Where 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.
     Will also now be employing our CAPM 
       tools as well.
                                                          13-2
     13.1 The Cost of Equity Capital
                                                                    Shareholder 
               Firm with                                              invests in 
              excess cash          Pay cash dividend                  financial 
                                                                         asset
                     A firm with excess cash can either pay a 
                      dividend or make a capital investment
                                        Shareholder’s 
               Invest in project           Terminal 
                                             Value
        Because 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.             13-3
     The Cost of Equity Capital
         From the firm’s perspective, the expected 
            return is the Cost of Equity Capital:
                          Rs RF β(RM  RF)
        • To estimate a firm’s cost of equity capital, we need 
           to know three things:
             1.  The risk-free rate, R
                                      F
             2.  The market risk premium, RM  RF
                                            Cov(R,R )          σi,M
             3.  The company beta, β               i   M 
                                        i     Var(R )          σ2
                                                      M          M
                                                                            13-4
    Example
       Suppose the stock of Stansfield Enterprises, a 
         publisher of PowerPoint presentations, has a beta 
         of 1.5. The firm is 100% equity financed. 
       Assume a risk-free rate of 3% and a market risk 
         premium of 7%.
       What is the appropriate discount rate for an 
         expansion of this firm?
                     Rs RF β(RM  RF)
                      Rs 3%1.57%
                           Rs 13.5%                           13-5
     Example
           Suppose Stansfield Enterprises is evaluating the following 
           independent projects. Each costs $100 and lasts one year.
           Project   Project b   Project’s         IRR        NPV at 
                                 Estimated Cash               13.5%
                                 Flows Next 
                                 Year
           A         1.5         $125              25%        $10.13
           B         1.5         $113.5            13.5%      $0
           C         1.5         $105              5%         -$7.49
                                                                            13-6