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Unformatted text preview: 15 15 Cost of Capital 152 Why Cost of Capital Is Important Why Cost of Capital Is Important We know from Ch. 13 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 (also called “cost of money”) 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 153 Required Return Required Return The required return, cost of capital, and appropriate discount rate are synonymous and are 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 154 Cost of Equity Cost of Equity 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 There are two major methods for determining the cost of equity Dividend growth model SML or CAPM 155 The Dividend Growth Model Approach The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for R E g P D R g R D P E E + = = 1 1 156 Example: Estimating the Dividend Example: Estimating the Dividend Growth Rate Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 2000 1.23 2001 1.30 2002 1.36 2003 1.43 2004 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% 157 Advantages and Disadvantages of Advantages and Disadvantages of Dividend Growth Model Dividend Growth Model Advantage – easy to understand and use 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 158 The SML Approach The SML Approach Use the following information to compute our cost of equity...
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 Fall '07
 JWELLMAN
 Finance, Corporate Finance, Weighted average cost of capital

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