Ch15 - Cost of Capital and Firm Valuation Valuation -...

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Cost of Capital and Firm aluation Valuation -- Chapter 15 Yihui Wang Cost of Capital and Firm Valuation
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Main Issues • The cost of equity • The cost of debt and preferred stock • The weighted average cost of capital • Basics of firm valuation • Project cost of capital Cost of Capital and Firm Valuation 2
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Why Cost of Capital Is Important i d i i i i i th t f i t Financing decision: minimize the cost of inputs, including capital apital budgeting: cost of capital is needed to determine Capital budgeting: cost of capital is needed to determine required return for capital budgeting projects ost of capital provides an indication of how the market Cost of capital provides an indication of how the market views the risk of the assets The return earned on assets depends on the risk of those assets • The required return of an investor is the same as the st to the compan Cost of Capital and Firm Valuation cost to the company 3
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equired Return vs Cost of Capital Required Return vs. Cost of Capital If you are an investor who is considering investing $100 in AT&T, which offers an expected return of 12% per annum. You are approached by a group of entrepreneurs who ask you to participate in a venture that is of exactly the same risk as an investment in AT&T. What will be your minimum required return on is alternative investment? this alternative investment? In order for the venture to be profitable, it must offer an internal rate of return of at least12%. -- If the internal rate of return > 12%, NPV of investment is _____ -- If the internal rate of return < 12%, NPV of investment is _____ ere 12% is the: Here, 12% is the: opportunity cost of capital required rate of return Cost of Capital and Firm Valuation 4 discount rate in NPV calculations
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Required Return • The required return is the appropriate discount rate and based on the risk of the cash flows, not the source nd of fund. • We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment • We need to earn at least the required return to compensate our investors for the financing they have provided Cost of Capital and Firm Valuation 5
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Required Return h h i d f d d h Note that the required rate of return depends on the risk of the investment rms obtain financing in arious forms Firms obtain financing in various forms: Common stock Preferred stock Bank loans Public debt We need to estimate the cost of each component separately Cost of Capital and Firm Valuation 6
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Cost of Equity • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Business risk nancial risk Financial risk • There are two major methods for determining the st of equity cost of equity Dividend growth model CAPM or SML Cost of Capital and Firm Valuation 7
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The Dividend Growth Model Approach • If dividend of the firm grow in a constant growth rate g
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Ch15 - Cost of Capital and Firm Valuation Valuation -...

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