2. The capital asset pricing model can be used to estimate the cost of capital because it allows for an estimate to be drawn as to the company's cost of equity. This can then be plugged into a weighted average cost of capital calculation along with the company's debt and, if relevant, preferred shares. The cost of equity reflects the company's risk in relation to the risk associated with the market in general. Investors will want the returns of the company to be commensurate with the risk that they are taking on, in order to justify that investment.

The capital asset pricing model is as follows:

Ra = Rf + ?(Rm-Rf)

That weighted average cost of capital is the discount rate that should be used to discount the expected future cash flows of the project to determine whether or not the project adds value to the firm.

3. The risk...
[ View Full Essay]