Lecture 16 - Cost of Capital (I)

Today

Cost of Capital

(Chapter 14)

BAFI 355 – Spring 2010

16-1

Objective Today

The cost of capital

Know how to determine a firm s cost of equity capital

firm’s

Know how to determine a firm’s cost of debt

Know how to determine a firm’s overall cost of capital

But first, a bit more on CAPM…

BAFI 355 – Spring 2010

16-2

The Security Market Line SML

Line,

Required rate of

return, E(Ri)

SML: E(Ri)=RF+βi[E(RM)-Rf ]

RM=11

Market risk premium, 5%

RF=6

Risk-free rate, RF

1.0

BAFI 355 – Spring 2010

Risk,

Risk βi

16-3

Required vs Expected

The SML equation computes the required return, i.e., how much return

q

p

q

,

,

investors demand for holding an asset with the systematic risk denoted

by its beta

But sometimes (or many times) we refer to the SML as providing us with the

expected return on that stock, i.e., what the investors expect the return on

stock i e

that asset to be.

Are expected and required returns on an asset always the same?

Unfortunately, no. They can different, but only momentarily. Supply and

y

y

y

y

pp y

demand forces will always force them towards the equilibrium – and in

equilibrium they have to be equal

Example: assume A has required return of 16% (from SML):

What if investors think (expect) its return to be 14%? Nobody buys A

A,

everybody tries to sell it: price goes down and expected return goes up

What if investors think (expect) its return to be 18%? Everybody tries to buy

the asset: price goes up, expected return goes down

Hence, we take the liberty to mix expected and required returns…

BAFI 355 – Spring 2010

16-4

CAPM: Buyer Beware

CAPM model widely used by academics and the industry (analysts,

investors,

investors and corporations)

But there are empirical challenges

Some studies found no relationship between beta and returns

But other studies also confront these challenges

g

The verdict is still (and maybe forever) open

CAPM extensions...