Official Ch.12 FIN 3414

Assume an all-equity company is considering expanding its current operations by increasing the size of its warehouse. The discount rate used for this project should be the

company's cost of equity capital.

A firm with high operating leverage is best defined as a firm that has

high fixed costs relative to variable costs.

Which of these are determinants of beta?

I . Financial leverage

II. Cyclicality of revenues

III. Total variation in revenues

IV. Operating leverage

I, II, and IV only

The terminal value of a firm is also commonly referred to as the:

horizon value

The weighted average cost of capital for a firm is the

Overall rate which the firm must earn on its projects to maintain the value of its stock.

The use of WACC as the discount rate when evaluating a project is acceptable when the

risk of the project is equal to the company's overall level of risk.

The beta of a firm is more likely to be high under which two conditions?

High cyclical business activity and high operating leverage

A firm with high operating leverage is best defined as a firm that has

high fixed costs relative to variable costs.

Which one of these statements related to beta is correct?

Beta measures systematic risk.

Market Risk Premium Def. 1

Method 1: Use historical data.

Method 2: Use the Dividend Discount Model.

Market Risk Premium Def. 2

Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis.

Market Portfolio

Theory: Portfolio of all assets in the economy

Practice: A broad stock market index, such as the S&P Composite to represent.

Beta

Sensitivity of a stock's return to the return on the market portfolio.

Estimating Beta 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.

Estimating Beta Solutions

- Problems 1 and 2 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 analysts argue that betas are generally stable for firms remaining in the same industry.

betas can change...

Changes in product line

Changes in technology

Deregulation

Changes in financial leverage

Industry Beta

Some argue that a better estimate of a firm's betais to use the beta for the whole industry.

Business Risk

Cyclicality of Revenues

Operating Leverage

Determinants of Beta

Business Risk

Financial Risk

Financial Risk

Financial Leverage

Cyclicality of Revenues Def. 1

Highly cyclical stocks have higher betas.

Ex: Retailers, high tech, and automotive firms fluctuate with the business cycle

Ex: Utilities, railroads, food companies are less dependent upon the business cycle

Cyclicality of Revenues Def. 2

Note that cyclicality is not the same as variability—stocks with high standard deviations need not have high betas.

Ex: Movie studios have revenues that are variable (eg,"hits" or "flops") but their revenues may not be especially dependent upon the business cycle.

Total risk is not systematic risk!

Operating Leverage

Degree of operating leverage measure show sensitive a firm (or project) is to its fixed costs.

OL increases as fixed costs rise andvariable costs fall.

OL magnifies the effect of cyclicality onbeta.

Operating leverage

refers to the sensitivity to the firm's fixed costs of production.

Financial leverage

is the sensitivity to a firm's fixed costs of financing.

Financial leverage always....

increases the equity beta relative to the asset beta.

Firm versus Project

Is project risk the same as firm risk?

Hurdle rate must depend on project!

Capital Budgeting & Project Risk

A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value.

Cost of Debt

Interest rate required on new debt issuance (i.e., yield to maturity on outstanding debt).

Adjust for the tax deductibility of interest expense

Weights

Market values are better than book

Often use book value of debt with market value of stock

WACC

The weighted average cost of a firm's common equity, preferred stock, and debt.

Valuation

Remember from capital budgeting:

Forecast cash flows (no interest)

Assess risk

Estimate opportunity cost of capital

Calculate NPV

apply to valuing a firm:

Dividend growth model has too many problems.

Free Cash Flow

is the amount of cash the firm can pay out to investors after making all necessary investments for growth

Better measure of value creation than dividend

WACC: Reminders

If you discount at WACC, cash flows have to be projected just as you would for a capital investment project.

Do not deduct interest.

The value of interest tax shields is picked up in the WACC formula.

Subtract value of debt/preferred from total value to get value of equity.