Page 124 - DMGT405_FINANCIAL%20MANAGEMENT

Financial Management

Notes Cost of Equity

I estimated the cost of equity, using the Capital Asset Pricing Model (CAPM). Other
methods such as the Dividend Discount Model (DDM) and the Earnings Capitalization
Ratio can be used to estimate the cost of equity. However, in my opinion, the CAPM is the
superior method.

My estimate of Nike’s cost of equity is 10.5 per cent I used the current yield on 20-year
Treasury bonds as my risk-free rate, and the compound average premium of the market
over Treasury bonds (5.9 per cent) as my risk premium. For beta, I took the average of
Nike’s beta from 1996 to the present.
Putting it all Together
After inputting all my assumptions into the WACC formula, my estimate of Nike’s cost of
capital is 8.4 per cent.
WACC = Kd (1 – t) × D/(D + E) + Kc × E/(D + E)
= 2.7% × 27.0% + 20.5% × 73.0%

= 8.4%
Question
What is the importance of cost of capital for any firm?

6.6 Summary

 The cost of capital is viewed as one of the corner stones in the theory of financial
management.
 Cost of capital may be viewed in different ways.

 Cost of capital is the weight average cost of various sources of finance used by the firm. It
comprises the risk less cost of the particular type of financing (r), the business risk premium,
j
(b) and the financial risk premium (f).

 The cost of capital is useful in designing optimal capital structure, investment evaluation,
and financial performance appraisal.

 The financial manager has to compute the specific cost of each type of funds needed in the
capitalisation of a company.

 Retained earnings are one of the internal sources to raise equity finance.
 The opportunity cost of retained earning is the rate of return the shareholder forgoes by
not putting his funds elsewhere.
 Cost of equity capital, is the minimum rate of return that a firm must earn on the equity
financed portions of an investment project in order to leave unchanged the market price of
the shares.
 The marginal cost of capital is the weighted average cost of new capital using the marginal
weights.
 Marginal cost of capital shall be equal to WACC, when a firm employs the existing
proportion of capital structure and some cost of component of capital structure.

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