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Risk, Cost of Capital and Capital Budgeting (Cost of Equity (Spare cash…
Risk, Cost of Capital and Capital Budgeting
Cost of Equity
Spare cash
Invest in new projects
Pay dividends
Expected Return on Equity calculated using CAPM
Beta
Formula
Regression
Problems with Beta
Can vary over time
Sample size may be too small
Influenced by financial leverage and business risk
Determinants of Beta
Cyclicity of Revenues
Some firms more susceptible to the business cycle
Operating Leverage
Higher proportion of fixed costs = More susceptible
Financial Leverage
More debt = Riskier
Risk of Projects
Pure Play Approach
Project beta different to firm beta
Unlever industry beta and relever to match capital structure