Chapter 15 Cost of Capital 0
0 Chapter 15 Cost of Capital
Chapter Outline The Cost of Capital:Some Preliminaries The Cost of Equity The Costs of Debt and Preferred Stock The Weighted Average Cost of Capital Divisional and Project Costs of Capital
1 Chapter Outline n The Cost of Capital: Some Preliminaries n The Cost of Equity n The Costs of Debt and Preferred Stock n The Weighted Average Cost of Capital n Divisional and Project Costs of Capital
Key Concepts and Skills Know how to determine a firm's cost of equity capital Know how to determine a firm's cost of debt Know how to determine a firm's overall cost of capital Understand pitfalls of overall cost of capital and how to manage them
2 Key Concepts and Skills n Know how to determine a firm’s cost of equity capital n Know how to determine a firm’s cost of debt n Know how to determine a firm’s overall cost of capital n Understand pitfalls of overall cost of capital and how to manage them
Why Cost of Capital is Important We know that the return earned on assets depends on the risk of those assets The return to an investor is the same as the cost to the company Our cost of capital provides us with an indication of how the market views the risk of our assets Knowing our cost of capital can also help us determine our required return for capital budgeting projects
3 Why Cost of Capital is Important n We know that the return earned on assets depends on the risk of those assets n The return to an investor is the same as the cost to the company n Our cost of capital provides us with an indication of how the market views the risk of our assets n Knowing our cost of capital can also help us determine our required return for capital budgeting projects
Required Return The required return is the same as the appropriate discount rate and is based on the risk of the cash flows We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment We need to earn at least the required return to compensate our investors for the financing they have provided
4 Required Return n The required return is the same as the appropriate discount rate and is based on the risk of the cash flows n We need to know the required return for an investment before we can compute the NPV and make a decision about whether or not to take the investment n We need to earn at least the required return to compensate our investors for the financing they have provided
Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm There are two major methods for determining the cost of equity Dividend growth model SML or CAPM 5
5 Cost of Equity n The cost of equity is the return required by equity investors given the risk of the cash flows from the firm n There are two major methods for determining the cost of equity q Dividend growth model q SML or CAPM
The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE D P 三 0 R E g D R E 二 + 8 P 6
6 The Dividend Growth Model Approach n Start with the dividend growth model formula and rearrange to solve for RE g P D R R g D P E E 0 1 1 0
Example:Dividend Growth Model Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1%per year and the market expects that to continue.The current price is $25.What is the cost of equity? 1.50 RE= +.051=.111 25
7 Example: Dividend Growth Model n Suppose that your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? .051 .111 25 1.50 RE
Example:Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average o Year Dividend Percent Change 2003 1.23 2004 1.30 (1.30-1.23)/1.23=5.7% 2005 1.36 (1.36-1.30)/1.30=4.6% 2006 1.43 (1.43-1.36)/1.36=5.1% ▣2007 1.50 (1.50-1.43)1/1.43=4.9% Average=(5.7+4.6+5.1+4.9)/4=5.1% 8
8 Example: Estimating the Dividend Growth Rate n One method for estimating the growth rate is to use the historical average q Year Dividend Percent Change q 2003 1.23 q 2004 1.30 q 2005 1.36 q 2006 1.43 q 2007 1.50 (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) / 1.30 = 4.6% (1.43 – 1.36) / 1.36 = 5.1% (1.50 – 1.43) / 1.43 = 4.9% Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%
Advantages and Disadvantages of Dividend Growth model Advantage -easy to understand and use Disadvantages o Only applicable to companies currently paying dividends Not applicable if dividends aren't growing at a reasonably constant rate Extremely sensitive to the estimated growth rate -an increase in g of 1%increases the cost of equity by 1% Does not explicitly consider risk 9
9 Advantages and Disadvantages of Dividend Growth Model n Advantage – easy to understand and use n Disadvantages q Only applicable to companies currently paying dividends q Not applicable if dividends aren’t growing at a reasonably constant rate q Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% q Does not explicitly consider risk