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FIN 620-session 2 lecture

FIN 620-session 2 lecture - FIN 620 Long Term Financial...

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FIN 620 Long Term Financial Mangement Session 2 1. Lecture Notes/Comments In Chapter 13 we study the cost of capital for a firm and its components. Firms finance themselves by selling different kinds of securities (broadly debt and equity) Cost of capital is the rate of return a firm has to pay to the buyers of the securities it sells. Different securities have different possible future cash flows based on differing contracts. For example for a simple capital structure, debt is supposed to get a fixed repayment and whatever is left. The different cash flows have different risks, and hence different securities have different associated costs of capital (for example cost of equity and cost of debt). Cost of Capital To make investments a firm requires money. If this money is raised from external sources, it could be through the sale of equity or debt. Some times its easier to grasp the intricacies of cost of capital estimation when related to applications. A good estimate is required for: Good capital budgeting decisions – neither the NPV rule nor the IRR rule can be implemented without knowledge of the appropriate discount rate Financing decisions – the optimal/target capital structure minimizes the cost of capital Operating decisions – cost of capital is used by regulatory agencies in order to determine the “fair” return in some regulated industries (e.g. utilities) The cost of capital, required return, and discount (hurdle) rate are different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk. Cost of Equity Investors who purchase equity from a firm will price the equity by discounting future expected cash flows (from their ownership of the equity) by a discount rate. This discount rate is called the “Equity Cost of Capital”. Suppose the firm wishes to raise a certain amount of money by selling equity. Higher the equity cost of capital, higher would be the expected cash flows the firm would have to provide the equity buyers. If you believe the CAPM is true, the equity cost of capital is given by: R E = R f + β E (E(R M ) – R f )
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The plot of the above relationship between R and β E is called the Security Market Line (SML). Beta is defined as: β S = σ iM / σ M 2 The Market Risk Premium: The MRP can be estimated using two methods. Method 1: We could use historical data. In chapter 10, we estimated that 7% might be a good approximation. Method 2: We could use the dividend discount model (DDM). Rearranging the DDM provides the following: g P R D + = 1 Whereas we previously applied this to an individual stock, we could also relate this to the market as a whole. The dividend yield on the S&P500 is readily available, and analysts’ forecasted dividend growth (say, over the next five years) can be used as an estimate for g.An interesting question is how you value the stock for a firm that does not pay dividends. In the case of growth-oriented, non-dividend-paying firms, analysts often look
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FIN 620-session 2 lecture - FIN 620 Long Term Financial...

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