Name: Randrianantenaina Solohery Mampionona Aime

NIM: 041924353041
Chapter 13 Risk, Cost of Capital, and Valuation
13.1 The Cost of Capital
Whenever a firm has extra cash it can pay out the cash directly to its investors or it can invest
the extra cash in a project, paying out the future cash flows of the project. The rule is simple:
The discount rate of a project should be the expected return on a financial asset of
comparable risk.
13.2Estimating the Cost of Equity Capital with the CAPM
Under the CAPM, RS=RF+β×(RM−RF)
This equation means that we need to know 3 things to estimate a firm’s cost of equity capital
RS (Required return on a stockholder’s investment in the firm): the risk-free rate RF, the
market risk premium RM − RF , and the stock beta β
THE RISK-FREE RATE
The risk-free rate represents the interest an investor would expect from an absolutely risk-
free investment over a specified period of time. The real risk-free rate can be calculated by
subtracting the current inflation rate from the yield of the Treasury bond matching the
investment duration.
MARKET RISK PREMIUM
Method 1: Using Historical Data: refer to chapter 10 that we can estimate the market risk
premium of 7%, but it’s not definitive
Method 2: Using the Dividend Discount Model (DDM)
The current price of a share of stock, P0, can be written as
D1
P0= where D1 is the dividend per share expected next year, RS is the discount rate or
R s−g
cost of equity, and g is the constant annual rate of expected growth in dividends. This
equation can be rearranged, yielding:
D1
Rs= +g
P0
In words, the annual expected return on a stock is the sum of the dividend yield (=D1/P0) over
the next year plus the annual expected growth rate in dividends.
13.3Estimation of Beta
Beta of Security 𝑖=Cov ¿ ¿
Real-world betas, determined by regression analysis approach
13.4Determinants of Beta
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
It is determined by the characteristics of the firm which is: the cyclical nature of revenues,
operating leverage, and financial leverage.
CYCLICALITY OF REVENUES: Some industries are cyclical and perform very
differently in different parts of the business cycle.
OPERATING LEVERAGE: The difference between variable and fixed costs within a
company or a project.
FINANCIAL LEVERAGE AND BETA: Financial leverage refers to the firms fixed costs
of finance. The use of debt financing increases the leverage of a firm and leads to higher
betas. The Asset Beta is the beta of all the firm’s assets. If these are financed using debt and
equity, then the asset beta would be the weighted average of the debt and equity betas.
Let B stand for the market value of the firm’s debt and S stand for the market value of the
firm’s equity. We have:
S B
βPortfolio=βAsset= ×βEquity+ ×βDebt where βEquity is the beta of the stock of the levered
B+ S B+ S
firm.
The beta of debt is very low in practice. If we make the common assumption that the beta of
debt is zero (or very close to zero), we have:
S
βAsset= ×β
B+ S Equity
Because S/(B + S) must be below 1 for a levered firm, it follows that β Asset < βEquity.
Rearranging this equation, we have:
B
βEquity=βAsset(1+ )
S
13.5 The Dividend Discount Model Approach
Under DDM approach,
D1
Rs= +g
P0
In order to apply the DDM to a particular stock, we must estimate both the dividend yield and
the expected growth rate. Alternatively, we can set next year’s dividend as the product of last
year’s dividend and 1 + g. The expected growth rate of dividends can be estimated in one of
three ways. First, we can calculate the firm’s historical growth rate in dividends from past
data. Refer to Chp.9 the growth rate in dividends can be expressed as: g = Retention ratio ×
ROE, where the retention ratio is the ratio of retained earnings to earnings and ROE stands
for return on equity. Third, security analysts commonly provide forecasts of future growth.
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
However, analysts’ estimates are generally for 5-year growth rates in earnings, while the
DDM requires long-term growth rates in dividends.
COMPARISON OF DDM AND CAPM
DDM is based on the value of the dividends a share of stock brings in, whereas CAPM
evaluates risks and returns compared to the market average. Neither DDM nor CAPM is a
perfect investment tool, because both rely on assumptions about the future.
13.6Cost of Capital for Divisions and Projects
Corporate discount rate, or hurdle rate: If a project’s beta differs from that of the firm, the
project’s cash flows should be discounted at a rate commensurate with the project’s own beta.
Here in this next figure shows the relationship between the Firm’s Cost of Capital and the
Security Market Line (SML)

13.7 Cost of Fixed Income Securities

COST OF DEBT
The cost of debt is the rate a company pays on its debt, such as bonds and loans. The key
difference between the cost of debt and the after-tax cost of debt is the fact that interest
expense is tax-deductible. Cost of debt is one part of a company's capital structure, with the
other being the cost of equity. In general, the aftertax cost of debt can be written as:
Aftertax cost of debt = (1−Tc)×Borrowing rate
COST OF PREFERRED STOCK
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NIM: 041924353041
Cost of preferred stock is the rate of return required by holders of a company's preferred
stock. It is calculated by dividing the annual preferred dividend payment by the preferred
stock's current market price. It can be written as:
RP = D/PV ; where PV is the present value, or price; D is the dividend to be received each
year; and RP is the yield, or rate of return
13.8The Weighted Average Cost of Capital
Suppose that a firm uses both debt and equity to finance its investments which is RB for its
debt financing and RS for its equity. So the overall or average cost of capital is:
S B
× RS+ × RB
S +B S+ B
The weights in the formula are, respectively, the proportion of total value represented by

S B
equity: and the proportion of total value represented by debt:
S +B S +B
After getting those results we can proceed to the average cost of capital (after tax) for the
firm:
S B
WACC= × RS + × R B ×(1−T C )
S+ B S+B
13.9Valuation with WACC
WACC is an appropriate discount rate for the firm or for a project that is a replica of the firm.
PROJECT EVALUATION AND THE WACC
When it comes to valuing a project, we start by determining the correct discount rate and use
discounted cash flows to determine NPV. To determine the WACC of a project, the first step
us to transforming the debt-equity (B/S) ratio to a debt-value ratio as well as the equity value.
Then we can proceed to the computation of WACC and then calculate NPV
FIRM VALUATION WITH THE WACC
Similarly as the one above, the procedure is the same except that we use a horizon for valuing
a complete business enterprise. Specifically, we use the firm’s WACC as our discount rate
and we set up the usual discounted cash flow model by forecasting the firm’s entire net cash
flow up to a horizon along with a terminal value of the firm:
CFA ¿1 CFA ¿1
PV 0= +
1+ WACC❑ ¿ ¿
CF t +1 CF t (1+ gCF )
RV t = =
WACC−gCF WACC−gCF
Where CFA* is the net cash flows, gCF is the growth rate of cash flows beyond t
Name: Randrianantenaina Solohery Mampionona Aime
NIM: 041924353041
13.11 Flotation Costs and the Weighted Average Cost of Capital
Flotation costs are incurred by a publicly traded company when it issues new securities, and
includes expenses such as underwriting fees, legal fees and registration fees.
THE BASIC APPROACH
We can calculate an overall or weighted average flotation cost, fA
fA=(S/V)×fS+(B/V)×fB ; where flotation cost for stock:fS, the percentage of stock (S/V),
flotation cost for bonds: fB, and the percentage of bonds (B/V). In taking issue costs into
account, the firm must be careful not to use the wrong weights. The firm should use the target
weights, even if it can finance the entire cost of the project with either debt or equity.
FLOTATION COSTS AND NPV
The flotation costs must be treated as part of the initial investment outlay at the start of a
project to correctly calculate the net present value (NPV) and internal rate of return (IRR) of
the project for which funding is needed. So in this section we should first calculate the
WACC and then take the result form that calculation to compute the NPV
INTERNAL EQUITY AND FLOTATION COSTS
Flotation costs are the costs incurred by the company in issuing the new stock. Flotation
costs increase the cost of equity such that cost of new equity is higher than cost of
(existing) equity.
fA=(S/V)×fS+(B/V)×fB ; we now assign a value of zero to the flotation cost of equity fS
because there is no such cost