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Cost of Capital
Cost of Capital
Key Concepts
Required Return
Cost of Equity
D1
g
P0
1.50
RE
.051 .111
25
Dividend
1.23
1.30
1.36
1.43
1.50
Percent Change
Ri RF i ( RM RF )
To estimate a firms cost of equity capital, we need
to know three things:
1. The risk-free rate, RF
RM R F
Cov ( Ri , RM ) i , M
2
The company beta, i
Var ( RM )
M
Example - SML
More
Example
Ri RF i ( RM RF )
R 5% 2.5 10%
R 30%
Example (continued)
Project
IRR
NPV at
30%
2.5
Projects
Estimated Cash
Flows Next
Year
$150
50%
$15.38
2.5
$130
30%
$0
2.5
$110
10%
-$15.38
IRR
Project
30%
5%
SML
Bad projects
Firms risk (beta)
2.5
An all-equity firm should accept a project whose IRR exceeds the cost of equity
capital and reject projects whose IRRs fall short of the cost of capital.
Estimation of Beta
Problems
Cov ( Ri , RM ) i2
2
Var ( RM )
M
Solutions
Stability of Beta
Determinants of Beta
Business
Risk
Cyclicity
of Revenues
Operating Leverage
Financial
Risk
Financial
Leverage
Cyclicality of Revenues
Operating Leverage
EBIT
Q(P - v)
EBIT + F
DOL = EBIT =
=
SALES Q(P - v) - F
EBIT
SALES
Operating Leverage
Debt
Equity
Debt +
Equity
Debt + Equity
Debt + Equity
Advantages
Explicitly adjusts for systematic risk
Applicable to all companies, as long as we can
compute beta
Disadvantages
Have to estimate the expected market risk premium,
which does vary over time
Have to estimate beta, which also varies over time
We are relying on the past to predict the future, which
is not always reliable
Cost of Debt
25 years/2 = 50 periods = N
HP
$-908.72 = PV
$90/2 = $45 = Payment12-C
(PMT)
YTM = i = ?
$1,000 = FV
5.00
(x2 = 10%)
TI BA II
Plus
25 yrs/2
= 50 payments = N
5%(5 x 2 = 10%
$ -908.72 = PV
$90/2 = $45 (PMT)
$1,000 = FV
YTM = I/Y = ?
1st
2nd
i=?
60
30
N
OUTPUT
30
...
-1,153.72
INPUTS
2
60
-1153.72 60
I/YR
PV
PMT
5.0% x 2 = Rd = 10%
60 + 1,000
1000
FV
R P = D P / P0
Notation
E = market value of equity = # outstanding shares times
price per share
D = market value of debt = # outstanding bonds times
bond price
P=market value of preferred stock=#outstanding shares
times price per share
V = market value of the firm = D + PF+ E
Weights
wE = E/V = percent financed with equity
wd = D/V = percent financed with debt
wP = PF/V = percent financed with preferred stock
WACC = wDRd(1-TC)+wP RP + w E RE
Equity Information
Debt Information
$1
billion in
outstanding debt (face
value)
Current quote = 110
Coupon rate = 9%,
semiannual coupons
15 years to maturity
50
million shares
$80 per share
Beta = 1.15
Market risk premium =
9%
Risk-free rate = 5%
Project
A
B
C
Required Return
20%
15%
10%
IRR
17%
18%
12%
Project IRR
SML
Incorrectly accepted
negative NPV projects
RF FIRM ( RM RF )
Hurdle
rate
Rf
FIRM
Incorrectly rejected
positive NPV projects
Firms risk (beta)
A firm that uses one discount rate for all projects may
over time increase the risk of the firm while decreasing
its value.
Subjective Approach
Discount Rate
WACC 8%
Low Risk
WACC 3%
WACC
High Risk
WACC + 5%
WACC + 10%
Flotation Costs
The required return depends on the risk, not
how the money is raised
However, the cost of issuing new securities
should not just be ignored either
Basic Approach
Compute
Quick Quiz