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1、McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-0Chapter Outline12.1 The Cost of Equity Capital12.2 Estimation of Beta12.3 Determinants of Beta12.4 Extensions of the Basic Model12.5 Estimating International Papers Cost of Capital12.6 Reducing the Cost of Capit
2、al12.7 Summary and ConclusionsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-1Whats the Big Idea?Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows.This chapter discusses the appropriate discount rate when cash flow
3、s are risky.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-2Invest in project12.1 The Cost of Equity CapitalFirm withexcess cashShareholders Terminal ValuePay cash dividendShareholder invests in financial assetBecause stockholders can reinvest the dividend in
4、 risky financial assets,the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk.A firm with excess cash can either pay a dividend or make a capital investmentMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Compa
5、nies,Inc.All rights reserved.12-3The Cost of EquityFrom the firms perspective,the expected return is the Cost of Equity Capital:To estimate a firms cost of equity capital,we need to know three things:1.The risk-free rate,RF2.The market risk premium,3.The company beta,McGraw-Hill/IrwinCopyright 2002
6、by The McGraw-Hill Companies,Inc.All rights reserved.12-4ExampleSuppose the stock of Stansfield Enterprises,a publisher of PowerPoint presentations,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 appro
7、priate discount rate for an expansion of this firm?McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-5Example(continued)Suppose Stansfield Enterprises is evaluating the following non-mutually exclusive projects.Each costs$100 and lasts one year.ProjectProject bP
8、rojects Estimated Cash Flows Next YearIRRNPV at 30%A2.5$15050%$15.38B2.5$13030%$0C2.5$11010%-$15.38McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-6Using the SML to Estimate the Risk-Adjusted Discount Rate for Projects An all-equity firm should accept a projec
9、t whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.Project IRRFirms risk(beta)5%Good projectsBad projects30%2.5ABCMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-712.2 Estimation of Beta:Measuring Ma
10、rket RiskMarket 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.Beta-Sensitivity of a stocks return to the return on the market portfolio.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc
11、.All rights reserved.12-812.2 Estimation of BetaTheoretically,the calculation of beta is straightforward:Problems1.Betas may vary over time.2.The sample size may be inadequate.3.Betas are influenced by changing financial leverage and business risk.SolutionsProblems 1 and 2(above)can be moderated by
12、more sophisticated statistical techniques.Problem 3 can be lessened by adjusting for changes in business and financial risk.Look at average beta estimates of comparable firms in the industry.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-9Stability of BetaMos
13、t analysts argue that betas are generally stable for firms remaining in the same industry.Thats not to say that a firms beta cant change.Changes in product lineChanges in technologyDeregulationChanges in financial leverageMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights re
14、served.12-10Using an Industry BetaIt is frequently argued that one can better estimate a firms 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,you should use the industry beta.If you believe that the operat
15、ions of the firm are fundamentally different from the operations of the rest of the industry,you should use the firms beta.Dont forget about adjustments for financial leverage.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-1112.3 Determinants of BetaBusiness
16、RiskCyclicity of RevenuesOperating LeverageFinancial RiskFinancial LeverageMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-12Cyclicality of RevenuesHighly cyclical stocks have high betas.Empirical evidence suggests that retailers and automotive firms fluctuate
17、 with the business cycle.Transportation firms and utilities are less dependent upon the business cycle.Note that cyclicality is not the same as variabilitystocks with high standard deviations need not have high betas.Movie studios have revenues that are variable,depending upon whether they produce“h
18、its”or“flops”,but their revenues are not especially dependent upon the business cycle.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-13Operating LeverageThe degree of operating leverage measures how sensitive a firm(or project)is to its fixed costs.Operating
19、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:McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-14Operating LeverageVolume$Fixed costsTotal
20、 costs EBIT VolumeOperating leverage increases as fixed costs rise and variable costs fall.Fixed costsTotal costsMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-15Financial Leverage and BetaOperating leverage refers to the sensitivity to the firms fixed costs
21、of production.Financial leverage is the sensitivity of a firms fixed costs of financing.The relationship between the betas of the firms debt,equity,and assets is given by:Financial leverage always increases the equity beta relative to the asset beta.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill
22、 Companies,Inc.All rights reserved.12-16Financial Leverage and Beta:ExampleConsider Grand Sport,Inc.,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
23、beta should remain 0.90.However,assuming a zero beta for its debt,its equity beta would become twice as large:McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-1712.4 Extensions of the Basic ModelThe Firm versus the ProjectThe Cost of Capital with DebtMcGraw-Hil
24、l/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-18The Firm versus the ProjectAny projects cost of capital depends on the use to which the capital is being putnot the source.Therefore,it depends on the risk of the project and not the risk of the company.McGraw-Hill/Irwin
25、Copyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-19Capital Budgeting&Project RiskA firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.Project IRRFirms risk(beta)rfbFIRMIncorrectly rejected positive NPV projec
26、tsIncorrectly accepted negative NPV projectsHurdle rateThe SML can tell us why:McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-20Suppose 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
27、 10%and the firms beta is 1.3.17%=4%+1.3 14%4%This is a breakdown of the companys investment projects:1/3 Automotive retailer b=2.01/3 Computer Hard Drive Mfr.b=1.31/3 Electric Utility b=0.6average b of assets=1.3When evaluating a new electrical generation investment,which cost of capital should be
28、used?Capital Budgeting&Project RiskMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-21Capital Budgeting&Project RiskProject IRRFirms risk(beta)17%1.32.00.6r=4%+0.6(14%4%)=10%10%reflects the opportunity cost of capital on an investment in electrical generation,g
29、iven the unique risk of the project.10%24%Investments in hard drives or auto retailing should have higher discount rates.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-22The Cost of Capital with DebtThe Weighted Average Cost of Capital is given by:It is becau
30、se interest expense is tax-deductible that we multiply the last term by(1-TC)McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-2312.5 Estimating International Papers Cost of CapitalFirst,we estimate the cost of equity and the cost of debt.We estimate an equity b
31、eta to estimate the cost of equity.We can often estimate the cost of debt by observing the YTM of the firms debt.Second,we determine the WACC by weighting these two costs appropriately.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-2412.5 Estimating IPs Cost
32、of CapitalThe industry average beta is 0.82;the risk free rate is 8%and the market risk premium is 9.2%.Thus the cost of equity capital isMcGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-2512.5 Estimating IPs Cost of CapitalThe yield on the companys debt is 8%a
33、nd the firm is in the 37%marginal tax rate.The debt to value ratio is 32%12.18 percent is Internationals cost of capital.It should be used to discount any project where one believes that the projects risk is equal to the risk of the firm as a whole,and the project has the same leverage as the firm a
34、s a whole.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-2612.6 Reducing the Cost of CapitalWhat is Liquidity?Liquidity,Expected Returns and the Cost of CapitalLiquidity and Adverse SelectionWhat the Corporation Can DoMcGraw-Hill/IrwinCopyright 2002 by The Mc
35、Graw-Hill Companies,Inc.All rights reserved.12-27What is Liquidity?The idea that the expected return on a stock and the firms cost of capital are positively related to risk is fundamental.Recently a number of academics have argued that the expected return on a stock and the firms cost of capital are
36、 negatively related to the liquidity of the firms shares as well.The trading costs of holding a firms shares include brokerage fees,the bid-ask spread and market impact costs.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-28Liquidity,Expected Returns and the
37、Cost of CapitalThe cost of trading an illiquid stock reduces the total return that an investor receives.Investors thus will demand a high expected return when investing in stocks with high trading costs.This high expected return implies a high cost of capital to the firm.McGraw-Hill/IrwinCopyright 2
38、002 by The McGraw-Hill Companies,Inc.All rights reserved.12-29Liquidity and the Cost of CapitalCost of CapitalLiquidityAn increase in liquidity,i.e.a reduction in trading costs,lowers a firms cost of capital.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-30Li
39、quidity and Adverse SelectionThere are a number of factors that determine the liquidity of a stock.One of these factors is adverse selection.This refers to the notion that traders with better information can take advantage of specialists and other traders who have less information.The greater the he
40、terogeneity of information,the wider the bid-ask spreads,and the higher the required return on equity.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-31What the Corporation Can DoThe corporation has an incentive to lower trading costs since this would result i
41、n a lower cost of capital.A stock split would increase the liquidity of the shares.A stock split would also reduce the adverse selection costs thereby lowering bid-ask spreads.This idea is a new one and empirical evidence is not yet in.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc
42、.All rights reserved.12-32What the Corporation Can DoCompanies can also facilitate stock purchases through the Internet.Direct stock purchase plans and dividend reinvestment plans handles on-line allow small investors the opportunity to buy securities cheaply.The companies can also disclose more inf
43、ormation.Especially to security analysts,to narrow the gap between informed and uninformed traders.This should reduce spreads.McGraw-Hill/IrwinCopyright 2002 by The McGraw-Hill Companies,Inc.All rights reserved.12-3312.7 Summary and ConclusionsThe expected return on any capital budgeting project sho
44、uld be at least as great as the expected return on a financial asset of comparable risk.Otherwise the shareholders would prefer the firm to pay a dividend.The expected return on any asset is dependent upon b.A projects required return depends on the projects b.A projects b can be estimated by considering comparable industries or the cyclicality of project revenues and the projects operating leverage.If the firm uses debt,the discount rate to use is the rWACC.In order to calculate rWACC,the cost of equity and the cost of debt applicable to a project must be estimated.