cost of capital

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

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

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