Introduction to Cost of Capital

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Introduction to Cost of Capital

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need estimates of beta and E(RM) 6. Dividend Growth Example ... Equity betas are influenced by the financing choice, but asset betas are not. ... – PowerPoint PPT presentation

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Title: Introduction to Cost of Capital


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Introduction to Cost of Capital
  • Idea Find the appropriate discount rate for a
    firms assets as a whole.
  • The cost of capital reflects the average cost of
    funds for the firm. In other words it is the
    return required by investors in the firm.
  • Cost of capital depends mostly on the assets (use
    of funds), not the financing (source of funds).

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Why is Cost of Capital Important?
  • A firms Weighted Average Cost of Capital (WACC)
    is the correct r to use in the DCF formulas
    when the project is of average risk.
  • For projects of different risk we need to make
    adjustments.
  • Knowing the cost of capital is critically
    important in making investment decisions.

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Example
  • Firm currently has
  • 60 equity, cost of 15
  • 40 debt, cost of 7, 30 tax rate
  • Project is same risk as other assets
  • Requires 1 million investment, pays 100,000 in
    perpetuity.
  • If the firm raises the 1 million by issuing
    debt, what is the project NPV?
  • What if the firm issues equity instead?

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All Equity Firms
  • With no debt, the cost of capital is just the
    cost of equity.
  • So where do we get cost of equity?
  • Dividend Growth Model
  • CAPM

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Estimating Cost of Equity
  • Dividend growth model
  • requires estimates of g and the dividend yield.
  • Does not work well when these are changing.
  • CAPM
  • need estimates of beta and E(RM)

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Dividend Growth Example
  • A firm expects dividends to grow 5 per year.
  • The next dividend is expected to be 1.
  • The current price is 10.

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CAPM Example
  • Suppose rf 6 and E(RM) 13.
  • Find rE if the stock has a beta of 1.5.

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Which Approach?
  • Dividend Growth
  • Simple
  • g constant not reasonable
  • Sensitive to assumptions
  • no risk adjustment
  • based on historical
  • CAPM
  • Adjusts for risk
  • g can vary
  • requires estimate of b and E(RM)
  • often historically-based

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Cost of Debt
  • Ignore the cost of capital idea for a moment and
    focus only on the cost of debt.
  • Use the bond formulas to find rD
  • Alternatively, look at the required return on
    debt with similar risks and provisions.

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Combining Debt and Equity
  • Combining the cost of debt and the cost of equity
    gives the cost of capital for all the assets
    (WACC).
  • Alternatively, we can find the asset beta
  • Portfolio betas are weighted averages
  • View a firm as portfolio of debt and equity

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WACC Calculation
  • To calculate the WACC we need
  • rE, and wE
  • rD, wD, and the tax rate t
  • The WACC represents the average cost of financing
    the assets.
  • It adjusts for the tax shield provided by debt.
  • Note We are ignoring complications such as
    flotation costs.

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WACC Example
  • Consider the firm in the opening example.
  • 60 equity, rE 15
  • 40 debt, rD 7, 30 tax rate

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Asset Beta Example
  • A firm has debt beta, bD 0.1 and asset beta, bA
    1.2.
  • The market value of the firm is 1 billion, and
    the equity has a value of 700 million.
  • The market return is expected to be 13, with a
    6 riskless rate.

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Note on Asset Betas
  • Asset betas apply to all assets, including
    equity, entire firms, specific divisions, or
    individual projects.
  • Equity betas are influenced by the financing
    choice, but asset betas are not.
  • To estimate project betas from the betas of peer
    firms, convert equity betas to asset betas to
    account for differences in financing.

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Project Cost of Capital
  • The WACC idea is appropriate for use in capital
    budgeting only when the project is of the same
    risk as the entire firm.
  • If the project is of different risk, we need to
    make adjustments.
  • Pure play approach
  • Subjective approach

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