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Old 06-28-2018, 02:38 PM
Spewin Spewin is offline
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Default ASM Exercises 7.22-25

These questions al deal with cost of capital for a company "in the same industry" used as a comparable for "your project". Is there some assumption that certain classes of company should have the same weighted average cost of capital? And if so, where is that justified in some reference material?

Specifically, 7.22 is:

You are starting a project. A company in the same industry as your project has 5mil shares with price 26 and equity cost of capital .12. And debt of 200mil with a rate of .06. You will finance your project with equity only, what is the cost of capital for the project?

The solution just calculates weighted average cost of capital with no commentary. Why is that appropriate for a project financed through equity only?
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Old 06-28-2018, 07:33 PM
Abraham Weishaus Abraham Weishaus is offline
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We assume that the method of financing should not affect the overall cost of capital. If it did, that would invalidate CAPM: the beta for a company would depend on how the company finances its investments rather than on the correlation of its free cash flows with the market.
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Old 06-28-2018, 08:05 PM
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Colymbosathon ecplecticos Colymbosathon ecplecticos is offline
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Originally Posted by Abraham Weishaus View Post
If it did, that would invalidate na´ve CAPM ...
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Old 06-28-2018, 09:25 PM
Academic Actuary Academic Actuary is online now
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Originally Posted by Abraham Weishaus View Post
We assume that the method of financing should not affect the overall cost of capital. If it did, that would invalidate CAPM: the beta for a company would depend on how the company finances its investments rather than on the correlation of its free cash flows with the market.
The beta does depend on how the company finances. More equity, lower beta, lower cost of equity capital. Under certain assumptions (no corp tax for example) it can be shown that the weighted average cost would be constant._

https://www.investopedia.com/terms/h/hamadaequation.asp
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Old 06-29-2018, 02:31 PM
Abraham Weishaus Abraham Weishaus is offline
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The beta does depend on how the company finances. More equity, lower beta, lower cost of equity capital. Under certain assumptions (no corp tax for example) it can be shown that the weighted average cost would be constant._
Isn't that what I said? I said "overall cost of capital", not "equity cost of capital".
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Old 06-29-2018, 09:33 PM
Academic Actuary Academic Actuary is online now
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Isn't that what I said? I said "overall cost of capital", not "equity cost of capital".
The beta for the company implies the equity beta as the standard assumption is that the debt is risk free and has zero beta. What did you mean by the beta of the company? You are also implying that constant cost of capital somehow implies CAPM. The capital structure irrelevance theorem is a result of some no arbitrage arguments by Miller and Modigliani that preceded the CAPM by five years. Later a paper by Hamada showed that the two models were internally consistent but CAPM is not necessary for capital structure irrelevance..

Last edited by Academic Actuary; 06-29-2018 at 09:39 PM..
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