Chap014s

# Chap014s - Cost of Capital Chapter Fourteen 1 Why Cost of...

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Cost of Capital Chapter Fourteen 1

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Why Cost of Capital Is Important We know 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 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 2
Required Return The required return is the same as the appropriate discount rate and is 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 3

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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 There are two major methods for determining the cost of equity Dividend growth model SML or CAPM 4
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 5

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Dividend Growth Model Example 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? 111 . 051 . 25 50 . 1 = + = E R 6
Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 1995 1.23 1996 1.30 1997 1.36 1998 1.43 1999 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% 7

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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 8
The SML (CAPM) Approach Use the following information to compute our cost of equity – Risk-free rate, R f – Market risk premium, E(R M ) – R f Systematic risk of asset, β ) ) ( ( f M E f E R R E R R - + = β 9

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Example - SML Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
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