COMMERCE 3FA3 Chapter Notes - Chapter 14-16: Private Equity, Systematic Risk, Exit Strategy
11 Oct 2014
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If required return on an investment is 10% it means that the firm must earn 10% on the investment to compensate investors for use of capital needed to finance project: so 10% is also the cost of capital, cost of capital for risk free investment is the risk free rate, appropriate discount rate for a risky investment exceeds risk free rate, cost of capital depends on the use of the funds not the source (the risk) The dividend growth model approach: first way to determine cost of equity, assume firm"s dividends grow at constant rate, g, return on equity (roe): net income after interest and taxes divided by average common shareholders" equity, advantages of the approach: simplicity (easy to understand and use, disadvantages of this approach, only really applicable to cases where steady growth in dividends is likely to occur, estimated cost of equity is very sensitive to estimated growth rate, this approach does not explicitly consider risk.
