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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,Slide,*,Risk,Cost of Capital,and Capital Budgeting,Key Conceptsand Skills,Know how todetermine afirmscostof equity capital,Understand the impact ofbetain determining thefirms costof equity capital,Know how todetermine the firm,s overall cost ofcapital,Understand how theliquidity of a firms stock affectsits cost ofcapital,Chapter Outline,12.1 The Cost of EquityCapital,12.2 Estimation ofBeta,12.3 Determinantsof Beta,12.4 Extensions ofthe Basic Model,12.5 Estimating EastmanChemicals Cost ofCapital,12.6 Reducing theCost of Capital,WhereDo WeStand?,Earlier chapters on capital budgeting focused onthe appropriate size and timing ofcash flows.,This chapterdiscusses the appropriate discountrate when cash flows arerisky.,Investin project,12.1 The Cost of EquityCapital,Firm withexcess cash,Shareholders Terminal Value,Pay cash dividend,Shareholderinvests in financial asset,Because stockholders canreinvest the dividend in risky financialassets,theexpected return ona capital-budgeting project shouldbe atleastas great asthe expectedreturn on afinancial asset of comparablerisk.,A firmwithexcesscashcan either pay a dividend,or,make acapital investment,The Cost ofEquityCapital,From the firms perspective,the expectedreturnis the Costof Equity Capital:,To estimatea firm,s cost of equitycapital,weneed to knowthreethings:,The risk-free rate,R,F,The market risk premium,The company beta,Example,Suppose thestockof Stansfield Enterprises,a publisher ofPowerPoint presentations,hasa betaof 2.5.Thefirmis 100%equity financed.,Assumea risk-freerateof 5%and amarketriskpremium of 10%.,What is theappropriatediscount rate foran expansionof this firm?,Example,Suppose StansfieldEnterprisesis evaluating thefollowing independent projects.Each costs$100and 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,Usingthe SML,An all-equity firmshould accept projectswhoseIRRs exceedthe cost ofequitycapital andreject projects whose IRRs fall short ofthe cost ofcapital.,Project,IRR,Firmsrisk(beta),5%,Good project,Bad project,30%,2.5,A,B,C,12.2 Estimation ofBeta,MarketPortfolio,-Portfolioof allassets in the economy.In practice,a broad stock market index,such asthe S&P Composite,is used to,represent,the market.,Beta,-Sensitivity of astock,s return tothe returnon themarket portfolio.,Estimation of Beta,Problems,Betasmay vary over time.,The sample size may be inadequate.,Betasare influenced bychanging financialleverage and business risk.,Solutions,Problems 1 and 2 can bemoderated bymoresophisticated statistical techniques.,Problem 3 can be lessened by adjusting forchanges inbusiness andfinancial risk.,Look at average beta estimatesof comparable firms inthe industry.,Stability ofBeta,Most analysts argue thatbetasare generally stable for firms remainingin thesameindustry.,That is notto saythata firm,s beta cannot change.,Changes in productline,Changes in technology,Deregulation,Changes in financial leverage,Usingan IndustryBeta,It isfrequently arguedthat one canbetter estimate afirms betaby involving thewholeindustry.,If youbelieve that theoperations of thefirm are similar to theoperations of therest of theindustry,you should usethe industry beta.,If youbelieve that theoperations of thefirm are fundamentally different from theoperations of therest of theindustry,you should usethe firmsbeta.,Do not forget aboutadjustments forfinancialleverage.,12.3Determinants ofBeta,Business Risk,Cyclicality ofRevenues,OperatingLeverage,FinancialRisk,FinancialLeverage,Cyclicality ofRevenues,Highly cyclicalstocks have higherbetas.,Empiricalevidence suggests that retailers and automotive firms fluctuate with the business cycle.,Transportationfirmsandutilitiesare less dependent upon the business cycle.,Notethatcyclicality isnot the same asvariabilitystockswithhighstandard deviationsneednot have high betas.,Moviestudios have revenues that are variable,depending upon whethertheyproduce“hits”or“flops,”,”buttheir revenuesmaynot be especially dependent upon the businesscycle.,OperatingLeverage,The degreeof operating leverage measures howsensitivea firm(or project)is to itsfixed costs.,Operatingleverage increases as fixed costs rise and variable costs fall.,Operatingleverage magnifies the effectof cyclicalityon beta.,The degreeof operating leverage isgiven by:,DOL,=,EBIT,D,Sales,Sales,D,EBIT,OperatingLeverage,Sales,$,Fixedcosts,Totalcosts,EBIT,Sales,Operatingleverage increases as fixed costs rise and variable costs fall.,Fixed costs,Total costs,FinancialLeverage and Beta,Operatingleverage,refers tothe sensitivityto the firmsfixedcosts of,production,.,Financialleverage,is the sensitivity to a firmsfixed costs of,financing,.,The relationship betweenthe betasof the firms debt,equity,and assets is given by:,Financialleverage alwaysincreasestheequity beta relativeto the asset bet
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