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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,CostofCapital,andCapitalBudgeting,KeyConceptsandSkills,Knowhowtodetermineafirm,scostofequitycapital,Understandtheimpactofbetaindeterminingthefirm,scostofequitycapital,Knowhowtodeterminethefirm,soverallcostofcapital,Understandhowtheliquidityofafirm,sstockaffectsitscostofcapital,ChapterOutline,12.1TheCostofEquityCapital,12.2EstimationofBeta,12.3DeterminantsofBeta,12.4ExtensionsoftheBasicModel,12.5EstimatingEastmanChemical,sCostofCapital,12.6ReducingtheCostofCapital,WhereDoWeStand?,Earlierchaptersoncapitalbudgetingfocusedontheappropriatesizeandtimingofcashflows.,Thischapterdiscussestheappropriatediscountratewhencashflowsarerisky.,Investinproject,12.1TheCostofEquityCapital,Firmwithexcesscash,Shareholder,sTerminalValue,Paycashdividend,Shareholderinvestsinfinancialasset,Becausestockholderscanreinvestthedividendinriskyfinancialassets,theexpectedreturnonacapital-budgetingprojectshouldbeatleastasgreatastheexpectedreturnonafinancialassetofcomparablerisk.,Afirmwithexcesscashcaneitherpayadividend,or,makeacapitalinvestment,TheCostofEquityCapital,Fromthefirm,sperspective,theexpectedreturnistheCostofEquityCapital:,Toestimateafirm,scostofequitycapital,weneedtoknowthreethings:,Therisk-freerate,R,F,The market risk premium,The company beta,Example,SupposethestockofStansfieldEnterprises,apublisherofPowerPointpresentations,hasabetaof2.5.Thefirmis100%equityfinanced.,Assumearisk-freerateof5%andamarketriskpremiumof10%.,Whatistheappropriatediscountrateforanexpansionofthisfirm?,Example,SupposeStansfieldEnterprisesisevaluatingthefollowingindependentprojects.Eachcosts$100andlastsoneyear.,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,UsingtheSML,Anall-equityfirmshouldacceptprojectswhoseIRRsexceedthecostofequitycapitalandrejectprojectswhoseIRRsfallshortofthecostofcapital.,Project,IRR,Firm,srisk(beta),5%,Goodproject,Badproject,30%,2.5,A,B,C,12.2EstimationofBeta,MarketPortfolio,-Portfolioofallassetsintheeconomy.Inpractice,abroadstockmarketindex,suchastheS&PComposite,isusedto,represent,themarket.,Beta,-Sensitivity of astock,sreturntothe returnonthemarket portfolio.,Estimation of Beta,Problems,Betasmayvaryover time.,Thesample sizemay be inadequate.,Betasareinfluencedbychangingfinancialleverageand business risk.,Solutions,Problems1 and2 canbemoderatedbymoresophisticated statistical techniques.,Problem 3can be lessened by adjustingforchangesinbusinessandfinancial risk.,Look at averagebetaestimatesofcomparablefirmsintheindustry.,StabilityofBeta,Most analysts argue thatbetasare generallystablefor firms remaininginthesameindustry.,That is nottosaythata firm,sbeta cannotchange.,Changes in productline,Changes in technology,Deregulation,Changes in financialleverage,UsinganIndustryBeta,Itisfrequently arguedthat onecanbetter estimate afirms betabyinvolving thewholeindustry.,Ifyoubelievethat theoperations of thefirm aresimilar to theoperations of therest of theindustry,you shouldusethe industry beta.,Ifyoubelievethat theoperations of thefirm arefundamentally differentfrom theoperations of therest of theindustry,you shouldusethe firm,sbeta.,Donotforget about adjustments forfinancialleverage.,12.3 DeterminantsofBeta,BusinessRisk,CyclicalityofRevenues,OperatingLeverage,FinancialRisk,FinancialLeverage,CyclicalityofRevenues,Highlycyclicalstocks havehigher betas.,Empiricalevidencesuggeststhatretailersand automotivefirmsfluctuate withthe business cycle.,Transportationfirmsandutilities areless dependentupon thebusinesscycle.,Note thatcyclicalityisnot thesame as variabilitystockswith highstandarddeviationsneed nothave highbetas.,Moviestudios haverevenuesthatarevariable,dependingupon whethertheyproduce“hits”or,“,“flops,”buttheirrevenuesmay notbeespecially dependentupon thebusinesscycle.,OperatingLeverage,Thedegree of operatingleveragemeasureshowsensitive afirm(orproject)istoits fixed costs.,Operatingleverageincreases as fixed costs riseand variable costs fall.,Operatingleveragemagnifies theeffectofcyclicalityonbeta.,Thedegree of operatingleverageisgivenby:,DOL,=,EBIT,D,Sales,Sales,D,EBIT,OperatingLeverage,Sales,$,Fixedcosts,Totalcosts,EBIT,Sales,Operatingleverageincreases as fixed costs riseand variable costs fall.,Fixed costs,Total costs,FinancialLeverageand Beta,Operatingleverage,referstothe sensitivity to thefirmsfixedcostsof,production,.,Financialleverage,isthesensitivitytoafirmsfixedcostsof,financing,.,Therelationship betweenthe betas of thefirmsdebt,equity,andassets is given by:,Financialleveragealways increasestheequity betarelativetothe asset beta.,b,Asset,=,Debt+Equity,Debt,b,Debt,+,Debt+Equity,Equity,b,Equity,Example,ConsiderGrandSport,Inc.,whichiscurrently all-equityfinancedand hasa betaof0.90.,Thefirmhasdecidedtoleveruptoa capitalstructure of 1partdebt to 1partequity.,Sincethefirmwill remaininthesameindustry,its asset betashould remai
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