risk cost of capital and capital budgeting

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1、CHAPTER12Risk,CostofCapital,andCapitalBudgetingInlate2005,SwissRe,oneoftheworldsleadingindustry.Oneofthemajorreasonsgivenforthepossiblereinsurers,publishedareportdiscussinghowinsurancesaleofGeneralMotorsAcceptanceCorporation(GMAC)companiescreatevalueforshareholders.OneofthebyGeneralMotorswasthatth

2、eloweringofGMsdebtkeycomponentsaddressedinthereportwasthecostratinghadincreasedthecostofcapitalforGMAC.ofcapital.AccordingtoSwissRe,thecostofcapitalforInthischapter,welearnhowtocomputeafirmscosttheU.S.non-lifeinsuranceindustryduringthe1980sofcapitalandfindoutwhatitmeanstothefirmanditswasabout15percen

3、t.By2005,thecostofcapitalforinvestors.Wewillalsolearnwhentousethefirmscosttheindustryhaddroppedto7to8percent.Butthecostofcapitalandperhapsmoreimportant,whennottoofcapitalisimportantinmorethanjusttheinsuranceuseit.12.1TheCostofEquityCapitalWheneverafirmhasextracash,itcantakeoneoftwoactions.Itcanpayou

4、tthecashim-mediatelyasadividend.Alternatively,thefirmcaninvestextracashinaproject,payingoutthefuturecashflowsoftheprojectasdividends.Whichprocedurewouldthestock-holdersprefer?Ifastockholdercanreinvestthedividendinafinancialasset(astockorbond)withthesameriskasthatoftheproject,thestockholderswoulddesir

5、ethealterna-tivewiththehighestexpectedreturn.Inotherwords,theprojectshouldbeundertakenonlyifitsexpectedreturnisgreaterthanthatofafinancialassetofcomparablerisk.ThisisillustratedinFigure12.1.Thisdiscussionimpliesaverysimplecapitalbudgetingrule:Thediscountrateofaprojectshouldbetheexpectedreturnonafina

6、ncialassetofcom-parablerisk.Fromthefirm’sperspective,theexpectedreturnisthecostofequitycapital.UndertheCAPM,theexpectedreturnonthestockcanbewrittenas:RS
RF(RMRF)(12.1)whereRFistherisk-freerateandRMRFisthedifferencebetweentheexpectedreturnonthemarketportfolioandtherisklessrate.Thisdifferenceiso

7、ftencalledtheexpectedexcessmarketreturnormarketriskpremium.Notewehavedroppedthebardenotingexpectationsfromourexpressiontosimplifythenotation,butrememberthatwearealwaysthinkingaboutexpectedreturnswiththeCAPM.342ro