# It is okay to earn the cost of capital. It is also appropriate to use different rates

## Question:

It is okay to earn the cost of capital.

It is also appropriate to use different rates for different projects depending on the level of risk.

Future interest rates or current weighted average cost of borrowing? o If possible, use expected future borrowing costs which is reflected in the yield curve. Upward sloping.

ROE not appropriate as cost of equity. It is a component in finding g when we use the dividend growth model. og = br o growth = retention ratio * ROE

Not appropriate to look at just dividend yield as the cost of equity. D1 K = +9 Po o If using the dividend growth model approach, we also add the growth rate 'g' which measures the expected future constant growth rate of dividends.

Do we include the cost of issuing new capital? o Yes if it is available - issuance cost increases the cost of capital o In practice, usually ignored because not readily available.

What is the impact of deferred tax liabilities? o Tax regimes usually allow faster depreciation for tax purposes to encourage investment

Lower taxes paid today but will be paid in the future. o Deferred tax can be thought of as an allocation from current MTRC Case Study FAQs/Comments It is okay to earn the cost of capital. . It is also appropriate to use different rates for different projects depending on the level of risk. Future interest rates ar current weighted average cost of borrowing? o if possible, use expected future borrowing costs which is reflected in the yield curve. Upward sloping, ROE not appropriate as cost of equity. It is a component in finding g when we use the dividend growth model og br o growth retention ratio "ROE

Not appropriate to look at just dividend yield as the cost of equity K = - +9 o if using the dividend growth model approach, we also add the growth rate 'g' which measures the expected future constant growth rate of dividends. . Do we include the cost of issuing new capital? ? Yes if it is available - issuance cost increases the cost of capital o in practice, usually ignored because not readily available. .

What is the impact of deferred tax liabilities? Tax regimes usually allow faster depreciation for tax purposes to encourage investment

Lower taxes paid today but will be paid in the future. - Deferred tax can be thought of as an allocation from current earnings to a deferred tax account. .

Consequently, deferred tax can be added to equity in the capital structure o Deferred taxes are also sometimes added to debt in the capital structure.

o Usually ignored in practice and in the case. of the company is expected to keep growing then in theory it can defer taxes forever . Consequently, we can ignore deferred tax CAPM Formula K. = 7+ (-1) K = 1+ B (Market Risk Premium) The first is the current risk-free rate. The Hong Kong or US risk-free rate can be used.

The second r, which is used to determine the market risk premium can be based on the average long-term rates (in the case a 30-year average of the 10 year U.S rate). This is because the market returns were determined using data for 30 years for both the US and Hong Kong .

Do we use Hong Kong or U.S treasury bond yields in computing the market risk premium? o US Bond yields may be appropriate as it has a longer time series

Do we use Hong Kong or U.S stock returns in calculating beta? - You can use either. However, historical market risk premiums in Hong Kong have been higher than the U.S. The big question is if these higher market risk premiums will continue into the future. Our interest is in the future market risk premiums. Historical market risk premiums are a guide.

Should we use geometric or arithmetic return in computing CAPM returns? o Geometric returns are usually recommended since they represent the compound rate of return o Arithmetic returns tend to overstate the return

Important to use the firm's target capital structure, not the capital structure today. Short term or long-term debt-include short term debt like borrowings with interest rates and working capital investments if their cast is - available . The book value of debt can be assumed to be the market value of debt.

Retained earnings is not free.

Beta should be forward looking. Using past returns assumes that future will be like the past. CASE QUESTIONS

1. Compute the cost of debt for MTRC.

2. Compute the cost of equity for MTRC using the dividend growth model +9

3. Compute the cost of equity for MTRC using the CAPM K = 7, + ( 1-1)

4. Compute the cost of capital for MTRC (using CAPM)

5. How would you recommend that MTRC should employ this cost of capital?

**Related Book For**

## Intermediate Financial Management

ISBN: 9780357516669

14th Edition

Authors: Eugene F Brigham, Phillip R Daves