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**preview**shows pages 1-3. to view the full**20 pages of the document.**Week 4 Lecture 4 – Chapter 13: Risk, Cost of Capital and Valuation

The Cost of Equity Capital (13.1)

Whenever a firm has extra cash, it can take one of two actions. It can pay out the cash

Directly to its investors. Alternatively, the firm can invest the extra cash in a project, paying

Out the future cash flows of the project.

Because stockholders can reinvest the dividend in risky financial assets, the expected return

on a capital-budgeting project should be at least as great as the expected return on a

financial asset of comparable risk.

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Which action would the investors prefer?

• If investors can re-invest the cash in a financial asset (stock or bond) with the same

risk as that of the project, the investors would desire the alternative with the higher

expected return

• In other words, the project should be undertaken only if its expected return is greater

than that of a financial asset of comparable risk

Our discussion implies a very simple capital budgeting rule: The discount rate of a project

should be the expected return on a financial asset of comparable risk.

• The discount rate is often called the required return on the project – This is an

appropriate name, since the project should be accepted only if the project generates

a return above what is required

• Alternatively, the discount rate of the project is said to be its cost of capital – This

name is also appropriate, since the project must earn enough to pay its suppliers of

capital

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The Cost of Equity Capital (CAPM Approach)

We start with the cost of equity capital, which is the required return on a stockholders’

investment in the firm. The problem is that stockholders do not tell the firm what their

required returns are. So, what do we do?

• We can use CAPM since it used to estimate the required return

From the firm’s perspective, the expected return is the Cost of Equity Capital:

How to interpret this formula:

Example of using the formula above:

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