cost_of_capital_ch_14 - COST OF CAPITAL CHAPTER 14 Required...

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COST OF CAPITAL C H A P T E R 1 4
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Required return VS cost of capital Any returns for investors are costs for the company NPV What is the required rate of return? What does it mean? What is the difference between: required rate of return / appropriate discount rate and cost of capital?
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Capital structure Common stock Debt Preferred stock
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Cost of equity Cost of common equity ( Re ) is the rate of return that an investor requires when investing in common shares of a company The cost of common equity is the return required by equity investors given the risk of the cash flows from the firm Business risk Financial ris k
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There are two major methods for determining the cost of common equity 1. Dividend growth model 2. SML Cost of equity
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Reminder Debt Interest Preferr ed stock Preferred dividends Commo n stock Dividends Capital gain
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1. Dividend growth model Cost of equity D 1 : expected dividend for upcoming year Po: current share price g: growth rate g P D R E 0 1 g g D P Re ) 1 ( 0 0
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Suppose STC paid a dividend of 4$ per share last year. The stock is currently sells for 60 $ per share. You estimate that the dividend will grow steadily at a rate if 6% per year into the infinite future. What is the cost of equity for STC? Cost of equity
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Suppose that your company is expected to pay a dividend of $1.50 per share next year. You bought the common stock for 20 and expect to sell it next year worth $25. What is your required rate of return? Cost of equity
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Estimating g: There are two ways of estimating g 1. Use historical growth rates 2. Use analysts’ forecasts of future growth rates Cost of equity dividend Year 1.10$ 2005 1.20 2006 1.35 2007 1.40 2008 1.55 2009
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Cost of equity Advantages and Disadvantages of Dividend Growth Model Advantages: simplicity Disadvantages: 1. Only applicable to companies currently paying dividends 2. Not applicable if dividends aren’t growing at a reasonably constant rate 3. Extremely sensitive to the estimated growth rate – an increase in g of 1% increases the cost of equity by 1% 4. Does not explicitly consider risk
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2. The Security Market Line Approach (SML) The SML essentially tells us the reward (return) for bearing risk in financial markets – what return is expected for a given level of risk required return is a function of 3 things: 1. risk free rate 2. market risk premium 3. systematic risk of the asset relative to the average risk - called the ‘beta’ coefficient Cost of equity
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1. risk free rate: return on a risk free asset 2. market risk premium - reflecting the return associated with the market as a whole e.g. the Saudi market return 3. systematic risk of the asset relative to the average risk called the ‘ beta’ coefficient : A measure of the systematic risk, of a security or a portfolio in comparison to the market as a whole - so if the stock historically is much more volatile (risky) than the market then the return should reflect that incremental risk Cost of equity
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From the SML comes the Capital Asset Pricing Model
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