cost of capital

# cost of capital - Cost of Capital Chapter Outline The Cost...

This preview shows pages 1–10. Sign up to view the full content.

Cost of Capital

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

View Full Document
Chapter Outline The Cost of Equity Capital Estimation of Beta Determinants of Beta Extensions of the Basic Model Estimating International Paper’s Cost of Capital Reducing the Cost of Capital Summary and Conclusions
What are we going to learn? During the last month we looked at capital budgeting by focusing on the appropriate size and timing of cash flows. Now, we are going to focus on the cost of capital of a firm, that is the appropriate discount rate to apply in capital budgeting when cash flows are risky.

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

View Full Document
Invest in project The Cost of Capital Firm with excess cash Shareholder’s Terminal Value Pay cash dividends Shareholder invests in stocks A firm with excess cash can either pay a dividend or make a capital investment
The Cost of Capital The expected return on a capital-budgeting project should be greater than the expected return on a financial asset of comparable risk (which is the cost of capital). Why? Otherwise the firm should give cash to investors in the form of dividends and let them invest the money. Investors will be better off investing in securities with the same risk of the firm. This is why the firm must only accept projects with positive NPV (positive NPV means that the return of the project is higher than what investors can get in the outside markets by investing in stocks of comparable risk).

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

View Full Document
The Cost of Equity To start, let’s consider a firm that does not have debt but only equity. From the firm’s perspective, the expected return is the Cost of Equity Capital: ) ) ( ( ) ( F M i F i R R E β R R E - + = To estimate a firm’s cost of equity capital, we need to know three things: 1. The risk-free rate, R F F M R R E - ) ( 1. The market risk premium, 2 , ) ( ) , ( M M i M M i i σ σ R Var R R Cov β = = 1. The company beta,
Expected return β F R 1.0 Security Market Line (SML) ) ) ( ( β ) ( F M i F i R R E R R E - × + = E(R M )

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

View Full Document
Estimates of β for Selected Stocks Stock Beta MGM Mirage 1.88 Sprint Nextel 1.53 Microsoft 1.00 Bank of America 0.87 Kimberly-Clark Corp. 0.77 Anheuser-Busch (before merger) 0.31 Wisconsin Energy Corp. 0.30
Example Suppose the stock of Kent Enterprises has a beta of 2.5. The firm is 100 % equity financed. Assume a risk-free rate of 5% and a market risk premium of 10%. What is the appropriate discount rate for an

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

View Full Document
This is the end of the preview. Sign up to access the rest of the document.

## This note was uploaded on 03/19/2011 for the course ACCT 440 taught by Professor Smith during the Spring '11 term at Saginaw Valley.

### Page1 / 28

cost of capital - Cost of Capital Chapter Outline The Cost...

This preview shows document pages 1 - 10. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online