Financial Policy and Planning
(MB 29)









The concept of required rate of return for a project
The concept of weighted average cost of capital
Cost of Capital for all equity firm
Significance of Beta
How to measure Beta?
Stability of Beta over time
Determinants of Beta
Cost of capital with Debt




Given an unbiased estimate of cash flows of a project, at what rate should we discount the cash flows of the project?
Cash flows should be discounted at the required rate of return—

 the rate of return that similar risk class investments are providing in the market or the minimum rate of return that a project must earn to justify investment of resources
Required rate chosen to discount the cash flows and to compute the NPV must be appropriate to the risk of the project.


What if we choose a required rate of return that is too high for the project given its riskiness?

We will end up rejecting some good projects,
 because with a high discount rate the NPV will either be very low or sometimes even negative, because we are unnecessarily using a very conservative discount rate.

By rejecting good projects, the firm will compromise its competitiveness and market value


What if we choose a required rate of return that is too low for the project given its riskiness?

We will end up accepting some bad projects,

 because with a low discount rate the NPV will either be high and positive, because we are unnecessarily using a very low discount rate.
By accepting bad projects, the firm will increase the risk of its cash flows.

This will compromise its competitiveness and market value





Choosing the right discount rate also know as required rate of return for a project is critical for its success
Use a weighted-average cost of capital
A weighted-average of the cost of each component of capital used to fund the project, where weights represent the proportion of each component in the total capital for the project
An optimal cost of capital is the cost at which value of the firm is maximum



Whenever a firm has excess cash, it can take one of the two actions.

On the one hand, it can pay out the cash immediately as dividend or
 it can invest extra cash in a project, paying out the future cash flows of the project as dividends
A firm should invest money in the project only if the project provides a return higher than the required rate of stockholders.


Stockholders’ required rate is the opportunity cost of not receiving dividend or the return they would forgo by not receiving the dividend, which will be the rate which similar risk class investments are providing in the market





Required Rate of Return = r
 equals market risk premium f
+ (r market
– r
Market rate of return minus the risk free rate f
) 

If we multiply market risk premium by the beta of the security, it is known as the security risk premium
Required rate of return equals risk free rate of return plus security risk premium
How do we compute beta?  = ( 
Beta equals covariance between the security and the market divided by the variance of the market i,m
)/  2 m






Look at the spreadsheet
Beta is defined as the sensitivity of a security to the market. How sensitive a security’s price is to the changes in the market?
Beta of the market always equals 1
Beta of a risk free security equals 0
Beta books are compiled by various investment services companies such as Value
Line, Merrill Lynch



Use historical beta carefully, beta keeps changing over time
Beta is affected by cyclical revenues, operating leverage, and financial leverage




If a firm uses both debt and equity to finance its investments, we need to use overall cost of capital as the discount rate r wacc
= (S/V  r s
) + (D/V  r
D
Where
 (1-T c
))






 r wacc
= the weighted average cost of capital
S = market value of equity
D = market value of debt
V = total market value of the firm (D+S) r s r
D
= cost of equity
= cost of debt
T c
= corporate tax rate






Debt to equity ratio = 0.25
Beta of common equity = 1.15
Beta of debt = 0.3
Market risk premium = 10%
Risk free rate = 6%

Corporate Tax Rate = 35%
What is the overall cost of capital?
Rs = 6 + (10)  1.15 = 17.5% rD = 6 + (10)  0.3 = 9%
Rwacc = (0.8  17.5) + (0.2  9  (1 – 0.35)) = 15.17%