRUCTURE AND COST OF CAPITAL This part of the class relies on a simple equilibrium: The return generated by the projects must the equal to the return demanded by the investors in the firm.
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