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Session 3, 4: 7 Dec 2011 Course: SLFI 604; Second Year Sem 2; Class of 2012
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Expected return on any asset is equal to a risk free rate of return plus a risk premium
Risk
Use of Short term or long term depends on how long the investor intends to hold the investment
Market
risk of equity premium refers to the additional rate of return in excess of risk free
Ke= Rf + (Rm - Rf ) Rf - Risk Free rate of return Beta Rm - Expected rate of return on equities 3/20/12
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of Debt = Cost of debt of borrowed funds Reflects the default risk of the firm Can be measured by the firms credit rating For non rated firms
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= dpr/PR
Kpr - Cost of Preferred Stock Dpr Dividend per share PR Market Value of Preferred Stock
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Market value of equity D- Market value of Debt PR Market Value of Preferred Stock
Non
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Analyzing Risk
Non diversifiable and Diversifiable Risk Represents non diversifiable portion of the risk < 1 Less risky than the general market >1 More Risky than general market
Investors
compensated for risk that cannot be eliminated through diversification calculate by this regression equation
Can
Rf = + Rm
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Leverage on Beta
Financial
Leverage boosts equity returns in good times and depresses in bad times l = u [ 1 + (1-t)D/E]
Steps
Determine firms current equity Beta* and D/E* Estimate unlevered u = l/ [ 1 + (1-t)D/E] Now estimate levered Beta using the latest target D/E structure l = u [ 1 + (1-t)D/E**] Estimate the firms cost of equity for new levered
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= EBIT (1- Tax rate) + Depreciation and Amortization Gross Capex Change in Net working capital Represents cash flow to all investors holding claims to firms resources FCFE = [Net Income + Depreciation and Amortization Change in working Capital]1 Gross Capex2 + [New preferred Equity Preferred Dividends + New Debt Issue Principal Payments]3 1- CFO, 2- CFI, 3 CFF
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