Page 150 - DMGT521_PROJECT_MANAGEMENT

Unit 9: Financial Estimates and Projections

The company cost of capital is the rate of return expected by the existing capital providers. It Notes
reflects the business risk of existing assets and the capital structure currently employed.
The project cost of capital is the rate of return expected by capital providers for a new project or
investment the company proposes to undertake. Obviously, it will depend on the business risk
and the debt capacity of the new project.

If a firm wants to use its company cost of capital, popularly called the Weighted Average Cost of
Capital (WACC), for evaluating a new investment, two conditions should be satisfied.
The business risk of the new investment is the same as the average business risk of existing
investments. In other words, the new investment will not change the risk complexion of the
firm.

The capital structure of the firm will not be affected by the new investment. Put differently, the
firm will continue to follow the same financing policy.
Thus, strictly speaking the WACC is the right discount rate for an investment which is a carbon
copy of the existing firm. This unit assumes that new investments will be similar to existing
investments in terms of business risk and debt capacity.

9.5.2 Cost of Equity

SML Approach

A popular approach to estimating the cost of equity is the Security Market Line (SML) relationship.
According to the SML, the required return on a company’s equity is:
Re = R + E (E(R ) – R )
f M f
where
Re = required return on the equity of company

R = risk free rate
f
= beta of the equity of company
E
E(R ) = expected return on the market portfolio
M
The SML is regarded by many as a fairly rigorous and objective approach to determining the
required return on equity. This approach, however, is based on the assumption that investors
eliminate unsystematic risk by efficient diversification and hence require compensation only
for systematic risk which is reflected in beta. Market imperfections may impede efficient
diversification by investors, exposing them to unsystematic risk. When this occurs, investors
will require compensation for unsystematic risk, a factor which is not found in the security
market line relationship. Another shortcoming of the SML relates to the instability of the betas
of individual securities. Studies have shown that individual securities have unstable betas. This
makes the use of a historical beta as a proxy for the future beta somewhat questionable.
Notwithstanding these shortcomings, the SML approach is a useful approach for estimating the
required rate of return of equity stocks.

Bond Yield Plus Risk Premium Approach
Analysts who do not have faith in the SML approach often resort to a subjective procedure to
estimate the cost of equity. They add a judgmental risk premium to the observed yield on the
long term bonds of the firm to get the cost of equity:

LOVELY PROFESSIONAL UNIVERSITY 145