Financial Management of the firm Final exam Chapters 14 and 16 Chapter 14 Why Cost of Capital Is Important o We know that the return earned on assets depends on the risk of those assets o The return to an investor is the same as the cost to the company o Our cost of capital provides us with an indication of how the market views the risk of our assets o Knowing our cost of capital can also help us determine our required return for capital budgeting projects Required Return o The required return is the same as the appropriate discount rate and is based on the risk of the cash flows o 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 o We need to earn at least the required return to compensate our investors for the financing they have provided o The cost of capital depends primarily on the use of funds not the source Cost of capital for an investment depends primarily on how and where the capital is raised Cost of Equity o The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Business risk Financial risk o There are two major methods for determining the cost of equity Dividend growth model SML or CAPM The Dividend Growth Model Approach o Start with the dividend growth model formula and rearrange to solve for RE P 0 D 1 g R E D 1 P 0 E o g R o D1 next periods dividend D0 Dividend just paid X 1 g o P0 price per share of stock o g growth at a constant rate estimated Historical growth rates Analysts forecasts of future growth rates Different sources will have different estimates could obtain multiple estimates and average them Dividend Growth Model Example o 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 o One method for estimating the growth rate is to use the historical average o Year Dividend o 2005 1 23 o 2006 1 30 o 2007 1 36 Example Estimating the Dividend Growth Rate Percent Change 1 30 1 23 1 23 5 7 1 36 1 30 1 30 4 6 50 1 25 1 11 ER 051 111 o o 2008 1 43 1 43 1 36 1 36 5 1 1 50 1 43 1 43 4 9 o 2009 1 50 o Average 5 7 4 6 5 1 4 9 4 5 1 Advantages and Disadvantages of Dividend Growth Model o Advantage easy to understand and use o Disadvantages 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 No allowance for the degree of certainty or uncertainty surrounding the estimated growth rate for dividends The SML Approach or CAPM Approach Risk free rate Rf T bills Rf Rm market risk premium Market risk premium E RM Rf BE is the estimated beta Systematic risk of asset Risk free rate t bills estimated beta X Market risk premium o Suppose your company has an equity beta of 58 and the current risk free rate is 6 1 If the expected market risk premium is 8 6 what is your cost of equity capital o RE 6 1 58 8 6 11 1 o Since we came up with similar numbers using both the dividend growth model and the SML approach we should feel good about our estimate o Use the following information to compute our cost of equity Example SML RE M R E E R R o f f Advantages and Disadvantages of SML o Advantages Explicitly adjusts for systematic risk Applicable to all companies as long as we can estimate beta o Disadvantages Have to estimate the expected market risk premium which does vary over time Have to estimate beta which also varies over time We are using the past to predict the future which is not always reliable Example Cost of Equity o Suppose our company has a beta of 1 5 The market risk premium is expected to be 9 and the current risk free rate is 6 We have used analysts estimates to determine that the market believes our dividends will grow at 6 per year and our last dividend was 2 Our stock is currently selling for 15 65 What is our cost of equity o Using SML RE 6 1 5 9 19 5 o Using DGM RE 2 1 06 15 65 06 19 55 o The cost of debt is the required return on our company s debt o We usually focus on the cost of long term debt or bonds o The required return is best estimated by computing the yield to maturity on the existing debt Simply the interest rate the firm must pay on a new borrowing Example if the firm already has bonds outstanding then the yield to maturity on those bonds is the market required rate on the firms debt o We may also use estimates of current rates based on the bond rating we expect when issuing new debt o The cost of debt is NOT the coupon rate Tells us roughly what the firms cost of debt was back when the bonds were issued not what the cost of debt is today Cost of Debt Example Cost of Debt o Suppose we have a bond issue currently outstanding that has 25 years left to maturity The coupon rate is 9 and coupons are paid semiannually The bond is currently selling for 908 72 per 1 000 bond What is the cost of debt o N 50 PMT 45 FV 1000 PV 908 72 o CPT I Y 5 YTM 5 2 10 Cost of Preferred Stock o Reminders Preferred stock generally pays a constant dividend each period Dividends are expected to be paid every period forever o Preferred stock is a perpetuity so we take the perpetuity formula rearrange and solve for RP o RP D P0 o D fixed dividend o P0 current price per share Example Cost of Preferred Stock o Your company has preferred stock that has an annual dividend of 3 If the current price is 25 what is the cost of preferred stock o RP 3 25 12 The Weighted Average Cost of Capital o We can use the individual costs of capital that we have computed to get our average cost of capital for the firm o This average is the required return on the firm s assets based on the market s perception of the risk of those assets o The weights are determined by how much of each type of financing …
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