Chapter 11 Capital Budgeting and risk

Beta affects ke and that affects wacc radr adjusts

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Beta affects Ke and that affects WACC RADR adjusts for risk by varying the rate at which the expected net cash flows are discounted when determining a projects NPV Net cash flows for each project are discounted at a risk adjusted rate to obtain the NPV An individual project is discounted with a discount rate adjusted to reflect the project’s risk (ka) instead of discounting all projects with the average rate (WACC) ka=rf + risk premium Magnitude of ka depends on relationship between the total risk of the individ project and overall risk of firm Risk free rate - req rate of return assoc with investment projects characterized by certain cash flow streams Diff between risk free rate and firm’s req rate of return (cost of capital) is an average risk premium to compensate investors for the fact that the company’s assets are risky Cash flows from a project having greater than avg risk are discounted at a higher rate (ka) to reflect the increased riskiness Total project risk premiums applied to individ projects are commonly established subjectively Risk class approach leads to suboptimal decisions bc risk premiums themselves are usually determined subjectively and no explicit consideration is given to the variation in returns of the projects assigned to individ classes Most useful when evaluating relatively small projects that are repeated frequently A lot is known about project’s potential returns, prob not worth the effort to try to compute more precise risk premiums Calculate the NPV substituting ka for k What should be the risk premium? How can we make this adjustment without introducing subjectivity? Adjusting for Beta risk in Capital Budgeting We can apply the same “beta” concepts that were introduced in Chapter 8 Appropriate for a firm whose stock is widely traded and for which there is little chance of bankruptcy Systematic risk of firm is weighted avg of systematic risk of individ assets Use CAPM to compute approp risk premium to evaluate individ projects RADR for any project j = risk free rate + risk premium Applying CAPM: RADR for any project j = risk free rate + projects beta (expected market return - risk free rate) Therefore: Risk premium for a project = project’s beta x (expected
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market return - risk free rate) Req rate of return on the project = project’s equity return req and the debt return req for the funds expected to be used to finance the project Finding the asset beta (project’s systematic risk) Normally, we estimate beta for just the cost equity But stock returns are impacted by the amount of debt in the firm’s capital structure In other words, the equity of levered firms is riskier (all else equal) than is the equity of unlevered firms Estimated betas reflect both business and financial risk Thus, we need to adjust the estimated beta to reflect the firm’s leverage ratio, and
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