Chapter 14 - Cost of Capital.docx - Chapter 14 Cost of...

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Chapter 14: Cost of Capital14.1 The Cost of Capital: Some PreliminariesHow risky returns from buying securities looked from POV of SH in firm Help understand more about alternatives available to an investor in capital markets Look at returns and securities from POV of issuing companies Return an investor receives = cost of security that company issuedRequired Return versus Cost of Capital“Required return on investment is 10%” Investment has positive NPV only if return > 10%Firm must earn 10% on the investment just to compensate its investors for the use of the capital needed to finance the project cost of capitalCost of capital for risk-free investment = risk-free rateCost of capital for risky project = >risk-free rate Required return, appropriate discount rate, cost of capital SAME THING!Cost of capital associated with an investment depends on risk of that investmentCost of capital depends on USE of funds, NOT SOURCEuse of funds = risk associated with investment Financial Policy and Cost of CapitalCapital structure – mix of debt/equity managerial variableAssume that firm has a fixed D/E ratio that it maintains target capital structureOverall cost of capital is a mixture of returns needed to compensate creditors and SHs cost of debt and equity capitalOverall cost of capital = required return on firm’s assets as a whole14.2 The Cost of EquityCoE: Return that equity investors require on their investment in the firmMust estimate it dividend growth model approach vs. security market line (SML) approachThe Dividend Growth Model Approach**RE= cost of equity capitalGrowth rate must be estimated Current price and dividend paid is given Estimating GrowthUse historical growth ratesUse analysts’ forecasts of future growth rates multiple estimates averagethemOr calculate compound growth rate for X # of yearsCompound growth rate is the rate $1.10 grew to $1.55 during 4 periodsIf historical growth has been volatile, compound growth rate wouldbe sensitive to choice of beg and end yearsoBetter to calculate yearly growth rates and average themAveraging annual growth rates compound growth rateAn Alternative ApproachEstimate g with earnings retentionEarnings next year = Earnings this year + (Retained earnings thisyear * Return on retained earnings)Retention ratio:RE / NI1 + g = 1 + Retention ratio * Return on RE

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