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Corporate Finance Lecture 6

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**Topics covered CAPM for cost of capital Estimation of beta**

Long-term financing

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**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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**Capital budgeting rule**

The discount rate of a project should be expected return on a financial asset of comparable risk. The expected return is the cost of equity capital. Risk-free rate Risk premium Company beta ) ( F M i R β - + =

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**Cost of capital % 10 5 . 2 ´ + = R % 30 = R 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? % 10 5 . 2 + = R % 30 = R

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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.

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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. Changes in product line Changes in technology Deregulation Changes in financial leverage

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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, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firm’s beta. Adjustments for financial leverage.

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**Determinants of beta Financial leverage bAsset = Debt + Equity Debt**

Financial leverage is the sensitivity of a firm’s fixed costs of financing. The relationship between the betas of the firm’s debt, equity, and assets is given by: The beta of debt is very low. Therefore with financial leverage, asset beta<equity beta. bAsset = Debt + Equity Debt × bDebt + Equity × bEquity

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**Financial Leverage and Beta: Example**

Consider a company which is currently all-equity and has a beta of 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 However, assuming a zero beta for its debt, its equity beta would become: bAsset = 0.90 = 1 + 1 1 × bEquity bEquity = 2 × 0.90 = 1.80

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**Financial leverage and beta**

Conclusion: financial leverage always increases equity beta relative to asset beta!

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