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Corporate Valuation by Laura Zanetti, Gianfranco Gianfrate, Mario Massari

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Chapter 8Estimating the Cost of Capital

8.1 DEFINING THE OPPORTUNITY COST OF CAPITAL

In the previous Chapters we have discussed the calculation of the proper discount rate for cash flows by introducing formulas that are consistent with the asset and equity side standpoints and with the different definitions and derivations of the tax benefits associated with debt. All these formulas stem from two basic parameters referred to as the opportunity cost of capital of a firm with no debt (r01-math-0001) and the opportunity cost of debt (r01-math-0002).

r01-math-0003 measures the rate of return that is considered acceptable by investors in the equity of a firm with no debt. The return should reflect only the risk profile associated with corporate assets regardless of the financial structure. As we are dealing with an opportunity cost, this return should be estimated taking into account the alternative returns that could be obtained from other investments characterized by similar risk profiles.

On the other hand, r01-math-0004 measures (again, as an opportunity cost) the rate of return that is deemed acceptable by the holders of the firm debt. ...

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