Malkiel_Random Walk_Chapter 15

Malkiel_Random Walk_Chapter 15 - Chapter 15 Cost of Capital...

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Chapter 15 - Cost of Capital Cost of capital – the minimum required return associated with the project. Weighted Average Cost of Capital (WACC) – the cost of capital for the firm as a whole. It can be interpreted as the required return on the overall firm. The Cost of Capital: Some Preliminaries In this chapter the focus is on looking closely at how the returns and securities look from the viewpoint of the company issuing them. Required Return Versus Cost of Capital If a firm has a required rate of return of 10% it means that the investment will have a positive NPV if its return exceeds 10%. Another way of interpreting this is by saying that the firm must earn 10% on the investment just to compensate its investors for the use of the capital needed to finance the project. Therefore, 10% is the cost of capital associated with the project. The “key fact to grasp” is that the cost of capital associated with an investment depends on the risk of that investment. o Meaning, the cost of capital depends primarily on the use of the funds, not the source. o Thus the cost of capital for an investment does not depend on how and where the capital is raised. Financial Policy and Cost of Capital The firm’s overall cost of capital will reflect the required return on the firm’s assets as a whole. Given that a firm uses both debt and equity capital, this overall cost of capital will be a mixture of the returns needed to compensate its creditors and those needed to compensate its stockholders. Therefore, the firm’s cost of capital will reflect both its costs of debt capital and costs of equity capital. The Cost of Equity There is no way of directly observing the return that the firm’s equity investors require on their investments, so this is a very difficult measure to evaluate. But this section outlines 2 different approaches to estimating it: the dividend growth model approach and the security market line (SML) approach. Dividend Growth Model Approach This method was discussed in chapter 8. Under the assumption that the firm’s dividend will grow at a constant rate, g, the price per share of the stock, Po, can be written as: Po = [Do x (1 + g)] / Re – g = D1/Re-g
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Do = Dividend just paid D1 = Next period’s projected dividend Re = Required return on the stock (e stands for equity) it can also be interpreted as the firm’s cost of equity capital. There are three pieces of information necessary for the model, Po, Do, and g.
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