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4. The Capital Asset Pricing Model The SML Approach Discounted Cash Flow Approach The "Bond Yield Plus Risk Premium" Approach Approaches to Calculating the Cost of Capital Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance?campaign_content=book_192_section_89&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=dir ect&utm_source=boundless

5. CAPM determines the expected rate of return of an asset. The model takes into account the asset's sensitivity to systematic risk (beta), the expected return of the market, and the expected return of a risk-free asset. CAPM states that investors are only rewarded for bearing systematic risk. CAPM states that if the expected return is not greater than or equal to our required return the investment should not be made. The Capital Asset Pricing Model Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/approaches-to-calculating-the-cost-of- capital-89/the-capital-asset-pricing-model-380- 3907?campaign_content=book_192_section_89&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boundl ess CAPM Equation View on Boundless.com Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital

6. The SML graphs the relationship between risk β (beta) and expected return. All correctly priced assets lie on the SML. If a security is priced above the SML, it is undervalued. If it is priced below the SML, it is overvalued. The SML Approach Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/approaches-to-calculating-the-cost-of- capital-89/the-sml-approach-381- 3908?campaign_content=book_192_section_89&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boundl ess SML Equation View on Boundless.com Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital

7. In the DCF approach, all future expected cash flows associated with the asset are discounted in order to find their present values. To determine the value of the asset, the present values of all expected cash flows are summed. When future cash flows are infinite or extend past a certain period, a terminal value can be found and discounted back to the present. Comparing a value found using the DCF approach with the actual price of an asset determines if an asset is undervalued, overvalued, or correctly priced. Discounted Cash Flow Approach Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/approaches-to-calculating-the-cost-of- capital-89/discounted-cash-flow-approach-382- 3909?campaign_content=book_192_section_89&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boundl ess Present Value Equation View on Boundless.com Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital

8. The BYPRP approach applies to a company's publicly traded equity. The yield to maturity is the discount rate at which the sum of all future cash flows from a bond are equal to its price. The equity risk premium is the return that stocks are expected to receive in excess of the risk-free interest rate. The BYPRP approach does not produce as accurate an estimate as the capital asset pricing model or discounted cash flow analysis. The "Bond Yield Plus Risk Premium" Approach Free to share, print, make copies and changes. Get yours at www.boundless.com www.boundless.com/finance/textbooks/boundless-finance-textbook/introduction-to-the-cost-of-capital-10/approaches-to-calculating-the-cost-of- capital-89/the-bond-yield-plus-risk-premium-approach-383- 8734?campaign_content=book_192_section_89&campaign_term=Finance&utm_campaign=powerpoint&utm_medium=direct&utm_source=boundl ess Bond Yield Plus Risk Premium Equation View on Boundless.com Introduction to the Cost of Capital > Approaches to Calculating the Cost of Capital

9. Free to share, print, make copies and changes. Get yours at www.boundless.com Appendix

10. Key terms beta Average sensitivity of a security's price to overall securities market prices. coupon payment A periodic interest payment that the bondholder receives during the time between when the bond is issued and when it matures. discount rate The interest rate used to discount future cash flows of a financial instrument; the annual interest rate used to decrease the amounts of future cash flow to yield their present value. dividend yield A company's total annual dividend payment per share, divided by its price per share. principal payment The payment made upon maturity of a bond projection period The time duration for estimating the future cash flows of a proposed investment. slope The ratio of the vertical and horizontal distances between two points on a line; zero if the line is horizontal, undefined if it is vertical. systematic risk The risk associated with an asset that is correlated with the risk of asset markets generally, often measured as its beta. time value of money The value of money, figuring in a given amount of interest, earned over a given amount of time. Unsystematic risk Risk peculiar to an asset, which can be eliminated through diversification. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital

11. Bond Yield Plus Risk Premium Equation States that the required return on an equity equals the yield of the company's long-term debt plus the equity's risk premium. Free to share, print, make copies and changes. Get yours at www.boundless.com Code Cogs. "Online LaTeX Equation Editor - create, integrate and download." CC BY http://codecogs.com/latex/eqneditor.php View on Boundless.comCC BYhttp://codecogs.com/latex/eqneditor.phpView on Boundless.com Introduction to the Cost of Capital

12. Yield To Maturity Graph A hypothetical graph showing yield to maturities (or internal rates of return) for corresponding present values. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikipedia. "IRR1 - Grieger." CC BY-SA http://en.wikipedia.org/wiki/File:IRR1_-_Grieger.jpg View on Boundless.comCC BY-SAhttp://en.wikipedia.org/wiki/File:IRR1_-_Grieger.jpgView on Boundless.com Introduction to the Cost of Capital

13. Systematic vs. Unsystematic Risk As the number of stocks in a portfolio increase, the amount of unsystematic risk approaches zero. However, it is impossible to remove systematic risk, as it concerns the economy in general. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikibooks. "Principles of Finance/Section 1/Chapter 5/Risk/Risk." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_5/Risk/Risk View on Boundless.comCC BY-SA 3.0http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_5/Risk/Risk View on Boundless.com Introduction to the Cost of Capital

14. Present Value of the Terminal Value Use this equation to find the present value of a future terminal value. Where TV = terminal value, k = discount rate, and n = the number of periods back to the present. Free to share, print, make copies and changes. Get yours at www.boundless.com OER Commons. CC BY http://www.oercommons.org/courses/entrepreneurial-finance-spring-2011/view View on Boundless.comCC BYhttp://www.oercommons.org/courses/entrepreneurial-finance-spring-2011/viewView on Boundless.com Introduction to the Cost of Capital

15. SML Equation The SML is the graphical representation of CAPM, and thus is found using the same equation. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model View on Boundless.comCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelView on Boundless.com Introduction to the Cost of Capital

16. Terminal Value Equation FCFN+1 = future cash flow one year after the projection period. k = discount rate. g = assumed constant growth rate. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikipedia. "Terminal value (finance)." GNU FDL http://en.wikipedia.org/wiki/Terminal_value_(finance) View on Boundless.comGNU FDLhttp://en.wikipedia.org/wiki/Terminal_value_(finance)View on Boundless.com Introduction to the Cost of Capital

17. Example Equation Required return = 6% + 4% Free to share, print, make copies and changes. Get yours at www.boundless.com Code Cogs. "Online LaTeX Equation Editor - create, integrate and download." CC BY http://codecogs.com/latex/eqneditor.php View on Boundless.comCC BYhttp://codecogs.com/latex/eqneditor.phpView on Boundless.com Introduction to the Cost of Capital

18. CAPM Equation The expected rate of return = the rate of return for a risk-free asset + beta* (the rate of return of the market - the risk-free rate). The return of the market minus the risk-free rate is also known as the risk premium. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model View on Boundless.comCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelView on Boundless.com Introduction to the Cost of Capital

19. CAPM-SML The Security Market Line for the Dow Jones Industrial Average over a 3 year period, with the x-axis representing beta and the y-axis representing expected return. Free to share, print, make copies and changes. Get yours at www.boundless.com Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model View on Boundless.comCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelView on Boundless.com Introduction to the Cost of Capital

20. Present Value Equation To find the discounted present value of an asset, it is necessary to sum the discounted present value of each future cash flow (FV) at any time period (t) in years from the present time, using the appropriate interest rate (i). Free to share, print, make copies and changes. Get yours at www.boundless.com Wikipedia. "Discounted cash flow." GNU FDL http://en.wikipedia.org/wiki/Discounted_cash_flow View on Boundless.comGNU FDLhttp://en.wikipedia.org/wiki/Discounted_cash_flowView on Boundless.com Introduction to the Cost of Capital

21. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital A company has a risk free rate of 3%. The market rate of return is 8% and the company has a beta of 2. What is the company's expected rate of return? A) 8% B) 19% C) 13% D) 10%

22. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ Introduction to the Cost of Capital A company has a risk free rate of 3%. The market rate of return is 8% and the company has a beta of 2. What is the company's expected rate of return? A) 8% B) 19% C) 13% D) 10%

23. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital In the capital asset pricing model (CAPM), you derive a stock’s: A) Beta B) Expected return (or cost of capital) C) Equity Premium D) Beta, expected return (or cost of capital), and equity premium

24. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Saylor OER. "Business Administration « Saylor.org – Free Online Courses Built by Professors." CC BY 3.0 http://www.saylor.org/majors/Business/CC BY 3.0http://www.saylor.org/majors/Business/ Introduction to the Cost of Capital In the capital asset pricing model (CAPM), you derive a stock’s: A) Beta B) Expected return (or cost of capital) C) Equity Premium D) Beta, expected return (or cost of capital), and equity premium

25. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital In order to compute the statistical values in the capital asset pricing model (CAPM), you need information over time about: A) a rate of return from a risk-free asset (like the 90-day U.S. Treasury bill rate). B) an overall stock market rate of return. C) The rate of return of a risk-free asset, the overall stock market return, and a company's rate of return. D) a company’s rate of return.

26. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Saylor OER. "Business Administration « Saylor.org – Free Online Courses Built by Professors." CC BY 3.0 http://www.saylor.org/majors/Business/CC BY 3.0http://www.saylor.org/majors/Business/ Introduction to the Cost of Capital In order to compute the statistical values in the capital asset pricing model (CAPM), you need information over time about: A) a rate of return from a risk-free asset (like the 90-day U.S. Treasury bill rate). B) an overall stock market rate of return. C) The rate of return of a risk-free asset, the overall stock market return, and a company's rate of return. D) a company’s rate of return.

27. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital Which of the following interpretations of data related to a Security Market Line (SML) is correct? A) If an asset's value lies on the SML, it is correctly priced. B) If an asset is priced at a point above the SML it is overvalued. C) If an asset is priced at a point below the SML, it is undervalued. D) All of these answers.

28. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ Introduction to the Cost of Capital Which of the following interpretations of data related to a Security Market Line (SML) is correct? A) If an asset's value lies on the SML, it is correctly priced. B) If an asset is priced at a point above the SML it is overvalued. C) If an asset is priced at a point below the SML, it is undervalued. D) All of these answers.

29. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital A company makes an initial $10,000 investment in a project. This project is projected to earn $8000 in year one, $10,000 in year 2, $12,000 in year 3, and $20,000 in year 4. If the interest rate is 5%, what is the project's present value? A) $43,509 B) $40,000 C) $33,509 D) $37,619

30. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ Introduction to the Cost of Capital A company makes an initial $10,000 investment in a project. This project is projected to earn $8000 in year one, $10,000 in year 2, $12,000 in year 3, and $20,000 in year 4. If the interest rate is 5%, what is the project's present value? A) $43,509 B) $40,000 C) $33,509 D) $37,619

31. Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital Which of the following is NOT an element in the bond yield plus risk premium approach? A) The company's CAPM. B) The future cash flows from the benchmark bond. C) The current yield of a 10-year U.S. Treasury Bond. D) The benchmark bond's internal rate of return.

32. Free to share, print, make copies and changes. Get yours at www.boundless.comwww.boundless.com Boundless - LO. "Boundless." CC BY-SA 3.0 http://www.boundless.com/CC BY-SA 3.0http://www.boundless.com/ Introduction to the Cost of Capital Which of the following is NOT an element in the bond yield plus risk premium approach? A) The company's CAPM. B) The future cash flows from the benchmark bond. C) The current yield of a 10-year U.S. Treasury Bond. D) The benchmark bond's internal rate of return.

33. Attribution Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model Wikibooks. "Principles of Finance/Section 1/Chapter 5/Risk/Risk." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_5/Risk/RiskCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_5/Risk/Risk OER Commons. CC BY http://www.oercommons.org/courses/15-433-investments-spring-2003/viewCC BYhttp://www.oercommons.org/courses/15-433-investments-spring-2003/view Wiktionary. "systematic risk." CC BY-SA 3.0 http://en.wiktionary.org/wiki/systematic+riskCC BY-SA 3.0http://en.wiktionary.org/wiki/systematic+risk Wiktionary. "beta." CC BY-SA 3.0 http://en.wiktionary.org/wiki/betaCC BY-SA 3.0http://en.wiktionary.org/wiki/beta Wikipedia. "Unsystematic risk." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Unsystematic%20riskCC BY-SA 3.0http://en.wikipedia.org/wiki/Unsystematic%20risk Wikipedia. "Security market line." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Security_market_lineCC BY-SA 3.0http://en.wikipedia.org/wiki/Security_market_line Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model Wiktionary. "slope." CC BY-SA 3.0 http://en.wiktionary.org/wiki/slopeCC BY-SA 3.0http://en.wiktionary.org/wiki/slope Wikibooks. "Principles of Finance/Section 1/Chapter 7/Capital Asset Pricing Model." CC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_ModelCC BY-SA 3.0 http://en.wikibooks.org/wiki/Principles_of_Finance/Section_1/Chapter_7/Capital_Asset_Pricing_Model Wikipedia. "Time value of money." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Time_value_of_moneyCC BY-SA 3.0http://en.wikipedia.org/wiki/Time_value_of_money Wikipedia. "Discounted cash flow." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Discounted_cash_flowCC BY-SA 3.0http://en.wikipedia.org/wiki/Discounted_cash_flow Wikipedia. "Terminal value (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Terminal_value_(finance)CC BY-SA 3.0http://en.wikipedia.org/wiki/Terminal_value_(finance) Wiktionary. "discount rate." CC BY-SA 3.0 http://en.wiktionary.org/wiki/discount+rateCC BY-SA 3.0http://en.wiktionary.org/wiki/discount+rate Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/projection-periodCC BY-SA 3.0http://www.boundless.com//finance/definition/projection-period OER Commons. CC BY http://www.oercommons.org/courses/entrepreneurial-finance-spring-2011/viewCC BYhttp://www.oercommons.org/courses/entrepreneurial-finance-spring-2011/view OER Commons. CC BY http://www.oercommons.org/courses/real-estate-finance-and-investment-fall-2006/viewCC BYhttp://www.oercommons.org/courses/real-estate-finance-and-investment-fall-2006/view Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital

34. Wikipedia. "time value of money." CC BY-SA 3.0 http://en.wikipedia.org/wiki/time%20value%20of%20moneyCC BY-SA 3.0http://en.wikipedia.org/wiki/time%20value%20of%20money Wikipedia. "Bond (finance)." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Bond_(finance)#YieldCC BY-SA 3.0http://en.wikipedia.org/wiki/Bond_(finance)#Yield Wikipedia. "Risk premium." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Risk_premiumCC BY-SA 3.0http://en.wikipedia.org/wiki/Risk_premium Wikipedia. "Yield to maturity." CC BY-SA 3.0 http://en.wikipedia.org/wiki/Yield_to_maturityCC BY-SA 3.0http://en.wikipedia.org/wiki/Yield_to_maturity Wikispaces. CC BY-SA http://tradingdiary.wikispaces.com/Market+Valuation+%2528Price-2-Earnings+Ratio%2529CC BY-SAhttp://tradingdiary.wikispaces.com/Market+Valuation+%2528Price-2-Earnings+Ratio%2529 Wikipedia. "coupon payment." CC BY-SA 3.0 http://en.wikipedia.org/wiki/coupon%20paymentCC BY-SA 3.0http://en.wikipedia.org/wiki/coupon%20payment Wikipedia. "dividend yield." CC BY-SA 3.0 http://en.wikipedia.org/wiki/dividend%20yieldCC BY-SA 3.0http://en.wikipedia.org/wiki/dividend%20yield Boundless Learning. "Boundless." CC BY-SA 3.0 http://www.boundless.com//finance/definition/principal-paymentCC BY-SA 3.0http://www.boundless.com//finance/definition/principal-payment Free to share, print, make copies and changes. Get yours at www.boundless.com Introduction to the Cost of Capital