Page 68 - DMGT409Basic Financial Management

Unit 4: Cost of Capital

Solution: Notes

Years Cash infl ows (`) DF 10% PV of Cash infl ows (`)
1998 14.0 0.909 12.7
1999 14.0 0.826 11.6
2000 14.5 0.751 10.9
2001 14.5 0.683 9.9
2002 14.5 0.621 9.0
2003 300.0 0.621 186.3
240.4
(-) Purchase price in 1998 240.0
0.4
At 10 per cent discount rate, the total PV of cash inflows equals to the PV of cash outfl ows. Hence,

cost of equity capital is 10 per cent.

Capital Asset Pricing Model Approach (CAPM)

Capital Asset Pricing Model (CAPM) was developed by William F. Sharpe. This is another
approach that can be used to calculate cost of equity. From the cost of capital point of view,
CAPM explains the relationship between the required rate of return, or the cost of equity capital

and the non-diversifiable or relevant risk, of the firm as reflected in its index of non-diversifi able

risk that is beta (β). Symbolically,
K = R + (R – R ) β
e f mf f
Where,
K = Cost of equity capital.
e
R = Rate of return required on a risk free security (%).
f
β = Beta coeffi cient.
R = Required rate of return on the market past folio of assets, that can be viewed as the
mf
average rate of return on all assets.

Assumptions

CAPM approach is based on the following assumptions:
1. Perfect Capital Market: All investors have the same information about securities:
(a) There are no restrictions on investments (buying and selling)
(b) Securities are completely divisible
(c) There are no transaction costs

(d) There are no taxes
(e) Competitive market – means no single investor can affect market price signifi cantly
2. Investors preferences: Investors are risk averse:
(a) Investors have homogenous expectations regarding the expected returns, variances
and correlation of returns among all securities.
(b) Investors seek to maximise the expected utility of their portfolios over a single period
planning horizon.

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