Exam 4 Study Guide Chapters 14 16 17 3 Chapter 14 Cost of Capital The return an investor in a security receives is the cost of that security to the company that issued it Higher risk historically goes with higher investment We can only predict broadly and generally We can come up with expected return based on systematic risk but only what can be reasonably foreseen is the relationship between returns on stock and market Using this as a discount rate only really works if it s entirely based on equity and the project is the same as the business The required return and the cost of capital are basically the same thing Required return yield to maturity what rate determines the price in the marketplace From an investor s point of view Cost of capital form company s point of view Issuing of debt and equity Rate to be able to use your money From the borrower user point of view All of this is based on the opportunity cost of capital The investor could spend their money elsewhere or with you in different ways What the investor is giving up when he chooses what he invests in determines these rates The investors assess the borrowers The cost of capital of an investment depends on the risk of the investment Cost depends primary on the use of the funds not the source The firms overall cost of capital reflects the required return on the firm s assets as a whole This is a mix of the returns needed to compensate its creditors and stockholders It reflects both the cost of debt capital and the cost of equity capital Cost of equity the return that equity investors require on their investment in the firm The overall cost of equity is difficult to determine because you can t observe how much the investors require on their investment This can be estimated using the dividend growth model approach or the security market line approach Dividend growth model approach easier o P0 D0 X 1 g RE g D1 RE g This can be rearranged to show RE D1 P0 g o This assumes that the dividend grows at a constant rate g o P0 is the price of the stock and D0 is the dividend just paid where D1 will be the following dividend RE is the required return and since this is the return the stockholders require it can be interpreted as the firm s cost of equity capital o To solve this we need P and g which must be estimated G can be estimated either with historical growth rates or forecasting 0 and D0 which can both be observed directly o Example If the last dividend was 4 and the stock price is 60 and you ve estimated there is a 6 growth rate first find D1 D1 D0 X 1 g 4 x 1 06 4 24 Then use this D1 to find RE RE D1 P0 g 4 24 60 06 13 07 cost of equity Security Market Line Approach o The primary advantage is the simplicity o Disadvantages limited to companies that pay dividends and even those aren t entire accurate as this assumes the dividends are growing at a constant rate Also the estimated cost of equity is very sensitive to the estimate growth rate so the estimated cost of equity can be off if the growth rate was estimated very well This approach also doesn t really consider or directly adjust for risk o Using the SML we can write the expected return on the company s equity as E Rg Rf g X E RM Rf This can be denoted like Rg Rf g X RM Rf to stay consistent with the dividend growth model o To use this we need a risk free rate Treasury bills can be used as Rf an estimate of the market risk premium RM Rf and an estimate of the relevant which is widely available for publicly traded companies o Example Risk free rate 10 1 68 market risk premium 7 Rg Rf g X RM Rf 10 1 68 x 7 11 86 o Advantages explicitly adjusts for risk and is applicable to more companies than just those with steady dividend growth o Disadvantages requires the market risk premium and beta coefficient to be estimated which could lead to inaccuracies if our estimates are bad Economic conditions change quickly so the past may not always be a good guide to the future Cost of debt the return the creditors demand on new borrowing This can usually be observed directly or indirectly as it is simply the interest rate the firm has to pay on new borrowing which can be observed through the financial markets or through the ratings of their bonds Remember the coupon rate of the outstanding debt is unrelated because it has nothing to do with the cost today Cost of debt is abbreviated RD and can be calculated using the yield to maturity on a bond Cost of short term debt like liabilities if you have 60 days to pay it figure out what the discount would be if you paid now Usually not very big but for small businesses this may be the only debt they have Equity has a higher rate than debt because the IRS allows you to deduct interest payments but not dividends Cost of preferred stock since it has a fixed dividend it is pretty much a perpetuity Rp D P0 Simply equal to the dividend yield Also since they are rated similarly as bonds the cost of preferred stock can be estimated by observing the required returns on other similarly rated shares of preferred stock Capital Structure Weights E stands for the market value of the firm and is calculated by taking the number of outstanding shares and multiplying it by the price per share D stands for the market value of the firm s debt and is calculated by multiplying the market price of a bond by the number of outstanding bonds V E D meaning the value equals the equity and debt We can divide both sides by V to see the percentages of total capital represented by debt and equity 100 E V D V these percentages are often called the capital structure weights This is a good evaluation for what you would sell the company for Taxes Always concerned with after tax cash flows The discount rate will have to be expressed on an after tax basis Interest paid is tax deductible but payments to stockholders like dividends aren t need to look at the pretax and after tax cost of debt The after tax interest rate is the pretax rate X 1 tax rate or RD x 1 Tc To total up the overall cost of capital we multiply the capital structure weights by the associated costs and add them up Weighted Average Cost of Capital E V x RE P V x Rp D V x RD x 1 Tc Rp being the cost of preferred stock We can use the WACC as the discount rate for future cash flows when …
View Full Document
Unlocking...