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Finanças

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

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  1. Finanças November 7 QDai for FEUNL

  2. Topics covered • CAPM for cost of capital • Estimation of beta QDai for FEUNL

  3. 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 QDai for FEUNL

  4. Pay cash dividend 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

  5. Capital budgeting rule • The discount rate of a project • The expected return QDai for FEUNL

  6. Cost of capital • 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

  7. Project 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

  8. Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects Project IRR 5% Firm’s risk (beta) QDai for FEUNL

  9. Estimation of beta • 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

  10. Stability of Beta • 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

  11. Using an Industry Beta • 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 • Adjustments QDai for FEUNL

  12. Determinants of beta • Cylicality of revenues QDai for FEUNL

  13. Determinants of beta • Operating leverage • how sensitive a firm is to its fixed costs. QDai for FEUNL

  14. Operating Leverage  EBIT $  Volume Volume QDai for FEUNL

  15. Determinants of beta • 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

  16. Financial Leverage and Beta: Example 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

  17. Financial leverage and beta • Conclusion QDai for FEUNL

  18. Extension of the basic model • The firm vs the project • The risk of a project • The project should be discounted with QDai for FEUNL

  19. rf 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

  20. The firm vs the project 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

  21. Capital Budgeting & Project Risk 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

  22. Extention of the basic model • The Weighted Average Cost of Capital • It is because interest expense is tax-deductible that we multiply the last term by QDai for FEUNL

  23. WACC • 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% QDai for FEUNL

  24. Steps to calculate WACC Cost of equity Cost of debt Calculate WACC QDai for FEUNL

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