Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Introduction
Capital Budgeting process involves discounted
cash flow analysis
...

This topic reviews this proper discount rate
namely:
Weighted Average Cost of Capital (WACC)
Marginal Cost of Capital (MCC)

Introduction
Definition
Kd – The rate at which the firm can issue new
debt
...
This is also called the before-tax component
cost of debt
Kd(1-t)-The after-tax cost of debt
...
This is used to WACC
Kp- Cost of preferred stock= Dp/P
Ke-The cost of common equity
...


WACC
Definition
WACC = Wd*Kd(1-t) + Wp*Kp + We*Ke
Where:
Wd=percentage of debt in the capital structure
Wp=percentage of preferred stock in the capital
structure
We=percentage of common stock in the capital
structure

WACC
Example
A company has the following capital structure
Source
Equity
Debt
Preferred Shares

Proportion
60%
30%
10%

The cost of preferred shares is 8% and the before tax cost of
debt is 12%
...
2
per share on common stocks at the end of the year
...
20 per share
...

The tax rate is 30%
...

• Tax Rate: 35%
...
5%
...

• The company's common shares have a value of Kshs 40
and a dividend in year 0 of D0 = Kshs 3
...
The
company’s growth rate is estimated at 6
...

Required
Calculate WACC

Marginal Cost Capital
MCC is the cost of the last new dollar of
capital a firm raises
...

MCC schedule shows the WACC for different
amounts of financing
...


Marginal Cost Capital
Break point=Amount of capital at which the component’s cost of capital changes
Weight of the component in the capital structure

Marginal Cost Capital

Marginal Cost Capital

Marginal Cost Capital

Marginal Cost Capital

Capital Asset Pricing Model

Capital Asset Pricing Model
Assumptions of CAPM

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model

Capital Asset Pricing Model
Example
Assume the correlation of returns between Transport Co
...
80, the standard deviation of
Transport Co
...
60 and the standard deviation of the
market portfolio equals 0
...

Required
Calculate the beta for Transport Co

Capital Asset Pricing Model

Capital Asset Pricing Model

The theoretical of CAPM
Theoretical Limitations of the CAPM
Single-factor model: Only systematic risk or beta risk is priced in the CAPM
...
As a consequence, it is prescriptive and
easy to understand and apply, although it is very restrictive and inflexible
...
For example,
it may be optimal to default on interest payments in the current period to
maximize current returns, but the consequences may be negative in the next
period
...


Market portfolio: The true market portfolio according to the CAPM includes all assets,
financial and nonfinancial, which means that it also includes many assets that are not investable,
such as human capital and assets in closed economies
...

Proxy for a market portfolio: In the absence of a true market portfolio, market participants
generally use proxies
...
and generate different return estimates for the same asset, which is impermissible in the
CAPM
...
The historical state of the company, however, may not be an accurate representation
of the current or future state of the company
...
In addition, using different periods for estimation results
in different estimates of beta
...
Thus, we are likely to estimate different returns for the same
asset depending on the estimate of beta risk used in the model
...

The CAPM is a poor predictor of returns: If the CAPM is a good model, its estimate of
asset returns should be closely associated with realized returns
...
8 In other words, tests of the CAPM show that asset
returns are not determined only by systematic risk
...

Homogeneity in investor expectations: The CAPM assumes that homogeneity exists in
investor expectations for the model to generate a single optimal risky portfolio (the
market) and a single security market line
...
Clearly,
investors can process the same information in a rational manner and arrive at
different optimal risky portfolios
...
The risk
free rate equals 5%
...
5

2
...
0300

0

---