Page 154 - DMGT521_PROJECT_MANAGEMENT

Unit 9: Financial Estimates and Projections

(c) Current expected return on common stocks = 14 percent Notes
(d) Current return on long term Treasury bonds = 7 percent
Sometimes, the market risk premium is calculated as the difference between the historical
average return on common stocks and the current return on long-term Treasury bonds.
This is not correct.
To calculate the market risk premium, you can use the historical risk premium (19 percent
10 percent) or the current risk premium (14 percent 7 percent), but not the difference
between the historical average return on common stocks and the current return on long-
term Treasury bonds (19 percent 7 percent).
5. The cost of equity is equal to the dividend rate or return on equity: It appears that the cost
of equity is often measured incorrectly. Sometimes it is measured as the current dividend
rate (dividend per share as a percentage of face value per share) or as return on equity.
Only by accident do these measures represent the cost of equity correctly.
It should be clearly understood that the cost of equity is the rate of return required by
equity investors given the risk they are exposed to. It has nothing to do with the current
dividend rate or return on equity, which are mere historical numbers.
6. Retained earnings are either cost free or cost significantly less than external equity: Often
firms impute a negligible or low cost to retained earnings under the influence of wrong
notions like “retained earnings have no cost because shareholders are satisfied with
dividends” or “retained earnings are already with the firm and hence some nominal
returns on them may suffice”.
The error in such reasoning stems from ignoring the opportunity cost associated with
retained earnings. When a firm retains a portion of its earnings, equity shareholders are
denied dividends to that extent. If the same were distributed as dividends, equity
shareholders can invest elsewhere to earn a rate of return comparable to the cost of equity.
Hence the opportunity cost of retained earnings is more or less equal to the cost of equity
funds.
7. Depreciation has no cost: Similar to the misconception that retained earnings are more or
less cost free is the notion that depreciation generated funds are also virtually cost free. As
one manager put it: “Depreciation is capital already in the company. Since it does not have
to be raised, even in an indirect sense of retained earnings, it clearly has no cost.”
To guard against such an error, invoke the opportunity cost principle once again.
Theoretically, the firm can return the depreciation generated funds to its shareholders and
lenders (the parties which provided the finance for asset acquisition) and they, in turn, can
invest these funds elsewhere. Hence, the opportunity cost of depreciation generated funds
is the average return the shareholders and lenders would earn on these funds by investing
them elsewhere. And this would be more or less equal to the average cost of capital of the
firm.
8. Book value weights may be used to calculate the WACC: Often firms use book value
weights in the existing capital structure to calculate the WACC. This is not correct.
Weights should be based on market values, not book values. Ideally, the target capital
structure (in market value terms) should determine the weights for the WACC. If the
target capital structure is not specified, use the current market value weights.
9. The cost of capital for a project is calculated on the basis of the specific sources of finance
used for it: If a firm raises debt when it is investing in some project, it may regard the post
tax cost of debt as the relevant cost of capital. Likewise, if it happens to raise equity when

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