{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Chapter 12. Cost of capital

Chapter 12. Cost of capital - Cost of Capital Chapter 12...

Info icon This preview shows pages 1–6. Sign up to view the full content.

View Full Document Right Arrow Icon
Cost of Capital Chapter 12 Finance 357
Image of page 1

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Cost of Equity Capital Firms have two choices when they make a profit. They can pay the cash out as a dividend or they can retain the cash and reinvest it. If the money is reinvested within the company, it should make a return higher than what it could receive from an outside investment. Thus, the discount rate of a project should be the expected return on a financial asset of comparable risk.
Image of page 2
Using CAPM to Find Equity Cost of Capital From the perspective of a firm, its expected return is the cost of equity capital. Using CAPM it can be written as This formula is often called the Security Market Line formula or SML. Now we can estimate the cost of equity capital for a firm. We need Risk Free Rate Market Risk Premium Company Beta
Image of page 3

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Example Microsoft has a Beta of .99. It is 100% equity financed; that is it has no debt. Microsoft is considering a new project that has a risk profile similar to its other projects; therefore its beta for the new project is the same as its overall beta. If the risk free rate is 2% and the market risk premium is 5.4%, what is the appropriate discount rate for the new project?
Image of page 4
Project Evaluation and Beta Suppose Alpha Air Freight is an all-equity firm with a beta of 1.21. The market risk premium is 9.5% and the risk free rate is 5%. We calculate the expected return on the common stock by using the SML formula.
Image of page 5

Info icon This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 6
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern