principlesofcorporatefinancechap009

1、chapter 9risk and the cost of capitalmcgraw-hill/irwinprinciples of corporate financetopics covered company and project costs of capital measuring the cost of equity analyzing project risk certainty equivalentsreviews valuing bonds or debts ytm and interest rate valuing stock capm assets=debts+equit

2、y the order of profit appropriation debtors vs shareholders costs of capital debt vs equity, which one has a high level of risk? company cost of capital company cost of capital: expected return on a portfolio of all the companys existing securities. opportunity cost of capital for investment in a fi

3、rm a firms value can be stated as the sum of the value of its various assetspv(b)pv(a)pv(ab) valuefirmcompany cost of capital a companys cost of capital can be compared to the capm required return the constant cost of capital a company holds requires the company to invest in high risk projectsrequir

4、edreturnproject beta0.5company cost of capital3.80.20smllow risk projectshigh risk projectsimportante, d, and v are all market values of equity, debt and total firm valueequity of valuemarket debt of valuemarket ededv veequityvddebtassetsrrcocr)(bondson ytmfmfequitydebtrrbrrrcompany cost of capitalw

5、eighted average cost of capital wacc is the traditional view of capital structure, risk and return. veevddcrrtwacc)1 (tax reduction of the cost of capitalq: as debt has a tax reduction of the corporate cost of capital, does it mean the more debt the lower the corporate cost of capital is?capital str

6、ucture how a firm finance its overall operation using debt, equity or the mix of debt & equity.expand capm to include cs r = rf + ( rm - rf )becomesrequity = rf + ( rm - rf ) capital structure and equity costmeasuring betas the sml shows the relationship between return and risk capm uses beta as a p

7、roxy for risk other methods can be employed to determine the slope of the sml and thus beta regression analysis can be used to find betameasuring betasreturn of amazonreturn of amazonmeasuring betasreturn of disneyreturn of disneymeasuring betasreturn of compbellreturn of compbellestimated betasimpl

8、ication of a corporate stock would change over time ytm of long-term treasuries as risk-free rate is higher than that of short-term bill risk premium of long-term bond is higher than that short-term bill estimation error of of a corporate stock is larger than that of an industrial portfolio represen

9、ts systematic risk but not unique risk practically, could be smaller than 0 and even larger than 1 r2 represents the extent to which the estimated y is not biased.company cost of capitalcompany cost of capital (coc) is based on the average beta of the assetsthe average beta of the assets is based on

10、 the % of funds in each assetassets = debt + equity bassetsbdebtdvbequityevbeta (rm-rf) in capmhow volatile the underlying business iscapital structure & cocexpected return (%)debtassetsequityrrdebt=8rassets=12.2requity=15expected returns and betas prior to refinancingcompany cost of capital (coc) i

11、s based on the average beta of the assetsthe average beta of the assets is based on the % of funds in each assetexample1/3 new ventures b=2.01/3 expand existing business b=1.31/3 plant efficiency b=0.6weighted avg b of assets = 1.3company cost of capitalsimple approachasset betas what influences ass

12、et beta of a firm? economic cyclicality high beta: highly correlated with economy operating leverage: the degree to which a firm/project incurs a combination of fixed costs and variable costs fixed cost: a cost that does not change with an increase or decrease in the amount of goods or services prod

13、uced. variable cost: a corporate expense that varies with production outputpv(asset)cost) pv(fixed1b pv(asset)cost) epv(variabl- )pv(revenuebbrevenuerevenueasset brevenue bfixed costpv(fixed cost)pv(revenue) bvariable costpv(variable cost)pv(revenue)bassetpv(asset)pv(revenue)operating leverageasset

14、beta operating leverage: is a multiplier of the degree to which the fixed costs of a firm/project can generate profitability of sales degree of operating leverage (dol)=(revenue-variable costs)/profitsthe higher dol is, the greater the potential danger from forecasting risk. high operating leverage

15、is companied with high beta of assets/projectasset beta unique risk should not influence the cost of capital r subjective fudge factors should be avoid when assessing the cost of capital rallowing for possible bad outcomesexampleproject z will produce just one cash flow, forecasted at $1 million at

16、year 1. it is regarded as average risk, suitable for discounting at a 10% company cost of capital: pvc11r1,000,0001.1$909,100allowing for possible bad outcomesexample- continuedbut now you discover that the companys engineers are behind schedule in developing the technology required for the project.

17、 they are confident it will work, but they admit to a small chance that it will not. you still see the most likely outcome as $1 million, but you also see some chance that project z will generate zero cash flow next year.allowing for possible bad outcomesexample- continuedthis might describe the ini

18、tial prospects of project z. but if technological uncertainty introduces a 10% chance of a zero cash flow, the unbiased forecast could drop to $900,000. pv900,0001.1 $818,000avoid fudge factorfudge factor makes the pv of long-term projects reduced morethe deduction of pv with 22% is larger than 10%r

19、isk,dcf and ceqrisk,dcf and ceqtftttrceqrcpv)1 ()1 (certainty equivalent: a guaranteed return that someone would accept, rather than taking a chance on a higher, but uncertain, return.it is used to assess whether taking risky decision with a higherpotential payoff is better off the risk-free decisio

20、nunder a given value.risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the pv of the project?risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of t

21、hree years. given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the pv of the project? rrfb(rmrf) 6.75(8)12%risk-adjusted risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free rate of 6%, a market premium of 8%, an

22、d beta of .75, what is the pv of the project?%12)8(75.6)(fmfrrbrr240.2 pvtotal71.2100379.7100289.3100112% pv flowcashyearaproject risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free rate of 6%, a market premium of 8%, and beta of .75, what

23、 is the pv of the project?%12)8(75.6)(fmfrrbrr240.2 pvtotal71.2100379.7100289.3100112% pv flowcashyearaproject now assume that the cash flows change, but are risk free. what is the new pv?risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free

24、 rate of 6%, a market premium of 8%, and beta of .75, what is the pv of the project? now assume that the cash flows change, but are risk free. what is the new pv?240.2 pvtotal71.284.8379.789.6289.394.616% pv flowcashyearproject b240.2 pvtotal71.2100379.7100289.3100112% pv flowcashyearaproject risk,d

25、cf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the pv of the project? now assume that the cash flows change, but are risk free. what is the new pv?240.2 pvtotal71.284.8379.789.628

26、9.394.616% pv flowcashyearproject b240.2 pvtotal71.2100379.7100289.3100112% pv flowcashyearaproject since the 94.6 is risk free, we call it a certainty equivalent of the 100.risk,dcf and ceqexampleproject a is expected to produce cf = $100 mil for each of three years. given a risk free rate of 6%, a market premium of 8%, and beta of .75, what is the pv of the project? deduction for risk15.284.8100310.489.610025.494.61001riskfor deduction