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Cost of Capital (the marginal cost of capital (Describe the marginal cost…
Cost of Capital
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Calculate and interpret the beta and cost of capital for a project. #
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pure-play method
The beta of a firm is a function not only of the business risks of its projects (lines of business) but also of its financial structure. For a given set of projects, the greater a firm’s reliance on debt financing, the greater its equity beta. For this reason, we must adjust the pure-play beta from a comparable company (or group of companies) for the company’s leverage (unlever it) and then adjust it (re-lever it) based on the financial structure of the company evaluating the project. We can then use this equity beta to calculate the cost of equity to be used in evaluating the project.
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Beta is estimated using historical returns data. The estimate is sensitive to the length of time used and the frequency (daily, weekly, etc.) of the data.
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Betas are believed to revert toward 1 over time, and the estimate may need to be adjusted for this tendency.
Estimates of beta for small-capitalization firms may need to be adjusted upward to reflect risk inherent in small firms that is not captured by the usual estimation methods.
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Flotation costs are the fees charged by investment bankers when a company raises external equity capital.
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Calculate and interpret the cost of noncallable, nonconvertible preferred stock.
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Calculate and interpret the cost of debt capital using the yield-to-maturity approach and the debt-rating approach.
