ExampleCapitalAssetPricingModel(CAPM)andWeightedAverageCostof

Capital(WACC)
CAPM

Ke=Rf+Rp
Rp=betax(RmRf)
where:
Keisthecostofequitycapital
Rfisthe"riskfree"rate
Rpisthe"riskpremium"rate
(beta)isthemeasureofsystematicrisk
Rmisthereturnrateofamarketbenchmark,liketheS&P500.

Rf=RiskfreeRate

5%

(beta)=measureofsystematicrisk

1.25

Rm=Proportionofequityincapitalstructure 12%

Rp=betax(RmRf)=1.25(12.0%5%)=8.75%
Ke(aftertax)=Rf+Rp=6.0%+8.75%=14.75%
Ke(pretax)=14.75%/[1.35]=22.7%

WACC = (k e We ) + (k d [1 t ] Wd )
WACC
where:
WACC = Weightedaveragecostofcapital
= Costofequitycapital
ke
kd
= Costofdebtcapital
We
= Percentageofequitycapitalinthecapitalstructure
Wd
= Percentageofdebtcapitalinthecapitalstructure
t
= Companyseffectiveincometaxrate
Assume:
Kd=Costofdebtcapital
6%
We=Proportionofequityincapitalstructure 70%
Wd=Proportionofdebtincapitalstructure 30%
Incometaxrate
35%

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Strategy Operations Technology
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WACC=(22.7%x0.7)+(6%[10.35)]x0.3)=17.1%

TheoverallCAPM&WACCcostofequitycapitalintheaboveexample:17.1%.
ExampleProjectCostofEquityCapitalusingMDVandProjectPremium
EquityInvestorsTotalRequiredReturn=MDV+Pp
MDV=Rsi+Rdp+Evp Rsi=4.0%;
Rdp=2.5%; Evp=11.0%.
Rsiisthesovereigninflationrisk
Rdpisthedefaultriskpremium
Evpistheearningsvolatilitypremium Ppistheprojectpremium

A B C
Criteria(putonlyoneineitherA,BorC)
CompanySpecificCriteria

Relationofcompanytoproject:integraterelevantmanagement

systems
Relianceonandimpactofsuccessthatinfluencesordictatefuture

choicesofcompany
Historicalinformationandreview:corporatesuccessesandfailures,

corporatestrengths,otherprojectdevelopmentaccomplishments
Budgetconstraints

Entrepreneurialnatureofcompany

Comparablescompanyandindustriesassessment

Managerialoptions

ProjectSpecificCriteria

Documenteddetailedprojectdevelopmentstudiesandplans

Documentedanalyticalreview:product,schedule,andcosts

Trained,qualifiedandexperiencepersonnel(bewareexcessive

relianceonselectindividuals)
Projectmanagementsupervisionandcontrols

Qualitymanagementsupervisionandcontrols

Uniqueaspectsofprojecte.g.sourcesofvalue;spillovereffects

Financial

Documentedsalesforecasts

DCFvaluationwithproperriskadjusteddiscountrateandsensitivity

analysis(positiveNPVrule)
RankingSelection:AAboveAverage

BBaseline
CConcern

ProjectPremiumAdditionalAdjustmenttoDiscountRate
ProjectPremiumPp
ProjectPremiumPp
Ranking
Additionaldiscountriskadjustment%

Keycare
Strategy Operations Technology
www.keycare.ca

A
0
B
EqualtoMDVRdp
C
EqualtoMDVEvp

ProjectPremium=Pp=additionaladjustmenttodiscountrate=MDVRdp=2.5%

MDV=Rsi+Rdp+Evp=(4.0+2.5+11.0+2.5)=20.0%

TheMCPM&ProjectPremiumcostofequitycapitalintheaboveexample:20.0%

Keycare
Strategy Operations Technology
www.keycare.ca