Chap015 - Chapter 15 Cost of Capital Why Cost of Capital Is...

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Chapter 15 Cost of Capital
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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
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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
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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
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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 + = - = 0 1 1 0
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Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 2004 1.23 - 2005 1.30 2006 1.36 2007 1.43 2008 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%
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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 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
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Use the following information to compute our cost of equity – Risk-free rate, R f – Market risk premium, E(R
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This note was uploaded on 01/09/2010 for the course HADM 2225 taught by Professor Wellman, j during the Winter '08 term at Cornell University (Engineering School).

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Chap015 - Chapter 15 Cost of Capital Why Cost of Capital Is...

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