Chapter_15-Classnotes - Chapter 15 Classnotes Chapter 15...

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Chapter 15 Classnotes Chapter 15 Cost of Capital We can talk about: the cost of debt the cost of equity cost of preferred stock cost of all capital (weighted average cost of capital) The required return by investors is the cost of that capital to the  company The required return is the same as the appropriate discount rate and  is based on the risk of the cash flows The required return by investors depends upon the risk The cost of all capital is the relevant measure for valuing the firm 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 Cost of Equity The cost of equity is the return required by equity investors given  the risk of the cash flows from the firm 1
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Chapter 15 Classnotes 0. Business risk 1. Financial risk There are two major methods for determining the cost of equity 2. Dividend growth model 3. SML or CAPM 2
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Chapter 15 Classnotes The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to  solve for R E 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? Advantages and Disadvantages of 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 3 1 0 1 0 E E D P R g D R g P = - = +
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Chapter 15 Classnotes 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 4
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