BADM 7090 IIIC 2011 - Capital Investment Decisions (The Effect of Risk)

BADM 7090 IIIC 2011 - Capital Investment Decisions (The Effect of Risk)

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BADM 7090 Financial Management Unit III.C Capital Investment Decisions: The Effect of Risk Text material: GSM, Ch. 9 D. Chance
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 2 of 25 Questions How do companies determine the appropriate discount rate to use for investing in assets with risk, in particular risk that differs from the risk of their existing assets? How are discount rates based on risk used to discount cash flows from an investment?
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 3 of 25 The Supply of Capital and the Generation of Returns Creditors Shareholders Funds invested in assets Assets Funds invested in assets Assets generate cash P r i n c p a l d t e s D iv id fu in v te fo tu it l g
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 4 of 25 The Supply of Capital and the Generation of Returns (cont.) To justify lending money to the company, creditors require and expect a rate of return, often called the required rate of return on debt or the cost of debt . To justify investing in the company, shareholders require and expect a rate of return, often called the required rate of return on equity or the cost of equity . Note that if the assets generate a positive NPV, the shareholders will get not only their required returns but an extra or abnormal return. Both sets of returns are also sometimes referred to as expected returns , because they are the returns these suppliers of capital expect in to justify their commitment of funds to an investment involving risk.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 5 of 25 The Cost of Capital It should be apparent that the assets must generate a rate of return sufficient to pay the required/expected returns for the suppliers of capital. This overall required or expected return on assets is also referred to as the cost of capital because it represents the return the assets must produce to cover the costs of debt and equity.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 6 of 25 The Cost of Capital (cont.) First assume that the shareholders are responsible for no debt. Then the cost of capital is just the cost of equity.
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Version: 1/3/11 D. Chance – BADM 7090 – Unit IIIC p. 7 of 25 The Cost of Capital (cont.) What is the cost of capital when companies use debt? A weighted average of the costs of debt and
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This note was uploaded on 02/28/2012 for the course BADM 7090 taught by Professor Staff during the Fall '08 term at LSU.

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BADM 7090 IIIC 2011 - Capital Investment Decisions (The Effect of Risk)

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