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# Finanças - PowerPoint PPT Presentation

Finanças. November 7. Topics covered. CAPM for cost of capital Estimation of beta. Risk and cost of capital. Previously: Determine the timing and the size of cash flows Now: determine the discount rate for risky cash flows The discount rate can be computed from the CAPM.

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### Finanças

November 7

QDai for FEUNL

• CAPM for cost of capital

• Estimation of beta

QDai for FEUNL

• Previously: Determine the timing and the size of cash flows

• Now: determine the discount rate for risky cash flows

• The discount rate can be computed from the CAPM

QDai for FEUNL

Invest in project

Choices of a firm with extra cash

Shareholder invests in financial asset

Firm withexcess cash

A firm with excess cash can either pay a dividend or make a capital investment

Shareholder’s Terminal Value

QDai for FEUNL

• The discount rate of a project

• The expected return

QDai for FEUNL

• Example

• Suppose the stock of a company has a beta of 2.5. The firm is 100-percent equity financed.

• Assume a risk-free rate of 5-percent and a market risk premium of 10-percent.

• What is the appropriate discount rate for an expansion of this firm?

QDai for FEUNL

Project b

Project’s Estimated Cash Flows Next Year

IRR

NPV at 30%

A

2.5

\$150

50%

\$15.38

B

2.5

\$130

30%

\$0

C

2.5

\$110

10%

-\$15.38

Example (continued)

Suppose the company is evaluating the following non-mutually exclusive projects. Each costs \$100 and lasts one year.

QDai for FEUNL

Project

IRR

5%

Firm’s risk (beta)

QDai for FEUNL

Estimation of beta for Projects

• Beta: Sensitivity of a stock’s return to the return on the market portfolio.

• Market Portfolio: Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market.

QDai for FEUNL

Stability of Beta for Projects

• Many analysts argue that betas are generally stable for firms remaining in the same industry.

• That’s not to say that a firm’s beta can’t change.

QDai for FEUNL

Using an Industry Beta for Projects

• It is frequently argued that one can better estimate a firm’s beta by involving the whole industry.

• If you believe that the operations of the firm are similar to the operations of the rest of the industry,

• If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry

QDai for FEUNL

Determinants of beta for Projects

• Cylicality of revenues

QDai for FEUNL

Determinants of beta for Projects

• Operating leverage

• how sensitive a firm is to its fixed costs.

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Operating Leverage for Projects

 EBIT

\$

 Volume

Volume

QDai for FEUNL

Determinants of beta for Projects

• Financial leverage

• Operating leverage

• Financial leverage

• The relationship between the betas of the firm’s debt, equity, and assets is given by:

• The beta of debt

QDai for FEUNL

Financial Leverage and Beta: Example for Projects

Consider a company which is currently all-equity and has a beta of 0.90. The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity. Since the firm will remain in the same industry, its asset beta should remain 0.90. However, assuming a zero beta for its debt, its equity beta would become:

QDai for FEUNL

Financial leverage and beta for Projects

• Conclusion

QDai for FEUNL

Extension of the basic model for Projects

• The firm vs the project

• The risk of a project

• The project should be discounted with

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r for Projectsf

bFIRM

The firm vs the project

A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.

Project IRR

Hurdle rate

Firm’s risk (beta)

QDai for FEUNL

The firm vs the project for Projects

Suppose the Conglomerate Company has a cost of capital, based on the CAPM, of 17%. The risk-free rate is 4%; the market risk premium is 10% and the firm’s beta is 1.3.

17% = 4% + 1.3 × [14% – 4%]

This is a breakdown of the company’s investment projects:

1/3 Automotive retailer b = 2.0

1/3 Computer Hard Drive Mfr. b = 1.3

1/3 Electric Utility b = 0.6

average b of assets = 1.3

When evaluating a new electrical generation investment, which cost of capital should be used?

QDai for FEUNL

Capital Budgeting & Project Risk for Projects

SML

Project IRR

24%

Investments in hard drives or auto retailing should have higher discount rates.

17%

10%

Project’s risk (b)

0.6

1.3

2.0

r = 4% + 0.6×(14% – 4% ) = 10% 10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project.

QDai for FEUNL

Extention of the basic model for Projects

• The Weighted Average Cost of Capital

• It is because interest expense is tax-deductible that we multiply the last term by

QDai for FEUNL

WACC for Projects

• Example: a firms with a debt-equity ratio of 0.6, a cost of debt of 15.15%, and a cost of equity of 20%. The corporate tax rate is 34%.

• Debt to value ratio=6/(10+6)=0.375

• Equity to value ratio=1-0.375=0.625

• rwacc=0.625*20%+0.375*15.15%*(1-0.34)

=16.25%

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Steps to calculate WACC for Projects

Cost of equity

Cost of debt

Calculate WACC

QDai for FEUNL