1
FIN3004 Corporate Finance
Lecture 2
Cost of Capital

2
Learning Outcome
Learning Outcome
Know how to determine a firm
Know how to determine a firm
’
’
s
s
cost of equity capital
cost of equity capital
Understand the impact of beta in
Understand the impact of beta in
determining the firm
determining the firm
’
’
s cost of
s cost of
equity capital
equity capital
Know how to determine the firm
Know how to determine the firm
’
’
s
s
overall cost of capital
overall cost of capital
Understand the impact of flotation
Understand the impact of flotation
costs on capital budgeting
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 required 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,

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 equity capital.
Return
Firm’s risk (beta)
SML
5%
Good
project
Bad project
30%
2.5
A
B
C
Reject!

10
The Risk-free Rate
Treasury securities are close proxies for
the risk-free rate.

11
The Market Risk Premium
Method 1: Use historical data
Method 2: Use the Dividend Discount
Model (DDM):
Market data and analyst forecasts can
be used to implement the DDM
approach on a market-wide basis
g
P
D
R
0
1

12
Beta

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- Fall '15
- Finance, Corporate Finance, Interest, Weighted average cost of capital, Equity Capital