Team 1 Manajemen Keuangan Lanjutan

FINANCIAL
MANAGEMENT
CONCEPT, RISK,
AND COST OF
CAPITAL
PRESENTED BY
TEAM 1
M. SANRINO SITANGGANG M. ANAYA PRATAMA
11220810000076 11220810000077
DEVARA DIPA .D
11220810000045
SABILA APRILLITA INTAN LESTARI

11220810000149 11220810000143
CHAPTER
OUTLINE
• The Cost of Equity Capital
• Estimation of Beta
• Determinants of Beta
WHATS THE BIG
IDEA?
• Earlier chapter on capital
budgeting focused on the
appropriate size and timing of
cash flows.
• This chapter discuss the

appropriate discount rate when
each cash flows are risky.
THE COST OF EQUITY CAPITAL
Pay Cash
Firm with Dividend Shareholder
excess cash invests in
financial asset
A firm with excess cash can either pay a

dividend or make a capital investment
Invest in Shareholder's
Project Terminal Value
• From the firm's perspective, the
expected return is the Cost of Equity
Capital:
• To estimate a firm's cost of equity

capital, we need to know three
things:
Example
• Suppose the stock of Stansfield Enterprises, a publisher of Power Points
presentations, has a beta of 2.5. The firm is 100-percent equity financed.
• Assume a risk-free rate of 5-percent and a market risk premium of 10-percent.
• What is the appropiate discount rate for an expansion of this firm?

Example (Continued)
Suppose Stansfield Enterprises is
evaluating the following non-mutually
exclusive projects. It cost $100 and last
one years.
USING THE SML TO ESTIMATE THE RISK-ADJUSTED DISCOUNT RATE FOR PROJECTS
An all-equity firm should accept a project whose IRR exceeds

the cost of equity capital and reject project whose IRRs fall
short of the cost of capital.
THE RISK-FREE
RATE
How can we estimate this expected one- Suppose the yield on a 20-year Treasury
year rate? bond is about 3.5 percent. This yield
should reflect both the average one-year
Over the period from 1926 to 2011, the interest rate over the next 20 years and
average return on 20-year Treasury the term premium. Thus, one can argue
bonds was 6.1 percent, and the average that the average one-year interest rate
return on one-year Treasury bills was 3.6 expected over the next 20 years is 3.5% -
percent. Thus, the term premium, as it is 2.5% = 1.0%.
called, was 6.1 - 3.6 = 2.5%.
MARKET RISK
PREMIUM
We settled on an estimate of 7 percent for the
market risk premium, though this number
Method 1: Using should not be interpreted as definitive. As a
Historical Data quick example, consider an all-equity

company with a beta of 1.5. Given our
parameters, its cost of capital would be:
For example, suppose the numbers in the
Value Line (VL) Investment Survey imply a
five-year growth rate in dividends for VL’s
Industrial Composite Index of about 6
percent per year. With a dividend yield of 2.1
Method 2: Using the percent, the expected return on the market
becomes
Dividend Discount 2.1% + 6% = 8.1%.
Model (DDM) Given our anticipated average one-year
yield on Treasury bills of 1.0 percent, the
market risk premium would be 8.1% - 1.0% =
7.1%, almost identical to the 7 percent
provided by method 1. For our firm with a
beta of 1.5, the cost of capital becomes:
ESTIMATION OF BETA:
MEASURING MARKET RISK
Market Portofolio - Portofolio of all assets

in the economy. In practice a broad stock
market index, such as the TSE 300 index, is
used to represent the market.
Beta - Sensitivity of a stock's return to the

return on the market portofolio.
Estimation of Beta
• Theoretically, the calculation of beta is
straightforward:
• Problems
1. 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 (above) 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
STABILITY OF BETA
• Most analyst argue that betas are

generally stable for firms remaining
in the same industry.
• Thats not to say that a firm's beta

can't change.
- Changes in product line
- Changes in technology
- Deregulation
- Changes in financial leverage
• It is frequently argued that one can USING AN INDUSTRY BETA
better estimate a firm's beta by
involving the whole industry.
• If you believe that operations of the

firms are similiar to the operations of
the rest of the industry, you should use
the industry beta.
• If you believe that operations of the

firm are fundamentally different from
the operations for the rest of the
industry, you should use the firm's beta.
• Don't forget about adjustment for

financial leverage.
DETERMINANTS
OF BETA
• Business Risk
- Cyclicity of Revenues
- Operating Leverage
• Financial Risk
- Financial Leverage
Cyclicality of Revenues
• Highly cyclical stocks have high betas.

- Empirical evidence suggests that retailers and automotive firms fluctuate with
the business cycle.
- Transportation firms and utilities are less dependent upon the busniness cycle.
• Note the cyclicality is not the same as variability-stocks with high standard
deviations need to have high betas.
- Movie studios have revenues that are variable, depending upon whether they
produce "hits" or "flops", but their revenues are not especially dependent upon the
business cycle.
OPERATING
LEVERAGE
• The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs.
• Operating leverage increases as fixed costs fall.
• Operating leverage magnifies the effect of cyclicity of beta.
• The degree of operating leverage is given by:

Operating Leverage
Operating leverage increase as fixed costs rise and variable cost fall.
Financial Leverage and Beta
• Operating leverage refers to the sensitivity to the firm's fixed costs of production.
• Financial leverage is the sensitivity of firm's fixed costs of financing.
• The relationship between the betas of the firm's debt, equity, and assets is given by:
• Financial leverage always increases the equity beta relative to the assets beta.
Financial leverage and beta: Example
Consider Grand Sport, Inc., which is currently all-equity and has beta of 0.90.
The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity.
Since the firm will remain in the same industry, its asset beta should remain 0.90.
However, assuming a zero beta for its debt, its equity beta would became twice as
large.
THANK U

Team 1 Manajemen Keuangan Lanjutan

Uploaded by

Copyright:

Available Formats

Team 1 Manajemen Keuangan Lanjutan

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Team 1 Manajemen Keuangan Lanjutan

Uploaded by

Copyright:

Available Formats

FINANCIAL

SABILA APRILLITA INTAN LESTARI

• This chapter discuss the

A firm with excess cash can either pay a

• To estimate a firm's cost of equity

• Assume a risk-free rate of 5-percent and a market risk premium of 10-percent.

• What is the appropiate discount rate for an expansion of this firm?

An all-equity firm should accept a project whose IRR exceeds

Historical Data quick example, consider an all-equity

Market Portofolio - Portofolio of all assets

Beta - Sensitivity of a stock's return to the

• Most analyst argue that betas are

• Thats not to say that a firm's beta

• If you believe that operations of the

• If you believe that operations of the

• Don't forget about adjustment for

• Highly cyclical stocks have high betas.

• Operating leverage increases as fixed costs fall.

• Operating leverage magnifies the effect of cyclicity of beta.

• The degree of operating leverage is given by:

• Financial leverage is the sensitivity of firm's fixed costs of financing.

You might also like