Internatinal Finance Management 【国际财务管理】Lecture 5

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The use of cost of capital
• Using the cost of capital as hurdle rate to compute NPV of a project • Using the cost of capital as the benchmark for performance measurement • Using the cost of capital of entire firm to calculate the value of the firm, which can be
• Estimate the implied premium from historical data,assuming that return is independent drawing from some distribution.
• The problem is that return on market portfolio would not be expected to have constant mean
used to estimate the true value of the firm, in case of repurchase or take over
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The cost of capital for a safe project
• A project whose cash flow is fixed in real terms current nominal yield on U.S. government bond is 5%, CPI is 2%, we can say the cost of capital for this project in real terms is about 3% This is the appropriate rate for project with given cash flow
From CAPM,
E(ri ) rf i[E(rm ) rf )]
=5%+1.21*9.5%=16.495%
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Inputs Required to Use the CAPM
• The current risk-free rate. • The expected market risk premium (the premium expected for investing in risky
Lecture 5 Cost of Capital
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Learning Objectives
• Learning Objectives – Estimate the cost of capital – Distinguish among the cost of capital, the required return to equity, the required return to debt – Chapters covered: Chapter 12
assets over the riskless asset). • The beta of the asset being analyzed.
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The Bottom Line on Riskfree Rates
• Using a long-term government rate as the riskfree rate on all of the cash flows in a long term analysis will yield a close approximation of the true value
enough cash flow(including tax shield on the debt) to pay the shareholder and debtholder the required rate of return
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WACC
• Consider a project which generates pretax cash flow CF, interest rate is I, the project is financed with debt and equity at market value D and E, tax rate is T
ratEio)(tarrgee(t
debt
D
ra)tio) E
will
remain
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WACC
• To estimate WACC, we need – The required return on equity – The required return on debt – The intended capital structural (optimal weight)
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Cost of Capital
• Definition :the cost of capital is the required return for a capital budgeting project. It is an opportunity cost, it is the return at which investors would provide financing for the capital budgeting projects.
• The weighted average cost of capital is
• One could use WACC as the Ddiscount rate tEo value a firm ,but
WcoAnsCtWaCnAtasiCnsuCtmheesfrutdhtu(e1reD/TD)+( DE
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Measurement of the Risk Premium
• The risk premium is the premium that investors demand for investing in an average risk investment, relative to the riskfree rate.
country 1998
U.S.
5.3%
Japan 1.3%
China
4.9%
U.K.
5.4%
Asia new 12.2% industrial countries
1999 5.6% 1.7% 3.2% 5.4% 7%
2000 6% 1.7% 3.4% 5.4% 5.9%
average 5.6% 1.6% 3.8% 5.4% 8.3%
E(ri ) rf i[E(rm ) rf )]
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Exaห้องสมุดไป่ตู้ple
• Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21, further suppose the market risk premium is 9.5%, and the risk-free rate is 5%. Compute the cost of equity
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Cost of equity : The Capital Asset Pricing Model
• The CAPM is not the only model to estimate rate of return for risky asset, other models include APT, but CAPM is the most widely used model(70%)
• This is a forward-looking rate of return investors are to be received if the invest on market portfolio today, it is actually unobservable
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Estimating Risk Premiums in Practice
• For short term analysis, it is entirely appropriate to use a short-term government security rate as the riskfree rate.
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10-year treasury bond yield
forward.
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Why implied risk premium differ
• Many practitioners use the Ibbotson data base and estimate historical premiums. There are three reasons for why the premium estimated may differ:
Invest in project
Shareholder’ s 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.
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Cost of capital for risky asset
• What is the required rate of return for projects whose future cash flow is uncertain • Need a hurdle rate compatible to its risk • The hurdle rate is the rate of return on the asset at which the project merely return
– It defines a time period for the estimation (1962-Present....). – It calculates average returns on a stock index during the period. – It calculates average returns on a riskless security over the period. – It calculates the difference between the two and uses it as a premium looking
• But we can assume that the market risk premium, has a constant mean over time
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The Historical Premium Approach
• This is the default approach used by most to arrive at the premium to use in the model. • In most cases, this approach does the following:
– 1. How far back you go – 2. Whether you use T.Bill or T.Bond rates ( during period 1926-
1993,the arithmetic average of risk premium when riskfree rate is Tbill is 8.6%, and 7.2% when riskfree rate is T-bill rate – 3. Whether you use arithmetic or geometric means (there is significant difference between AA and GA, during period 1926-1993, AA on S&P 500 index is 7.2%, GA is 5.2% when riskfree rate is measured by T-bond)
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The Cost of Equity Capital
Firm with excess cash
Pay cash dividend
Shareholder invests in
financial asset
A firm with excess cash can either pay a
dividend or make a capital investment