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**Unformatted text preview: **1 Chapter 11 Calculating the Cost of Capital 2 Chapter 11 Learning Goals LG1: Grasp the basic intuition behind calculating the cost of capital and its relationship to the investor required return LG2: Use the Weighted Average Cost of Capital (WACC) formula to calculate a projects cost of capital LG3: Debate the firms choices in estimating the appropriate capital component costs of equity, preferred stock, and debt LG4: Calculate and justify appropriate weights used for WACC projections LG5: Clarify which parts of a firm-wide WACC can be used in calculating a project-specific WACC and which parts do not apply LG6: Note the tradeoff implicit in using either a firm-wide WACC or a divisional cost of capital approach LG7: Differentiate between the objective and subjective approaches to computing a divisional cost of capital LG8: Denote the impact that flotation costs have on capital budgeting decisions and adjust the WACC to reflect flotation costs 3 The WACC formula Note that the weights are based on market values rather than book values Market values reflect investors assessment of what they would be willing to pay for various types of securities ) 1 ( C D P E T i D P E D i D P E P i D P E E WACC- + + + + + + + + = 4 Calculating the Component Cost of Equity We have two methods for calculating the cost of equity: 1. CAPM 2. Constant Growth Model CAPM ] ) ( [ f M E f E i i E i i- + = 5 Constant Growth Model g P D i 1 E + = 6 Which one is better? In the CAPM, E estimates future systematic risk, but we calculate it based on historic data We cant use the CAPM if we dont have sufficient historic information or when we suspect that the past level of systematic (market) risk is not a good indicator of future risk The constant growth model assumes constant perpetual growth in dividends If this assumption is not approximately true for our firm then this model will not produce reliable estimates 7 Overall we should expect that the CAPM method for estimating i E will apply more accurately in most cases If the constant growth model applies it is a good idea to use both methods Some type of simple or weighted average of the two methods might be appropriate 8 Example 11-1 Calculate the cost of equity for ADK Industries given the following information: ADK common stock price = $32.75 The next dividend is expected to be $1.54 per share ADK expects future dividends to grow by 6 percent per year indefinitely The risk-free rate is 3 percent The expected return on the market is 9 percent ADK has a beta of 1.3 9 CAPM method: i E = i f + E [E(i M ) i f ] = .03 + 1.3[.09 - .03] = 10.80% Constant growth model: i E = D 1 /P + g = $1.54/$32.75 + .06 = 10.70% The best estimate is (10.80 + 10.70)/2 = 10.75%The best estimate is (10....

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