PowerPoint PresentationKey Concepts and SkillsChapter OutlineWhere Do We Stand?12.1 The Cost of Equity Capital12.2 Estimating the Cost of Equity Capital with the CAPMExample: Calculating “R” using CAPMExample: Using RS and the SML to Evaluate ProjectsApplication: Using the SML for Project SelectionThe Risk-free RateThe Market Risk Premium12.3 Estimation of BetaEstimation of BetaStability of BetaUsing an Industry Beta12.4 Determinants of BetaCyclicality of RevenuesOperating LeverageSlide 19Financial Leverage and BetaExample12.5 Dividend Discount Model12.6 Capital Budgeting & Project RiskSlide 24Capital Budgeting & Project Risk12.7 Cost of DebtCost of Preferred Stock12.8 The Weighted Average Cost of Capital12.9 Firm Valuation12.10 Example: Eastman ChemicalExample: Eastman ChemicalSlide 3212.11 Flotation CostsQuick Quiz12-1RISK, COST OF CAPITAL, AND VALUATIONChapter 12Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.12-2KEY CONCEPTS AND SKILLS•Measure a firm’s cost of equity capital•Grasp and interpret the impact of beta in determining the firm’s cost of equity capital•Comprehend and calculate the firm’s overall cost of capital•Incorporate the impact of flotation costs on capital budgeting12-3CHAPTER OUTLINE12.1 The Cost of Equity Capital12.2 Estimating the Cost of Equity Capital with the CAPM12.3 Estimation of Beta12.4 Determinants of Beta12.5 Dividend Discount Model12.6 Cost of Capital for Divisions and Projects12.7 Cost of Fixed Income Securities12.8 The Weighted Average Cost of Capital12.9 Valuation of RWACC12.10 Estimating Eastman Chemical’s Cost of Capital12.11 Flotation Costs and the Weighted Average Cost of Capital12-4WHERE DO WE STAND?•Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows.•This chapter discusses the appropriate discount rate when cash flows are risky.12-512-5Invest in project12.1 THE COST OF EQUITY CAPITALFirm withexcess cashShareholder’s Terminal ValuePay cash dividendShareholder invests in financial assetBecause stockholders can reinvest the dividend in 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 investment12-612.2 ESTIMATING THE COST OF EQUITY CAPITAL WITH THE CAPM•From the firm’s perspective, the expected return is the Cost of Equity Capital:)(FMFSRRβRR •To estimate a firm’s cost of equity capital, we need to know three things:1. The risk-free rate, RFFMRR 2. The market risk premium,2,)(),(MMSMMSσσRVarRRCovβ 3. The company beta,12-7EXAMPLE: CALCULATING “R” USING CAPM•Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100% equity financed. •Assume a risk-free rate of 5% and a market risk premium of 10%.•What is the appropriate discount rate for an expansion of this firm?)(FMFRRβRR %)105.2(%5 R%30R12-8EXAMPLE: USING RS AND THE SML TO EVALUATE PROJECTSSuppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year.Project Project  Project’s Estimated Cash Flows Next YearIRR NPV at 30%A 2.5 $150 50% $15.38B 2.5 $130 30% $0C 2.5 $110 10% -$15.3812-9APPLICATION: USING THE SML FOR PROJECT SELECTION An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.Project IRRFirm’s risk (beta)SML5%Good projectBad project30%2.5ABC12-10THE RISK-FREE RATE•Treasury securities are close proxies for the risk-free rate.•The CAPM is a period model. However, projects are long-lived. So, average period (short-term) rates need to be used.•As a practical matter, the one year Treasury Bill rate will be assumed as an accurate estimate of short term rates•CAPM suggests that we should use a Treasury security whose maturity matches the time horizon of investors:•No one agrees on what that horizon is!12-11THE MARKET RISK PREMIUM•Method 1: Use historical data•Method 2: Use the Dividend Discount Model•Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basisgPDR 112-1212.3 ESTIMATION OF BETAMarket Portfolio - Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P 500, is used to represent the market.Beta - Sensitivity of a stock’s return to the return on the market portfolio.12-13ESTIMATION OF BETA)(),(MMiRVarRRCovβ •Problems1. Betas may vary over time.2. The sample size may be inadequate.3. Betas are influenced by changing financial leverage and business risk.•Solutions–Problems 1 and 2 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 comparable firms in the industry.12-14STABILITY OF BETA•Most analysts argue that betas are generally stable for firms remaining in the same industry.•That is not to say that a firm’s beta cannot change.•Changes in product line•Changes in technology•Deregulation•Changes in financial leverage12-15USING 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.•Do not forget about adjustments for financial leverage.12-1612.4 DETERMINANTS OF BETA•Business Risk•Cyclicality of Revenues•Operating Leverage•Financial Risk•Financial Leverage12-17CYCLICALITY OF REVENUES•Highly cyclical stocks have higher betas.•Such firms do well in the expansion phase of the economic cycle and more poorly in the contraction phase•Cyclical industries include retail and automotive•Non-cyclical industries include transportation•Note that cyclicality is not the same as variability•Stocks with high standard deviations need not have high betas.•Price movement of such stocks is more dependent on quality of