35:, to compensate for the risk they undertake by investing their capital. Firms need to acquire capital from others to operate and grow. Individuals and organizations who are willing to provide their funds to others naturally desire to be rewarded. Just as landlords seek rents on their property, capital providers seek returns on their funds, which must be commensurate with the risk undertaken.
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increases/decreases, its cost of capital increases/decreases: capital providers expect reward for offering their funds to others. Such providers are usually rational and prudent preferring safety over risk. They naturally require an extra reward as an incentive to place their capital in a riskier
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Proposed by
Gebhardt et.al. (2001) - see Further Reading Section. The paper shows that a firm’s implied cost-of-capital is a function of its industry membership, B/M ratio, forecasted long-term growth rate, and the dispersion in analyst earnings
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While a firm's present cost of debt is relatively easy to determine from observation of interest rates in the capital markets, its current cost of equity is unobservable and must be estimated. At the least, though, as a firm's
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investment instead of a safer one. If an investment's risk increases, capital providers therefore demand higher returns or they will place their capital elsewhere.
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Firms obtain capital from two kinds of sources: lenders and equity investors. From the perspective of capital providers, lenders seek to be rewarded with
190:
Francis, Jennifer; Lafond, Ryan; Olsson, Per M.; Schipper, Katherine (2004). "Costs of Equity and
Earnings Attributes".
81:. Such decisions can be made after quantitative analysis that typically uses a firm's cost of capital as a model input.
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The Bond Yield Plus Risk
Premium (BYPRP), adds a subjective risk premium to the firm's long-term debt interest rate.
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A firm's overall cost of capital, which consists of the two types of capital costs, is then determined as the
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50:). From a firm's perspective, they must pay for the capital it obtains from others, which is called its
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Gebhardt, William; Lee, Charles; Swaminathan, Bhaskaran (2001). "Toward an
Implied Cost of Capital".
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model to estimate the market implied cost-of-capital, and the cost of equity can then be backed-out.
69:. Knowing a firm's cost of capital is needed in order to make better decisions. Managers make
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model based on dividend returns and eventual capital return from the sale of the investment.
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96:(and practice) offers various models for estimating a particular firm's cost of equity:
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31:) a firm theoretically pays to its equity investors, i.e.,
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The cost of equity can be calculated using the discounted
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decisions while capital providers make decisions about
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and attributed to these two kinds of capital sources.
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and/or appreciation in the value of their investment (
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163:Fama, Eugene F.; French, Kenneth R. (1997).
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54:. Such costs are separated into a firm's
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27:is the return (often expressed as a
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151:Weighted average cost of capital
67:weighted average cost of capital
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213:Journal of Accounting Research
169:Journal of Financial Economics
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182:10.1016/S0304-405X(96)00896-3
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104:, or CAPM, is prototypical.
102:capital asset pricing model
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204:10.2308/accr.2004.79.4.967
165:"Industry costs of equity"
42:and equity investors seek
225:10.1111/1475-679X.00007
192:The Accounting Review
113:discounted cash flow
71:capital budgeting
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146:Return on equity
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198:(4): 967–1010.
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157:Further reading
136:Cost of capital
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123:residual income
52:cost of capital
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94:Finance theory
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29:rate of return
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141:Depreciation
109:Gordon Model
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56:cost of debt
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257:Categories
246:forecasts.
233:References
79:investment
44:dividends
130:See also
40:interest
111:, is a
75:lending
21:finance
23:, the
263:Costs
107:The
100:The
87:risk
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