Chapter 12 Risk, Return, and Capital Budgeting

1
Chapter 12 Risk, Return, and Capital Budgeting

• 12.1 The Cost of Equity Capital
• 12.2 Estimation of Beta
• 12.3 Determinants of Beta
• 12.4 Extensions of the Basic Model
• 12.5 Estimating International Papers Cost of
  Capital
• 12.6 Summary and Conclusions

2
The Cost of Equity

• The Cost of Equity
• E(rs) RF bs x E(RM) - RF
• Equity Beta
• bS siM / sM2
• Factors affecting Equity Beta
• Business Risk
• Cyclicality of Revenues
• Operating Leverage
• Financial Risk
• Financial Leverage
• Interest Tax Shield

3
The Cost of Capital

• The Weighted Average Cost of Capital
• rWACC rS x S/(SB) rB x (1 Tc) x B/(SB).
• Asset Beta
• bASSET bEQUITY x S/(SB) bDEBT x (1 Tc) x
  B/(SB)
• Factors affecting Asset Beta
• Business Risk

4
Beta Estimation

• Problems
• Betas may vary over time.
• The sample size may be inadequate.
• Betas are influenced by changing financial
  leverage and business risk.
• Solutions
• Problems 1 and 2 (above) can be moderated by more
  sophisticated statistical techniques.
• Problem 3 can be lessened by adjusting for
  changes in business and financial risk.
• Look at average beta estimates of several
  comparable firms in the industry.