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1、12-0,CHAPTER,12,Risk, Cost of Capital, and Capital Budgeting,12-1,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 a
2、nd Conclusions,12-2,Whats 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.,12-3,12.1 The Cost of Equity Capital,Firm with excess cash,Shareholders Terminal Val
3、ue,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
4、dividend or make a capital investment,12-4,The Cost of Equity,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, RF,The market risk premium,The company beta,12-5,Example,Suppose t
5、he 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?,12-6,Example (co
6、ntinued),Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects. Each costs $100 and lasts one year.,12-7,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
7、 and reject projects whose IRRs fall short of the cost of capital.,Project IRR,Firms risk (beta),5%,Good project,Bad project,12-8,12.2 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&P Composit
8、e, is used to represent the market.Beta - Sensitivity of a stocks return to the return on the market portfolio.,12-9,12.2 Estimation of Beta,Theoretically, the calculation of beta is straightforward:Problems Betas may vary over time. The sample size may be inadequate. Betas are influenced by changin
9、g 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. Look at average beta estimates of comparable firms in the industry.,12-10,Stabi
10、lity of Beta,Most analysts argue that betas are generally stable for firms remaining in the same industry. Thats not to say that a firms beta cant change. Changes in product line Changes in technology Deregulation Changes in financial leverage,12-11,Using an Industry Beta,It is frequently argued tha
11、t 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 oper
12、ations of the rest of the industry, you should use the firms beta. Dont forget about adjustments for financial leverage.,12-12,12.3 Determinants of Beta,Business Risk Cyclicity of Revenues Operating Leverage Financial Risk Financial Leverage,12-13,Cyclicality of Revenues,Highly cyclical stocks have
13、high betas. Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle. Transportation firms and utilities are less dependent upon the business cycle. Note that cyclicality is not the same as variabilitystocks with high standard deviations need not have high be
14、tas. Movie studios have revenues that are variable, depending upon whether they produce “hits” or “flops”, but their revenues are not especially dependent upon the business cycle.,12-14,Operating Leverage,The degree of operating leverage measures how sensitive a firm (or project) is to its fixed cos
15、ts. Operating leverage increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicity on beta. The degree of operating leverage is given by:,12-15,Operating Leverage,Volume,$,Fixed costs,Total costs, EBIT, Volume,Operating leverage increases as fixed cost
16、s rise and variable costs fall.,12-16,Financial Leverage and Beta,Operating leverage refers to the sensitivity to the firms fixed costs of production. Financial leverage is the sensitivity of a firms fixed costs of financing. The relationship between the betas of the firms debt, equity, and assets is given by:Financial leverage always increases the equity beta relative to the asset beta.,12-17,When Debt0,12-18,Financial Leverage and Beta: Example,
