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