Page 151 - DMGT521_PROJECT_MANAGEMENT

Project Management

Notes Cost of equity = Yield on long term bonds + Risk premium
The logic of this approach is fairly simple. Firms that have risky and consequently high cost debt
will also have risky and consequently high cost equity. So it makes sense to base the cost of
equity on a readily observable cost of debt.
The problem with this approach is how to determine the risk premium. Should it be 2 percent,
4 percent, or n percent? There seems to be no objective way of determining it. Most analysts look
at the operating and financial risks of the business and arrive at a subjectively determined risk
premium that normally ranges between 2 percent and 6 percent. While this approach may not
produce a precise cost of equity, it will give a reasonable ballpark estimate.
Earnings-Price Ratio Approach

According to this approach, the cost of equity is equal to:
E / P
l 0
Where E = expected earnings per share for the next year
l
P = current market price per share
0
E may be estimated as: (Current earnings per share) × (1 + growth rate of earnings per share).
l
This approach provides an accurate measure of the rate of return required by equity investors in
the following two cases:

1. When the earnings per share are expected to remain constant and the dividend payout
ratio is 100 percent.
2. When retained earnings are expected to earn a rate of return equal to the rate of return
required by equity investors.
3. The first case is rarely encountered in real life and the second case is also somewhat
unrealistic. Hence, the earnings-price ratio should not be used indiscriminately as the
measure of the cost of equity capital.

9.5.3 Determining the Proportions

For calculating the WACC we need information on the cost of various sources of capital and the
proportions (or weights) applicable to them. So far we discussed how to calculate the cost of
specific sources of capital. We now look at how the weights should be established.
The appropriate weights are the target capital structure weights stated in market value terms.
What is the rationale for using the target capital structure? What is the logic for using market
values?
The primary reason for using the target capital structure is that the current capital culture may
not reflect the capital structure that is expected to prevail in future or the capital structure the
firm plans to have in future. While it is conceptually appealing to rely the target capital structure,
there may be some difficulties in using the target capital structure. A company may not have a
well defined target capital structure. Perhaps the changing complexion of its business or the
changing conditions in the capital market may be it difficult for the company to articulate its
target capital structure. Further, if the target capital structure is significantly different from the
current capital structure, it may difficult to estimate what the component capital costs would be.
Notwithstanding these difficulties, finance experts generally recommend that the weights must
be based on the target capital structure.

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