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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,*,*,*,13-,*,Risk,Cost of Capital,and Capital Budgeting,Chapter 13,Copyright 2021 by the McGraw-Hill Companies,Inc.All rights reserved.,McGraw-Hill/Irwin,Key Concepts and Skills,Know how to determine a firms cost of equity capital,Understand the impact of beta in determining the firms cost of equity capital,Know how to determine the firms overall cost of capital,Understand the impact of flotation costs on capital budgeting,Chapter Outline,13.1 The Cost of Equity Capital,13.2 Estimating the Cost of Equity Capital with the CAPM,13.3 Estimation of Beta,13.4 Beta,Covariance and Correlation,13.5Determinants of Beta,13.6Dividend Discount Model,13.7Cost of Capital for Divisions and Projects,13.8Cost of Fixed Income Securities,13.9The Weighted Average Cost of Capital,13.10Estimating Eastman Chemicals Cost of Capital,13.11Flotation Costs and the Weighted Average Cost of Capital,Where Do We Stand?,Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows.,This chapter discusses the appropriate discount rate when cash flows are risky.,Invest in project,13.1 The Cost of Equity Capital,Firm withexcess cash,Shareholders Terminal Value,Pay cash dividend,Shareholder invests in financial asset,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.,A firm with excess cash can either pay a dividend,or,make a capital investment,The Cost of Equity Capital,From the firms perspective,the expected return is the Cost of Equity Capital:,To estimate a firms cost of equity capital,we need to know three things:,The risk-free rate,R,F,The market risk premium,The company beta,Example,Suppose the stock of Stansfield Enterprises,a publisher of PowerPoint presentations,has a beta of 2.5.The firm is 100%equity financed.,Assume a risk-free rate of 5%and a market risk premium of 10%.,What is the appropriate discount rate for an expansion of this firm?,Example,Suppose Stansfield Enterprises is evaluating the following independent projects.Each costs$100 and lasts one year.,Project,Project,b,Projects Estimated Cash Flows Next Year,IRR,NPV at 30%,A,2.5,$150,50%,$15.38,B,2.5,$130,30%,$0,C,2.5,$110,10%,-$15.38,Using the SML,An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.,Project,IRR,Firms risk(beta),5%,Good project,Bad project,30%,2.5,A,B,C,The Risk-free Rate,Treasury securities are close proxies for the risk-free rate.,The CAPM is a period model.However,projects are long-lived.So,average period(short-term)rates need to be used.,The historic premium of long-term(20-year)rates over short-term rates for government securities is 2%.,So,the risk-free rate to be used in the CAPM could be estimated as 2%below the prevailing rate on 20-year treasury securities.,The Market Risk Premium,Method 1:Use historical data,Method 2:Use the Dividend Discount Model,Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis,13.3 Estimation of Beta,Market Portfolio,-Portfolio of all assets in the economy.In practice,a broad stock market index,such as the S&P 500,is used to,represent,the market.,Beta,-Sensitivity of a stocks return to the return on the market portfolio.,Estimation of Beta,Problems,Betas may vary over time.,The sample size may be inadequate.,Betas are influenced by changing financial leverage and business risk.,Solutions,Problems 1 and 2 can be moderated by more sophisticated statistical techniques.,Problem 3 can be lessened by adjusting for changes in business and financial risk.,Look at average beta estimates of comparable firms in the industry.,Stability of Beta,Most analysts argue that betas are generally stable for firms remaining in the same industry.,That is not to say that a firms beta cannot change.,Changes in product line,Changes in technology,Deregulation,Changes in financial leverage,Using an Industry Beta,It is frequently argued that one can better estimate a firms beta by involving the whole industry.,If you believe that the operations of the firm are similar to the operations of the rest of the industry,you should use the industry beta.,If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry,you should use the firms beta.,Do not forget about adjustments for financial leverage.,13.4 Beta,Covariance and Correlation,Beta is qualitatively similar to the covariance since the denominator(market variance)is a constant.,Beta and correlation are related,but different.It is possible that a stock could be highly correlated to the market,but it could have a low beta if its deviation were relatively small.,13.5 Determinants of Beta,Busin
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