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Chapter 12 notes - Chapter 12 introduces cost of capital...

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Chapter 12 introduces cost of capital. Cost of capital, required return, and appropriate discount (hurdle) rate are different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk. -required return is from an investor’s point of view -cost of capital is the same return from the firm’s point of view -appropriate discount rate is the same as used in a PV calculation 1. The Cost of Capital with Debt: Cost of debt (R D ) – the interest rate on new debt can easily be estimated using the yield-to-maturity on outstanding debt or by knowing the bond rating and looking up rates on new issues with the same rating. It is beneficial to reemphasize the distinction between the coupon rate, the current yield, and the yield-to-maturity. The cost of debt is equal to the yield-to-maturity because it is the market rate of interest that would be required on new debt issues. The coupon rate, on the other hand, is the firm’s promised interest payments on existing debt, and the current yield is the income portion of total return. 2. Cost of equity: The SML Approach: CAPM, R E = R f + β E (E(R M ) – R f ) The SML approach requires assumptions of normality of returns and/or quadratic utility functions. It also requires the absence of taxes, transaction costs, and other market imperfections. In practice, there are some problems in estimating beta: 1. Betas may vary over time. 2. The sample size may be inadequate. 3. Changing financial leverage and business risk influences betas.
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