Lecture 16 - Risk, Cost of Capital and Capital Budgeting Flashcards
2 options a company has when it has spare cash
- Pay out the cash to shareholders as a dividend
- Invest the money in the business with a view to paying out the cash flows the investment generates as a dividend
When to accept or reject project. evaluations based on the projects NPV?
Accept project if NPV is above 0
Reject project if it is below 0
Problems when estimating beta
- Betas may vary over time
- Sample size may be inadequate
- Betas are influenced by changing financial leverage and business risk
How to reduce the scope for estimation error of beta?
Look at industry averages rather than using the company’s own data
3 determinants of beta
- Cyclicity of revenues
- Operating leverage
- Financial leverage
Cyclicity of revenues
Most firms do well in the expansion phase and poorly in the contraction phase
High tech firms, retailers and automotive firms tend to fluctuate with the business cycle
Food, airlines, utilities tend to be less dependent on the business cycle
How does cyclicity affect beta?
Beta measures the responsiveness of a security’s returns to movements in the market
So, a cyclical firm is more responsive to movements in the market
Firms whose revenues are more responsive to movements in the economy will generally have higher betas
Operating leverage
Operating leverage refers to the relationship between fixed and variable costs
Firms with high operating leverage do well in the expansion phase but exhibit poorly in the contraction phase because of higher fixed costs
Explain beta for levered and non levered firms
A levered firm has a higher level of risk than all equity company
Meaning that the beta value for a levered firms equity will be higher than the beta of a similar but unlettered company’s equity
WACC formula
S B
——– x Rs + ———- x Rb x (1-tc)
S + B S + B
