{[ promptMessage ]}

Bookmark it

{[ promptMessage ]}

Chap015

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

This preview shows pages 1–9. Sign up to view the full content.

Chapter 15 Cost of Capital

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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
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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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
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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
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%
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

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
Use the following information to compute our cost of equity – Risk-free rate, R f – Market risk premium, E(R
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

### Page1 / 26

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

This preview shows document pages 1 - 9. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online