Capital Budgeting and Risk.pptVIP

Topics Covered Company and Project Costs of Capital Measuring the Cost of Equity Setting Discount Rates w/o Beta Certainty Equivalents Discount Rates for International Projects Company Cost of Capital A firm’s value can be stated as the sum of the value of its various assets Company Cost of Capital Company Cost of Capital A company’s cost of capital can be compared to the CAPM required return Measuring Betas The SML shows the relationship between return and risk CAPM uses Beta as a proxy for risk Other methods can be employed to determine the slope of the SML and thus Beta Regression analysis can be used to find Beta Measuring Betas The actual estimate of beta is derived by regressing the firm’s rate of return on the return for the market. That is, a line is fitted to the rates of return on the market and the firm Measuring Betas Total Risk = Market Risk + Unique Risk 1 = R2 + (1-R2) R-squared indicates how much of the total variance of the dependent variable (the firm’s rate of return) is explained by the regression model. The portion of the variability explained by the regression is an estimate of how much of the variance in a firm’s stock return is explained by systematic risk. (1 -R-squared) is the portion of the variance of the firm’s return explained by unique risk. Measuring Betas Measuring Betas Measuring Betas Measuring Betas Measuring Betas Measuring Betas Estimated Betas Beta Stability Company Cost of Capitalsimple approach Company Cost of Capital (COC) is based on the average beta of the assets The average Beta of the assets is based on the % of funds in each asset Company Cost of Capitalsimple approach Company Cost of Capital (COC) is based on the average beta of the assets The average Beta of the assets is based on the % of funds in each asset Example 1/3 New Ventures Beta=2.0 1/3 Expand existing business Beta=1.3 1/3 Plant efficiency Beta=0.6 AVG Beta of assets = 1.3 Capital Structure Capital Structure - the mix