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Risk, Return, and Capital Budgeting

Risk, Return, and Capital Budgeting. What should be the appropriate Required Rate of Return (RROR) for discounting CFs of CB Projects?. Cost of Equity Capital. Use CAPM: ` R S = R F + b S ( ` R M - R F ) Assume 100% equity financed firm also assume Project risk = Firm risk

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Risk, Return, and Capital Budgeting

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  1. Risk, Return, and Capital Budgeting What should be the appropriate Required Rate of Return (RROR) for discounting CFs of CB Projects?

  2. Cost of Equity Capital • Use CAPM: `RS = RF + bS (`RM - RF ) • Assume 100% equity financed firm • also assume Projectrisk = Firmrisk • Review: bi = Cov (Ri , Rm)/sm2 • Beta: A function of riskiness of CFs • Variability of CFs that is RELATED to the market Chhachhi/519/Ch. 12

  3. Determinants of Beta • 2 components of the variability of CFs: • Business Risk: • variability in CFs stemming from sales fluctuations (as economy Ý ß ) • Operating Leverage (from Ý fixed costs) magnifies business risk. • Financial Risk (Financial Leverage): • Ý if the firm/project has Ý debt. WHY?? • Debt exacerbates CF variability • Because Interest is a fixed cost

  4. Weighted Average Cost of Capital (WACC) • If Projectrisk ¹ Firmrisk ?? • Use the beta of the project • RROR= weighted average cost of equity and debt • Cost of Equity: CAPM • Cost of Debt: rB * (1-TC) • rB is the firm’s borrowing rate Chhachhi/519/Ch. 12

  5. WACC-- Continued • Debt = $ B; Equity = $ S; • Thus: Assets = B + S • Wt. of debt = B/(S+B) Wt. of equity = S/(S+B) • WACC = S/(S+B) * rS + B/(S+B) * rB * (1-TC) Chhachhi/519/Ch. 12

  6. Real-World Betas • Problems with Beta Estimation: • Betas may vary over time • Betas are influenced by changing financial leverage and business risk. • Solutions: • Adjust for changes in financial/business risk • Look at average beta estimates of several comparable firms in the industry • H.W. 1, 3, 9, 12, 15

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