Cap Structure

Capital Budgeting Lectures

Risk (beta), Return & Capital Budgeting

Chapter 12: problems 2,6,9,13,15

GOAL: Find discount rate for projects

SML gives the relationship between risk and

required return. This implies that we need a

measure of the riskiness of the project (project

beta).

Use proxies from existing firms to get estimates

for projects.

SUPPOSE

the company specializes in one line of business.

the project is in the same risk class as its already

existing line of business.

the riskiness of the firm’s assets is stable over time.

optimal financing (not immediate source of funds)

for the project and for the existing firm are the

same.

2

STEP 1: Find beta of the equity of the firm.

Use regression theory - estimate equity beta

Brokerage houses publish regression results

for many firms.

What you get is an estimate of the equity beta for

the firm over the last 5 years. However, the

project is in the future.

You’re not finished here because you have an estimate of

the riskiness of equity, but the firm is not just equity

financed.

Leverage magnifies variations in the earnings on equity and

makes it more risky than the assets of the firm.

3

Effect of Financial Leverage on the Riskiness of

Equity

Example: effect of leverage on returns

Value of firm’s assets = $1.

STATE PROBABILITY FIRM

PROFITS ($)

MARKET

RETURN

1 0.5 0.20 0.20

2 0.5 0.05 0.05

Expected return (market) = 0.125

Variance of market portfolio = 0.005625

Interest rate on debt = 10%

All equity firm: expected return = 0.125, beta = 1

Suppose 50% debt financed, value of debt = value of equity

= $0.5. Interest on debt = 10% x $0.5 = $0.05.

State 1 ROE = (.20-.05)/.5 = 0.3

State 2 ROE = (.05-.05)/.5 = 0

50% debt financed firm: expected return = 0.15

Covariance of return on equity with return on

market portfolio = 0.01125

Equity beta = covariance/variance of market

portfolio = 2

4

Leverage increases the riskiness of equity. There is less

equity to bear the risk...