Risk, Cost of Capital and Capital BudgetingChapter 12.ppt

Risk, Cost of Capital and Capital BudgetingChapter 12 12.1 The Cost of Equity Capital 12.2 Estimation of Beta 12.3 Determinants of Beta 12.4 Extensions of the Basic Model 12.5 Estimating International Paper’s Cost of Capital 12.6 Reducing the Cost of Capital 12.7 Summary and Conclusions What’s the Big Idea? 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. The Cost of Equity Capital The Cost of Equity From the firm’s perspective, the expected return is the Cost of Equity Capital: Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100-percent equity financed. Assume a risk-free rate of 5-percent and a market risk premium of 10-percent. What is the appropriate discount rate for an expansion of this firm? Example (continued) Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects. Each costs $100 and lasts one year. Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects An all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. Estimation of Beta: Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the SP Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio. Estimation of Beta Theoretically, the calculation of beta is straightforward: Beta Estimation, continued. 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 (above) can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for changes in business and financial risk