In computing the cost of capital, which sources of capital should be considered? Why do firms calculate their weighted average cost of capital? As the financial manager for your company, explain how you would use the cost of capital of your firm, or a firm you are familiar with, to determine the required rate of return on investment opportunities. Search the SEU library or the internet for an academic or industry-related article. Select an article that relates to cost of capital and doing business in Saudi Arabia.
For your discussion post, your first step is to summarize the article in two paragraphs describing what you think are the most important points made by the authors (remember to cite the information, as appropriate). For the second step, include the reference listing with a hyperlink to the article. Please note, do not copy the article into your post and limit your summary to two paragraphs. Let me know if you have any questions. Enjoy your search.
CAPM, RS = RF + b (RM – RF)
Implementing the Approach
Betas are widely available, and T-bill rates or the rate on long-term Treasury securities are often used for RF. The expected market risk premium is the more difficult number to come up with – make sure that the market risk premium used is consistent with the risk-free rate chosen.
One of the problems is that we really do need an expectation, but we only have past information, and market risk premiums do vary through time. Early in 2000, Federal Reserve Chairman Alan Greenspan indicated that part of his concern with the state of the U.S. stock markets at that time was the reduction in the market risk premium. He felt that investors were either becoming less risk averse, or they did not truly understand the risk they were taking by investing in stock.
Nonetheless, the historical average is often used as an estimate of the market risk premium.
Advantages and Disadvantages of the Approach
-This approach explicitly adjusts for risk in a fashion that is consistent with capital market history.
-It is applicable to virtually all publicly traded stocks.
-The main disadvantage is that the past is not a perfect predictor of the future, and both beta and the market risk premium vary through time.
A recent study finds that almost 3/4 of U.S. companies use the CAPM in capital budgeting, indicating that industry has largely approved this approach for estimating the cost of equity.
Please fill in the blanks with numerical input as per your perspective:
Risk Market Premium=?
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