Case | HBS Case Collection | 2004 (Revised from original 2003 version)

Giant Cinema

by Malcolm P. Baker, Richard S. Ruback, Erik Stafford and Kathleen Luchs

Abstract

The owner of Giant Cinema must decide whether to invest in a digital projector, a new technology for screening films, or purchase a traditional projector. The impact of the new technology is uncertain, and the case describes probabilities for different outcomes that students can incorporate in the financial analysis of the proposed project.

Keywords: Entrepreneurship; Film Entertainment; Technology Adoption; Financial Strategy; Investment; Outcome or Result; Risk and Uncertainty; Technology; Entertainment and Recreation Industry;

Format: Print

8 pages

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Citation:

Baker, Malcolm P., Richard S. Ruback, Erik Stafford, and Kathleen Luchs. "Giant Cinema." Harvard Business School Case 204-052, January 2004. (Revised from original September 2003 version.)

Minimum capital requirements are a central tool of banking regulation. Setting them balances a number of factors, including any effects on the cost of capital and in turn the rates available to borrowers. Standard theory predicts that, in perfect and efficient capital markets, reducing banks' leverage reduces the risk and cost of equity but leaves the overall weighted average cost of capital unchanged. We test these two predictions using U.S. data. We confirm that the equity of better-capitalized banks has lower systematic risk (beta) and lower idiosyncratic risk. However, over the last 40 years, lower risk banks have higher stock returns on a risk-adjusted or even a raw basis, consistent with a stock market anomaly previously documented in other samples. The size of the low risk anomaly within banks suggests that the cost of capital effects of capital requirements may be considerable. Assuming competitive lending markets, banks' low asset betas implied an average risk premium of only 40 basis points above Treasury yields in our sample period; a calibration suggests that a ten percentage-point increase in Tier 1 capital to risk-weighted assets may have increased this to between 100 and 130 basis points per year. In summary, the low risk anomaly in the stock market produces a potentially significant cost of capital requirements.

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