Capital budgeting Flashcards
describe the Risk-adjusted Discount Rate Method
Expected cash flows discounted by risk-adjusted discount rate
From the firm’s perspective, the expected return on equity is the?
Cost of Equity Capital:
RI=Rf+Bi*(Rm-Rf)
To estimate a firm’s cost of equity capital, we need to know?
The risk Free Rate = (Rf)
Market Risk Premium = (Rm-Rf)
Equity Beta = Bi
what can be used for risk free rate
Gov Bond Yield
what are the two ways to calculate the Market Risk Premium ?
Using Historical Data - using historical average excess return on the market over the risk-free rate
Using the Dividend Discount Model (DDM)
This approach estimates the market risk premium using dividend yield and expected dividend growth rate
What are the key points for using historical data to calculate the MRP
We face a trade-off in selecting the amount of data we use
It takes many years of data to produce even moderately accurate estimates of expected returns
Yet very old data may have little relevance for investors expectations of the market risk premium today
Determinants of BETA
Business Risk
(1) Cyclical nature of Revenues (2) Operating Leverage
Financial Risk
(3) Financial Leverage
implication of cyclical revenues on beta
While stocks with high volatility (standard deviation) have high betas
Stocks with high standard deviations do not always have high betas