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Chapter Outline
CHAPTER 12.1 The Cost of Equity Capital
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McGraw-Hill/Irwin McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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12.4 Extensions of the Basic Model The Firm versus the Project
The Firm versus the Project Any project’s cost of capital depends on the
The Cost of Capital with Debt use to which the capital is being put—not
the source.
Therefore, it depends on the risk of the
project and not the risk of the company.
McGraw-Hill/Irwin McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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Capital Budgeting & Project Risk Capital Budgeting & Project Risk
Project IRR
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12.5 Estimating IP’s Cost of Capital 12.5 Estimating IP’s Cost of Capital
The yield on the company’s debt is 8% and the firm is in
The industry average beta is 0.82; the risk the 37% marginal tax rate.
free rate is 8% and the market risk premium The debt to value ratio is 32%
is 8.4%. r = R + β × ( R – R ) S B
rWACC = × rS + × rB ×(1 – TC)
S F i M F S+B S+B
= 0.68 × 9.89% + 0.32 × 8% × (1 – 0.37)
Thus the cost of equity capital is = 8.34%
= 3% + 0.82×8.4% 8.34 percent is International’s cost of capital. It should be used to
discount any project where one believes that the project’s risk is
= 9.89% equal to the risk of the firm as a whole, and the project has the same
leverage as the firm as a whole.
McGraw-Hill/Irwin McGraw-Hill/Irwin
Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved.
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