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,KeyConceptsandSkills,Knowhowtodetermine afirm,s costof equity capital,Understand the impact ofbeta indeterminingthefirmscostofequity capital,Knowhowtodetermine the firmsoverallcost ofcapital,Understand how the liquidityofa firmsstock affects its costof capital,ChapterOutline,12.1TheCost ofEquityCapital,12.2Estimationof Beta,12.3Determinants ofBeta,12.4Extensionsof the BasicModel,12.5 Estimating Eastman ChemicalsCost ofCapital,12.6 Reducingthe Cost of Capital,Where Do We Stand?,Earlierchapters on capitalbudgeting focused onthe appropriate sizeand timing ofcash flows.,This chapter discusses the appropriate discount rate when cashflows are risky.,Investin project,12.1 The Costof Equity Capital,Firm withexcess cash,ShareholdersTerminal Value,Pay cash dividend,Shareholder invests in financial asset,Becausestockholderscan reinvest the dividend inriskyfinancial assets,theexpected return on acapital-budgeting project should be at least asgreat as the expectedreturnon a financial assetof comparablerisk.,A firmwith excess cash caneitherpay a dividend,or,make acapitalinvestment,The Cost of Equity Capital,From the firms perspective,the expectedreturnis theCost ofEquityCapital:,To estimate afirmscost ofequitycapital,we need toknow three things:,The risk-freerate,R,F,The market risk premium,The company beta,Example,Supposethe stock ofStansfield Enterprises,a publisherof PowerPointpresentations,has abeta of 2.5.The firm is 100%equity financed.,Assumea risk-free rate of 5%and amarketrisk premiumof 10%.,What isthe appropriate discount rate foran expansion of thisfirm?,Example,SupposeStansfield Enterprises is evaluating thefollowing independentprojects.Each costs$100 and 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,Using the SML,An all-equityfirm should accept projectswhose IRRs exceed thecost of equity capital andrejectprojects whoseIRRs fall short of the costof capital.,Project,IRR,Firmsrisk(beta),5%,Good project,Bad project,30%,2.5,A,B,C,12.2 Estimation of Beta,MarketPortfolio,-Portfolio ofall assets inthe economy.In practice,abroadstock market index,such asthe S&PComposite,isused to,represent,the market.,Beta,-Sensitivityof a stocks return to the return on the market portfolio.,Estimation ofBeta,Problems,Betas may varyover time.,The sample size may be inadequate.,Betas are influencedby changing financialleverage andbusiness risk.,Solutions,Problems 1 and2 canbe moderated by moresophisticatedstatistical techniques.,Problem3 canbe lessened byadjusting forchanges in businessand financialrisk.,Look ataverage betaestimates of comparable firms in the industry.,Stability of Beta,Most analystsargue that betas aregenerally stable forfirms remaining in the sameindustry.,That isnot tosay that a firms beta cannot change.,Changesin product line,Changesin technology,Deregulation,Changesin financialleverage,Using an Industry Beta,It is frequently argued thatone can better estimate a firms beta byinvolving thewhole industry.,If youbelievethat the operationsof thefirm are similar to the operationsof therest ofthe industry,you should use the industrybeta.,If youbelievethat the operationsof thefirm are fundamentally different from theoperations ofthe rest of the industry,you should use the firm,s beta.,Do notforgetabout adjustments forfinancial leverage.,12.3 Determinants ofBeta,Business Risk,Cyclicality ofRevenues,Operating Leverage,Financial Risk,Financial Leverage,Cyclicality ofRevenues,Highlycyclical stocks havehigherbetas.,Empirical evidence suggeststhat retailersand automotive firmsfluctuate with the businesscycle.,Transportationfirmsand utilitiesare less dependent upon thebusiness cycle.,Note that cyclicalityis notthe same as variabilitystocks with highstandard deviations need nothave high betas.,Movie studioshave revenuesthat are variable,dependingupon whetherthey produce“hits”or“flops,”buttheirrevenues may not be especially dependent upon thebusiness cycle.,OperatingLeverage,Thedegreeofoperatingleveragemeasureshowsensitiveafirm(orproject)istoitsfixedcosts.,Operatingleverageincreasesasfixedcostsriseandvariablecostsfall.,Operatingleveragemagnifiestheeffectofcyclicalityonbeta.,Thedegreeofoperatingleverageisgivenby:,DOL,=,EBIT,D,Sales,Sales,D,EBIT,OperatingLeverage,Sales,$,Fixedcosts,Totalcosts,EBIT,Sales,Operatingleverageincreasesasfixedcostsriseandvariablecostsfall.,Fixed costs,Total costs,FinancialLeverageandBeta,Operatingleverage,referstothesensitivitytothefirmsfixedcostsof,production,.,Financialleverage,isthesensitivitytoafirm,sfixedcostsof,financing,.,Therelationshipbetweenthebetasofthefirm,sdebt,equity,andassetsisgivenby:,Financialleveragealwaysincreasestheequitybetarelativetotheassetbeta.,b,Asset,=,Debt+Equity,Debt,b,Debt,+,Debt+Equity,Equity,b,Equity,Exampl