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ch10-lect - Chapter 10 Cost of Capital Introduction In this...

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Chapter 10 Cost of Capital Introduction In this session we study the cost of capital for a firm and its components. Firms finance themselves by selling different kinds of securities (broadly debt and equity) Cost of capital is the rate of return a firm has to pay to the buyers of the securities it sells. Different securities have different possible future cash flows based on differing contracts. For example for a simple capital structure, debt is supposed to get a fixed repayment and whatever is left. The different cash flows have different risks, and hence different securities have different associated costs of capital (for example cost of equity and cost of debt). Cost of Capital To make investments a firm requires money. If this money is raised from external sources, it could be through the sale of equity or debt. Cost of Equity Investors who purchase equity from a firm will price the equity by discounting future expected cash flows (from their ownership of the equity) by a discount rate. This discount rate is called the “Equity Cost of Capital”. Suppose the firm wishes to raise a certain amount of money by selling equity. Higher the equity cost of capital, higher would be the expected cash flows the firm would have to provide the equity buyers. If you believe the CAPM is true, the equity cost of capital is given by: R E = R f + β E (E(R M ) – R f ) The plot of the above relationship between R and β E is called the Security Market Line (SML). Beta is defined as: β S = σ iM / σ M 2 Implementing the Approach Betas are widely available, and T-bill rates or the rate on long-term Treasury securities are often used for R f . The expected market risk premium is the more difficult number to come up with – make sure that the market risk premium used is consistent with the risk-free rate chosen. One of
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