1 FIN3004 Corporate Finance Lecture 4 Cost of Capital
2 Learning Outcome Know how to determine a firm ’ s cost of equity capital Understand the impact of beta in determining the firm ’ s cost of equity capital Know how to determine the firm ’ s overall cost of capital Understand the impact of flotation costs on capital budgeting
3 Where Do We Stand? Earlier discussions on capital budgeting focused on the appropriate size and timing of cash flows. This lecture discusses the appropriate discount rate when cash flows are risky.
4 Invest in project The Cost of Equity Capital Firm with excess cash Shareholder’s Terminal Value Pay cash dividend Shareholder invests in financial asset Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital-budgeting project should be at least as great as the expected return on a financial asset of comparable risk. A firm with excess cash can either pay a dividend or make a capital investment
5 The Cost of Equity Capital From the firm ’ s perspective, the expected return is the Cost of Equity Capital: ) ( F M i F i R R β R R • To estimate a firm’s cost of equity capital, we need to know three things: 1. The risk-free rate, R F F M R R 2. The market risk premium, 3. The company beta, ) ( ) ( ) ( ) ( 2 , M i M M i i R R R R R Cov
6 Example Suppose Quantram has a beta of 1.3, and the firm is 100% equity financed. Assume a risk-free rate of 5% and a market risk premium of 8.4%. What is the appropriate discount rate for an expansion of this firm? ) ( F M i F R R β R R % 92 . 15 %, 4 . 8 3 . 1 % 5 R R
7 Example Suppose the stock of Stansfield Enterprises, a publisher of PowerPoint presentations, has a beta of 2.5. The firm is 100% equity financed. Assume a risk-free rate of 5% and a market risk premium of 10%. What is the appropriate discount rate for an expansion of this firm? ) ( F M i F R R β R R % 10 5 . 2 % 5 R % 30 R
8 Example Suppose Stansfield Enterprises is evaluating the following independent projects. Each costs $100 and lasts one year. Project Project Project’s Estimated Cash Flows Next Year IRR NPV at 30% A 2.5 $150 50% $15.38 B 2.5 $130 30% $0 C 2.5 $110 10% -$15.38
9 Using the SML An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital. Project IRR Firm’s risk (beta) SML 5% Good project Bad project 30% 2.5 A B C Reject Region
10 The Risk-free Rate Treasury securities are close proxies for the risk-free rate. The CAPM is a period model. However, projects are long-lived. So, average period (short-term) rates need to be used. The historic premium of long-term (20- year) rates over short-term rates for government securities is 2%.
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- Summer '19
- Finance, Weighted average cost of capital, market risk premium, Equity Capital