Reducing Cost of Capital Through Liquidity Enhancement

Risk, Cost of Capital, and Capital Budgeting

Chapter Outline ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Where Do We Stand? ,[object Object],[object Object]

12.1 The Cost of Equity Capital Invest in project Firm with excess cash Shareholder’s Terminal Value Pay cash dividend Shareholder invests in financial asset 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. A firm with excess cash can either pay a dividend or make a capital investment

The Cost of Equity Capital ,[object Object],[object Object],[object Object],[object Object],[object Object]

12.2 Estimation of Beta ,[object Object],[object Object]

Estimation of Beta ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Stability of Beta ,[object Object],[object Object],[object Object],[object Object],[object Object],[object Object]

Using an Industry Beta ,[object Object],[object Object],[object Object],[object Object]

12.3 Determinants of Beta ,[object Object],[object Object],[object Object],[object Object],[object Object]

Cyclicality of Revenues ,[object Object],[object Object],[object Object]

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Operating Leverage ,[object Object],[object Object],[object Object],[object Object],DOL = EBIT  Sales Sales  EBIT ×

Operating Leverage Sales $ Fixed costs Total costs  EBIT  Sales Operating leverage increases as fixed costs rise and variable costs fall. Fixed costs Total costs

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Financial Leverage and Beta ,[object Object],[object Object]

Financial Leverage and Beta ,[object Object], Asset = Debt + Equity Debt ×  Debt + Debt + Equity Equity ×  Equity

Financial Leverage and Beta ,[object Object],[object Object],[object Object],[object Object]

12.4 Extensions of the Basic Model ,[object Object],[object Object]

The Firm versus the Project ,[object Object],[object Object]

Capital Budgeting & Project Risk ,[object Object],Project IRR Firm’s risk (beta) Hurdle rate The SML can tell us why: r f  FIRM Incorrectly rejected positive NPV projects Incorrectly accepted negative NPV projects

The Cost of Capital with Debt ,[object Object],[object Object],r WACC = Equity + Debt Equity × r Equity + Equity + Debt Debt × r Debt × (1 – T C ) r WACC = S + B S × r S + S + B B × r B × (1 – T C )

12.6 Reducing the Cost of Capital ,[object Object],[object Object],[object Object],[object Object]

[object Object],What is Liquidity?

What is Liquidity? ,[object Object]

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Liquidity, Expected Returns, and the Cost of Capital ,[object Object]

Liquidity and the Cost of Capital Cost of Capital Liquidity An increase in liquidity ( i.e ., a reduction in trading costs) lowers a firm’s cost of capital.

Liquidity and Adverse Selection ,[object Object],[object Object],[object Object],[object Object]

What the Corporation Can Do? ,[object Object],[object Object]

DOL = = = DFL = = DTL = = = (=DOL*DFL) 14 15 △ EBIT / EBIT △ Q / Q Q(P–V) Q(P–V) –F S–VC S –VC –F △ EPS / EPS △ EBIT / EBIT EBIT EBIT –I △ EPS / EPS △ Q / Q Q(P–V) Q(P–V) –F –I S–VC S–VC –F –I

Reducing Cost of Capital Through Liquidity Enhancement

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Reducing Cost of Capital Through Liquidity Enhancement