Chapter 12. Cost of capital

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

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Cost of Capital Chapter 12 Finance 357

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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.
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

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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?
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. 5% + (1.21 x 9.5%) = 16.495%

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## This note was uploaded on 11/09/2010 for the course FIN 357 taught by Professor Hadaway during the Spring '06 term at University of Texas at Austin.

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

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