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Lecture 4

FINA601 Lecture Notes - Lecture 4: Cash Flow, Capital Budgeting, Tax Rate

20 pages119 viewsSummer 2018

Department
FINA
Course Code
FINA601
Professor
Ivan
Lecture
4

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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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