Increasing Insurance Costs with Adverse Selection

Chapter 16: Using Capital Budgeting to Prepare for the Future

The return on U.S. Treasury bills is 2 percent and the average return on stock is 7 percent. Variability in your firm’s stock return relative to variability in the average stock’s return is 1.8. Given this information, the cost of equity capital using the capital-asset-pricing method is calculated through the following steps:

1. Determine the risk premium.

The risk premium is determined by subtracting the risk-free rate of return from the average stock’s return and multiplying by β.

291

2. Add the risk premium to the risk-free rate of return.

This addition determines the cost of equity capital by including the risk premium.

Relying on external funds: Help!

The cost of using external funds, or the cost of debt capital, is the interest rate you must pay lenders. However, because interest expenses are tax deductible, the after-tax cost of debt, kd, is the interest rate, r, multiplied by 1 minus the firm’s marginal tax rate, t, or

You’ve decided to finance a capital investment by issuing bonds that have a 6 percent annual interest rate. In addition, your company’s marginal tax rate is 35 percent. The cost of using debt to finance the project equals

Calculating the composite cost of capital

Firms commonly raise funds for capital investment from both internal and external sources. The composite cost of capital, k c, is a weighted average of the cost of equity capital and the cost of debt capital. Therefore,