Managerial Finance . FINA 6335 The CAPM and Cost of Capital Lecture 9. Simplifying Assumptions . Individuals can trade securities without regard to fees, taxes, and other frictions. Individuals get any relevant information about the firms they are interested in costlessly.
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The CAPM and Cost of Capital
All investors have the same CML because they all have the same optimal risky portfolio given the risk-free rate.
Optimal Risky Porfolio
Rp = Rf + (sp /sM)(RM- Rf )
Optimal Risky Porfolio
Market Risk Premium
This applies to individual securities held within well-diversified portfolios.
Current Sales = $60
Cost of Goods Sold 25
Gross Profit 35
Less Operating Expenses 9
Less Depreciation 6
Less Income Tax Rate (@ 35%) 7
Operating (Unlevered) NI 13
Plus Depreciation 6
Less Capital Expenditures 2
Less Increases in Working Capital 1
Free Cash Flow 16
Retention rate = (1 – Payout ratio)
Return on Investments = Operating Income as a percentage of Book Value of Assets
V = Present Value of the firm’s Cash flows, discounted by a number called the “cost of capital”
Basically it is the IRR of the Firm.
Conceptually, you want to discount by a rate that reflects the risk of the firm’s operating Cash Flow.
Once you have the stream of operating Cash Flows generated by the firm, the next problem is to determine how to discount it.
The discount rate that makes the Value of the firm equal the firm’s cash flow is what we call the Cost of Capital.
As a practical matter this can be approximated by the Weighted Average Cost of Capital (WACC)
rWACC = rE X (E/(E+D)) + rD(1-t) X (D/(E+D))
The weighted average of the (after tax) cost of the component securities issued by the firm, weighted by the proportion of those securities issued by the firm.
rE is the required return to the equity of the firm
rD is the required return to the debt of the firm
D is the (market value) of the debt issued by the firm
E is the market value of the equity.
t is the firms tax rate.
To estimate D use the Book value of the debt.
To estimate rD use the ratio of Total Interest payments to the total book value of the debt
To estimate rE use the Capital Asset Pricing Model