Lectures Notes Financial markets first semester, Study notes of Economics

Download Lectures Notes Financial markets first semester and more Study notes Economics in PDF only on Docsity! The Debt Cost of Capital debt cost of capital = the cost of capital that a firm must pay on its debt. Debt Yields versus Returns The yield to maturity of a bond is the IRR an investor will earn from holding the bond to maturity and receiving its promised payments. Therefore, if there is little risk the firm will default, we can use the bond’s yield to maturity as an estimate of investors’ expected return. If there is a significant risk that the firm will default on its obligation, however, the yield to maturity of the firm’s debt, which is its promised return, will overstate investors’ expected return. Expected return of a bond is The importance of these adjustments will naturally depend on the riskiness of the bond, with lower- rated (and higher-yielding) bonds having a greater risk of default. Debt Betas In principle it would be possible to estimate debt betas using their historical returns in the same way that we estimated equity betas. Debt betas tend to be low, though they can be significantly higher for risky debt with a low credit rating and a long maturity. 12.5: A Project’s Cost of Capital In the case of a firm’s equity or debt, we estimate the cost of capital based on the historical risks of these securities. Because a new project is not itself a publicly traded security, this approach is not possible. Instead, the most common method for estimating a project’s beta is to identify comparable firms in the same line of business as the project we are considering undertaking. Indeed, the firm undertaking the project will often be one such comparable firm (and sometimes the only one). Then, if we can estimate the cost of capital of the assets of comparable firms, we can use that estimate as a proxy for the project’s cost of capital. All-Equity Comparables The simplest setting is one in which we can find an all-equity financed firm in a single line of business that is comparable to the project. Because the firm is all equity, holding the firm’s stock is equivalent to owning the portfolio of its underlying assets. Thus, if the firm’s average investment has similar market risk to our project, then we can use the comparable firm’s equity beta and cost of capital as estimates for beta and the cost of capital of the project. Levered Firms as Comparables The situation is a bit more complicated if the comparable firm has debt. In that case, the cash flows generated by the firm’s assets are used to pay both debt and equity holders. The returns of the firm’s equity alone are not representative of the underlying assets; because of the firm’s leverage, the equity will often be much riskier. Thus, the beta of a levered firm’s equity will not be a good estimate of the beta of its assets and of our project. We can recreate a claim on the firm’s assets by holding both its debt and equity simultaneously. The return of the firm’s assets is therefore the same as the return of a portfolio of the firm’s debt and equity combined. For the same reason, the beta of the firm’s assets will match the beta of this portfolio The Unlevered Cost of Capital