It is okay to earn the cost of capital. MTRC Case Study FAQs/Comments 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? 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. 08-bx growth retention ratio *ROE = Not appropriate to look at just dividend yield as the cost of equity. D 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 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 Deferred taxes are also sometimes added to debt in the capital structure. Usually ignored in practice and in the case. If the company is expected to keep growing then in theory it can defer taxes forever Consequently, we can ignore deferred tax CAPM Formula K = 1; + B (rm - Ty) Kry+B (Market Risk Premium) The first fy is the current risk-free rate. The Hong Kong or US risk-free rate can be used. The second Ty 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 US 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 US treasury bond yields in computing the market risk premium? US Bond yields may be appropriate as it has a longer time series Do we use Hong Kong or US 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? Geometric returns are usually recommended since they represent the compound rate of return 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 cost 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.