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1、Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,McGraw-Hill/Irwin,Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.,Click here for title,12-,*,Chapter Outline,12.1,The Cost of Equity Capital,12.2 Estimation of Beta,12.3 Determinants of Beta,12.4

2、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 budgeting focused on the appropriate size and timing of cash flows.,This chapter discusses the appropriate

3、 discount rate when cash flows are risky.,Invest in project,12.1,The Cost of Equity Capital,Firm withexcess cash,Shareholders Terminal Value,Pay cash dividend,Shareholder invests in financial asset,Because stockholders can reinvest the dividend in risky financial assets,the expected return on a capi

4、tal-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 m,ake a capital investment,The Cost of Equity,From the firms perspective,the expected return is the Cost of Equity Capital:,To estima

5、te a firms cost of equity capital,we need to know three things:,The risk-free rate,R,F,The market risk premium,The company beta,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 ra

6、te 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.,Project,Project,b,Projects Es

7、timated 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 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,fal

8、l short of the cost of capital.,Project,IRR,Firms risk(beta),5%,Good projects,Bad projects,30%,2.5,A,B,C,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 Composite,is used to,represent,the ma

9、rket.,Beta,-Sensitivity of a stocks return to the return on the market portfolio.,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 changing financial leverage and business r

10、isk.,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.,Stability of Beta,Most analysts argue that betas

11、 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,Using an Industry Beta,It is frequently argued that one can better estimate a firms beta by involvi

12、ng 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 operations of the rest of the industry,you should use

13、the firms beta.,Dont forget about adjustments for financial leverage.,12.3,Determinants of Beta,Business Risk,Cyclicity,of Revenues,Operating Leverage,Financial Risk,Financial Leverage,Cyclicality,of Revenues,Highly cyclical stocks have high betas.,Empirical evidence suggests that retailers and auto

14、motive 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 betas,.,Movie studios have revenues that are variable,depending u

15、pon whether they produce“hits”or“flops”,but their revenues are not especially dependent upon the business cycle.,Operating Leverage,The degree of operating leverage measures how sensitive a firm(or project)is to its fixed costs.,Operating leverage increases as fixed costs rise and variable costs fal

16、l.,Operating leverage magnifies the effect of,cyclicity,on beta.,The degree of operating leverage is given by:,Operating Leverage,Volume,$,Fixed costs,Total costs,EBIT,Volume,Operating leverage increases as fixed costs rise and variable costs fall.,Fixed costs,Total costs,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