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1、CHAPTER12Risk,CostofCapital,andCapitalBudgetingInlate2005,SwissRe,oneoftheworldsleadingindustry.Oneofthemajorreasonsgivenforthepossiblereinsurers,publishedareportdiscussinghowinsurancesaleofGeneralMotorsAcceptanceCorporation(GMAC)companiescreatevalueforshareholders.OneofthebyGeneralMotorswasthatth
2、eloweringofGMsdebtkeycomponentsaddressedinthereportwasthecostratinghadincreasedthecostofcapitalforGMAC.ofcapital.AccordingtoSwissRe,thecostofcapitalforInthischapter,welearnhowtocomputea?rmscosttheU.S.non-lifeinsuranceindustryduringthe1980sofcapitaland?ndoutwhatitmeanstothe?rmanditswasabout15percen
3、t.By2005,thecostofcapitalforinvestors.Wewillalsolearnwhentousethe?rmscosttheindustryhaddroppedto7to8percent.Butthecostofcapitalandperhapsmoreimportant,whennottoofcapitalisimportantinmorethanjusttheinsuranceuseit.12.1TheCostofEquityCapitalWhenevera?rmhasextracash,itcantakeoneoftwoactions.Itcanpayou
4、tthecashim-mediatelyasadividend.Alternatively,the?rmcaninvestextracashinaproject,payingoutthefuturecash?owsoftheprojectasdividends.Whichprocedurewouldthestock-holdersprefer?Ifastockholdercanreinvestthedividendina?nancialasset(astockorbond)withthesameriskasthatoftheproject,thestockholderswoulddesir
5、ethealterna-tivewiththehighestexpectedreturn.Inotherwords,theprojectshouldbeundertakenonlyifitsexpectedreturnisgreaterthanthatofa?nancialassetofcomparablerisk.ThisisillustratedinFigure12.1.Thisdiscussionimpliesaverysimplecapitalbudgetingrule:Thediscountrateofaprojectshouldbetheexpectedreturnona?na
6、ncialassetofcom-parablerisk.Fromthe?rm’sperspective,theexpectedreturnisthecostofequitycapital.UndertheCAPM,theexpectedreturnonthestockcanbewrittenas:RSRF(RMRF)(12.1)whereRFistherisk-freerateandRMRFisthedifferencebetweentheexpectedreturnonthemarketportfolioandtherisklessrate.Thisdifferenceiso
7、ftencalledtheexpectedexcessmarketreturnormarketriskpremium.Notewehavedroppedthebardenotingexpectationsfromourexpressiontosimplifythenotation,butrememberthatwearealwaysthinkingaboutexpectedreturnswiththeCAPM.342ro
