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1、Chapter Outline,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 Papers Cost of Capital 12.6 Reducing the Cost of Capital 12.7 Summary and Conclusions,Whats the Big Idea?,Earlier chapters on capital bud
2、geting focused on the appropriate size and timing of cash flows. This chapter discusses the appropriate discount rate when cash flows are risky.,12.1 The Cost of Equity Capital,Firm withexcess cash,Shareholders Terminal Value,Shareholder invests in financial asset,Because stockholders can reinvest t
3、he 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,From the firms persp
4、ective, 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, RF,The market risk premium,The company beta,Example,Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a bet
5、a 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
6、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.,Project IRR,Firms risk (beta)
7、,5%,Good projects,Bad projects,12.2 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 S the market risk premium is 10% and the firms beta is 1.3. 17% = 4% + 1.3 14% 4% This is a breakdown of the co
8、mpanys investment projects:,1/3 Automotive retailer b = 2.0 1/3 Computer Hard Drive Mfr. b = 1.3 1/3 Electric Utility b = 0.6,average b of assets = 1.3,When evaluating a new electrical generation investment, which cost of capital should be used?,Capital Budgeting the risk free rate is 8% and the mar
9、ket risk premium is 9.2%. Thus the cost of equity capital is,12.5 Estimating IPs Cost of Capital,The yield on the companys debt is 8% and the firm is in the 37% marginal tax rate. The debt to value ratio is 32%,12.18 percent is Internationals cost of capital. It should be used to discount any projec
10、t where one believes that the projects risk is equal to the risk of the firm as a whole, and the project has the same leverage as the firm as a whole.,12.6 Reducing the Cost of Capital,What is Liquidity? Liquidity, Expected Returns and the Cost of Capital Liquidity and Adverse Selection What the Cor
11、poration Can Do,What is Liquidity?,The idea that the expected return on a stock and the firms cost of capital are positively related to risk is fundamental. Recently a number of academics have argued that the expected return on a stock and the firms cost of capital are negatively related to the liqu
12、idity of the firms shares as well. The trading costs of holding a firms shares include brokerage fees, the bid-ask spread and market impact costs.,Liquidity, Expected Returns and the Cost of Capital,The cost of trading an illiquid stock reduces the total return that an investor receives. Investors t
13、hus will demand a high expected return when investing in stocks with high trading costs. This high expected return implies a high cost of capital to the firm.,Liquidity and the Cost of Capital,Cost of Capital,Liquidity,An increase in liquidity, i.e. a reduction in trading costs, lowers a firms cost
14、of capital.,Liquidity and Adverse Selection,There are a number of factors that determine the liquidity of a stock. One of these factors is adverse selection. This refers to the notion that traders with better information can take advantage of specialists and other traders who have less information.
15、The greater the heterogeneity of information, the wider the bid-ask spreads, and the higher the required return on equity.,What the Corporation Can Do,The corporation has an incentive to lower trading costs since this would result in a lower cost of capital. A stock split would increase the liquidit
16、y of the shares. A stock split would also reduce the adverse selection costs thereby lowering bid-ask spreads. This idea is a new one and empirical evidence is not yet in.,What the Corporation Can Do,Companies can also facilitate stock purchases through the Internet. Direct stock purchase plans and dividend reinvestment plans handles on-line allow small investors the opportunity to buy securities cheaply. The companies can also disclose more information. Especially to security analysts, to narro
