Beruflich Dokumente
Kultur Dokumente
Cost of Capital
D0 (1 g )
P0
RE g
Rearranging:
D1
RE g
P0
Disadvantages
Only applicable to companies paying dividends.
Assumes dividend growth is constant.
Cost of equity is very sensitive to growth estimate.
Ignores risk.
RE R f E RM R f
RE R f E RM R f
6% 1.40 7.94%
17.12%
Disadvantages
Requires two factors to be estimated: the market risk
premium and the beta co-efficient.
Uses the past to predict the future, which may not be
appropriate.
RD is observable:
yields on currently outstanding debt
yields on newly-issued similarly-rated bonds.
I PV NP /n
RD
PV NP /2
$12 $100 $86/10
$100 $86/2
14.4%
D
RP
P0
WACC E V R D V RE D 1 TC
RE R f E RM R f
5% 0.90 7.94%
12.15%
0.104 or 10.4%
SML
= 8%
Incorrect
16 B acceptance
15 WACC = 15%
14 A
Incorrect
rejection
Rf =7
Beta
A = .60 firm = 1.0 B = 1.2
If a firm uses its WACC to make accept/reject decisions for all types of projects, it will have a
tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.
SML
= 8%
20
High risk
A (+6%)
WACC = 14
10
Rf = 7 Moderate risk
Low risk (+0%)
(4%)
Beta
With the subjective approach, the firm places projects into one of several risk classes. The discount
rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk)
an adjustment factor to or from the firms WACC.
fA E fE D fD
V V
where f A weighted average flotationcost
f E equity flotationcost
f D debt flotationcost
0.118 or 11.8%
$195800
NPV $1 500 000
0.118
$159 322
0.092 or 9.2%
$1 500 000
T rue cost $1 651982
1 0.092
$195 800
NPV $1 651982
0.118
$7340