Lectures 1-2: Capital Budgeting and Risk
Throughout capital budgeting in semester 1 we made our decisions based on
mainly the net present rule. When calculating the NPV, we used discount rates
that were already given. However in this semester we will be focusing more on
calculating the discount rate.
Recap of the NPV rule:
According to the NPV rule, to maximise firm’s market value we accept any
investments which have a positive net present value. In other terms the present
value of the benefits should be more than the present value of the costs. Present
values are based on the after tax cash flows discounted back.
Opportunity cost of capital:
The appropriate discount rate for an investment would be its opportunity cost of
capital. Opportunity cast of capital refers to the return that the investor would
have received if he invested in a project of similar risk. Now the question here for
us is how do we determine this opportunity cost of capital and what risks affect
it.
Which risk determines the cost of capital?
The total firm risk comprises of both unsystematic (firm specific) and systemic
(market wide) risk. Since the unsystematic risk is diversifiable, the investors do
not get any premium on that. The market or the systematic risk, also
represented by the beta, is the one which decides the risk premium. This also
means that it determines the investors’ opportunity cost of capital and hence the
discount rate.
SML and cost of capital:
In the CAPM equation, we said that the only factor that changes from one market
to another is the beta. Therefore the CAPM equation is a linear equation and the
line obtained by that equation is also known as the security market line. SML
shows investors’ required return ri for any security i given its beta βi.
To estimate the risk premium in practise, we need the following proxies:
Return on the risk-free asset: in practise no asset is 100% risk free. However debt
securities issued by AAA rated governments such as Germany and the U.S.A. always
pay investors their promised return. To proxy risk-free rate rf, practitioners use the
yield on Treasury debt securities.
Market portfolio: theoretically market portfolio consist of all the shares in the market.
In a portfolio where the different securities are held in the proportion of their market
capitalisation is known as a value weighted portfolio.
Throughout capital budgeting in semester 1 we made our decisions based on
mainly the net present rule. When calculating the NPV, we used discount rates
that were already given. However in this semester we will be focusing more on
calculating the discount rate.
Recap of the NPV rule:
According to the NPV rule, to maximise firm’s market value we accept any
investments which have a positive net present value. In other terms the present
value of the benefits should be more than the present value of the costs. Present
values are based on the after tax cash flows discounted back.
Opportunity cost of capital:
The appropriate discount rate for an investment would be its opportunity cost of
capital. Opportunity cast of capital refers to the return that the investor would
have received if he invested in a project of similar risk. Now the question here for
us is how do we determine this opportunity cost of capital and what risks affect
it.
Which risk determines the cost of capital?
The total firm risk comprises of both unsystematic (firm specific) and systemic
(market wide) risk. Since the unsystematic risk is diversifiable, the investors do
not get any premium on that. The market or the systematic risk, also
represented by the beta, is the one which decides the risk premium. This also
means that it determines the investors’ opportunity cost of capital and hence the
discount rate.
SML and cost of capital:
In the CAPM equation, we said that the only factor that changes from one market
to another is the beta. Therefore the CAPM equation is a linear equation and the
line obtained by that equation is also known as the security market line. SML
shows investors’ required return ri for any security i given its beta βi.
To estimate the risk premium in practise, we need the following proxies:
Return on the risk-free asset: in practise no asset is 100% risk free. However debt
securities issued by AAA rated governments such as Germany and the U.S.A. always
pay investors their promised return. To proxy risk-free rate rf, practitioners use the
yield on Treasury debt securities.
Market portfolio: theoretically market portfolio consist of all the shares in the market.
In a portfolio where the different securities are held in the proportion of their market
capitalisation is known as a value weighted portfolio.
