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Chapter 13

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Wilfrid Laurier University
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BU393 Chapter 13 – Risk, Return, and Capital Budgeting Week 3 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 discount rate of a project should be the expected return on a financial asset of comparable risk -The expected return is the cost of equity capital -To estimate a firm’s cost of capital, we need: -The risk-free rate -The market risk premium -The company beta Determinants of Beta -The beta of a stock is determined by the characteristics of the firm -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 -We consider: -Cyclicality of revenues -Operating leverage -Financial leverage Cyclicality of Revenues -Some firms do well in the expansion phase of the business cycle and poorly in the contraction phase -Stocks with high standard deviations need not have high betas Operating Leverage -The difference between variable costs and fixed costs allows us to define operating leverage -The cyclicality of a firm’s revenues is a determinant of the firm’s beta -Operating leverage magnifies the effect of cyclicality on beta -Those projects whose revenues appear strongly cyclical and whose operating leverage appears high are likely to have high betas -Refers to the firm’s fixed costs of production Financial Leverage -The extent to which a firm relies on debt -A firm has an equity beta, as well as an asset beta -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 beta of debt is very low in practice -The equity beta will always be greater than the asset beta with financial leverage Extensions of the Basic Model -The risk of a project differs from that of the firm, while keeping the all-equity assumption -If a project’s beta differs from that of the firm, the project should be discounted at the rate commensurate with its own beta -The beta of a new project may be greater than the beta of existing firms in the same industry because the very newness of the project likely increases its responsiveness to economy wide movements -A new project may constitute its own industry The Cost of Debt BU393 Chapter 13 – Risk, Return, and Capital Budgeting Week 3 -The cost of debt
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