Internatinal Finance Management 【国际财务管理】Lecture 5 Cost of Capital.pptVIP

The Cost of Equity Capital 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 automotive 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 variability—stocks with high standard deviations need not have high betas. Movie studios have revenues that are variable, depending upon 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 fall. Operating leverage magnifies the effect of cyclicity on beta. The degree of operating leverage is given by: Operating leverage Consider two technology, technology has fixed cost of $1000/year, and variable cost of $8 per unit; technology B has fixed cost of $2000/year and variable cost of $6 per unit, compare their EBIT sensitivity to changes of sales Operating Leverage Financial Leverage and Beta Financial leverage is the sensitivity of a firm’s fixed costs of financing. The relationship between the betas of the firm’s debt, equity, and assets is given by: Financial Leverage and Beta: Example Assuming a zero beta for debt, following relation holds for equity beta and asset beta Consider Grand Sport, Inc., which is currently all-equity and has a beta of 0.90.The firm has decided to lever up to D/E as 1:1 Financial leverage always increases the equity beta relative to the asset beta. bAsset = Debt + Equity Debt × bDebt + Debt + Equity Equity × bEquity bEquity = 2 × 0.90 = 1.80 From Cost of Equity to Cost of Capital The cost of capital is a composite cost to the firm of raising financing to fund its projects. In ad