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Chapter 13

Chapter 13 Notes

Course Code
Derek Chau

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Chapter 13 Risk, Return, and Capital Budgeting Notes
cost of equity, rS required return on the company’s common stock in capital markets; it is also called equity holders’ required
rate of return because it is what equity holders can expect to obtain in a capital market; it is a cost from a firm’s perspective
13.1 The Cost of Equity Capital
whenever a firm has extra cash it can take one of two actions—it can pay out the cash immediately as a dividend or the firm can
invest extra cash in a project, paying out the future cash flows of the project as dividends
the project should be undertaken only if its expected return is greater than of a financial asset of comparable risk
13.2 Estimation of Beta
beta of a security i = Cov (Ri, RM) / Var (RM) = σi,M / σ2M
in words, the beta is the covariance of a security with the market, divided by the variance of the market
13.3 Determinants of Beta
if the firm is not traded on an exchange because it is a subsidiary of a larger firm or too small to be listed, examining these
characteristics may be the best way to estimate beta: the cyclical nature of revenues, operating leverage, and financial leverage
Cyclicality of Revenues
revenues of some firms are quite cyclical; that is, these firms do well in expansion phase and do poorly in contraction phase
high-tech firms, retailers, and mining firms fluctuate with cycle; firms in industries such as utilities and food are less dependent
since beta is standardized covariability of stock’s return with market’s return, highly cyclical stocks have high betas
stocks with high standard deviations need not have high betas
Operating Leverage
operating leverage degree to which firm’s costs of operation are fixed as opposed to variable; firm with high operating costs,
when compared to firm with low operating leverage, has fairly larger changes in EBIT with respect to change in sales revenue
business risk depends both on responsiveness of the firm’s revenues to the business cycle and on the firm’s operating leverage
those projects whose revenues appear strongly cyclical and whose operating leverage appears high are likely to have high betas
conversely, weak cyclicality and low operating leverage imply low betas
Financial Leverage and Beta
operating leverage refers to the firm’s fixed costs of production
financial leverage is the extent to which a firm relies on debt
because levered firm must make interest payments regardless of sales, financial leverage refers to firm’s fixed costs of finance
equity beta systematic risk of a firm’s stock decomposed into contributions of risk from assets and financial leverage
asset beta the beta of the assets of the firm
the asset beta may also be thought of as the beta of the common stock if the firm has been financed with equity only
βPortfolio = βAsset = (Debt / Debt + Equity) × βDebt + (Equity / Debt + Equity) × βEquity where βEquity is beta of equity of levered firm
because the portfolio is the levered firm, the beta of the portfolio is equal to the beta of the levered firm
13.4 Extensions of the Basic Model
weighted average cost of capital (rWACC) the average cost of capital on the firm’s existing projects and activities; the weighted
average cost of capital for the firm is calculated by weighting the cost of each source of funds by its proportion of the total
market value of the firm; it is calculated on a before- and after-tax basis
13.7 Summary and Conclusions
1. A firm with excess cash can either pay a dividend or make a capital expenditure. Because shareholders 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.
2. The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The
appropriate procedure employs regression analysis on historical returns.
3. We considered the case of a project whose beta risk was equal to that of the firm. If the firm its unlevered, the discount rate on
the project is equal to RF + β × (RM – RF) where RM is the expected return on the market portfolio and RF is the risk-free rate. In
words, the discount rate on the project is equal to the CAPM’s estimate of the expected return on the security.
4. If the project’s beta differs from that of the firm, the discount rate should be based on the project’s beta. The project’s beta can
sometimes be estimated by determining the average beta of the project’s industry.
5. The beta of a company is a function of a number of factors. Perhaps the three most important are: cyclicality of revenues,
operating leverage, and financial leverage.
6. Sometimes one should not use the average beta of the project’s industry as an estimate of the beta of the project. In this case, one
can estimate the project’s beta by considering the project’s cyclicality of revenues and its operating leverage. This approach is
qualitative in nature.
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