Investment Appraisal

Identify the main components of weighted average cost of capital, and outline how they normally are estimated

Rd = YTM on bonds, interest rates
D = market value debt
Tc = corp tax raet
Re = Rf + B (Rm - Rf)
E = market value equity

are adjustment to estimated cost of capital necessary when individual proposed investments are under consideration

yes, each project should be evaluated on its own discount rate, depending on its risk, not company risk. company wide discount rate may not be suitable and reject good projects and accept bad projects.
- cyclicality of rev = high beta
- high operating leverage = high beta
- long term projects = high beta
unlever asset beta, relever to comparable pure-play companies.

CAPM assumptions

1) investors are risk averse
2) capital markets are perfect (no transaction costs, all info is costless & available to everyone, all assets are infinitely divisible)
3) investors expectations are homogeneous 4) investors share same set of investor opportunities

CAPM graph

graph

steps estimating beta

1) obtain past weekly/monthly rates of return for stock and market index
2) avg them, find deviations from avg for each week
3) market variation → avg squared deviation from market
4) covariance → avg of deviation market x deviation stock
5) beta = covariance/market variance

challenges estimating beta

instability: past day may not be reflective/accurate for future (e.g. zoom before was cyclication with 1.8 beta, after covid it became countercyclical with -0.3 beta)
action: incorporate changing risk in estimates rather than just past data
estimation error: only small portion of risk is market risk, noise in returns, hard to estimate true beta
action: calculate standard error of estimated beta, then confidence interval +- 2se

impact: estimates off target, affects discount rate, affects NPV and projects