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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 project’s cost of capital LG3: Debate the firm’s 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 firmwide WACC can be used in calculating a projectspecific WACC and which parts do not apply LG6: Note the tradeoff implicit in using either a firmwide 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 + = β 5 • Constant Growth Model g P D i 1 E + = 6 • Which one is better? – In the CAPM, β E estimates future systematic risk, but we calculate it based on historic data • We can’t use the CAPM if we don’t 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 111 • 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 riskfree 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 + β 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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 Spring '10
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 Cost Of Capital, Weighted Average Cost Of Capital (WACC), Weighted average cost of capital, Constant Growth Model, click open hyperlink

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