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Unformatted text preview: If we then
add the risk-free interest rate, we arrive at the cost of capital:
Cost of capital = rf + β asset (rm - rf)
β Suppose the expected risk-free rate of interest is 4 percent and the expected return on the market as a
whole is 10 percent. If the basset is 2.00, this means that if there is a 1 percent change in the market
risk premium, we expect a 2 percent change in the return on the project. In this case, the cost of capital
is 16 percent:
Cost of capital = 0.04 + 2.00 (0.10 - 0.04) = 0.16 or 16%
If asset beta is 0.75, instead, the cost of capital is 8.5 percent:
Cost of capital = 0.04 + 0.75 (0.06) = 0.085 or 8.5%
If we are able to gauge the market risk of a project, we estimate the risk-free rate and the premium for
market risk and put them together. But often we are not able to measure the market risk, nor even the
risk-free rate. So we need another way to approach the estimation of the project's cost of capital. C. Adjusting the company's cost of capital Another way to estimate the cost of capital for a project without estimating the risk premium directly is to
use the company's average cost of capital as a starting point. The average cost of capital is the
company's marginal cost of raising one more dollar of capital -- the cost of r...
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This note was uploaded on 02/07/2014 for the course MIS 304 taught by Professor Mejias during the Spring '07 term at Arizona.
- Spring '07