ch 14 (Cost of Capital)

ch 14 (Cost of Capital) - Key Concepts and Skills Know how...

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Chapter 14 Cost of Capital Slide 14 - 1 Key Concepts and Skills ± Know how to determine a firm’s cost of equity capital ± Know how to determine a firm’s cost of debt ± Know how to determine a firm’s overall cost of capital ± Understand pitfalls of overall cost of capital and how to manage them ± Compute floatation costs Slide 14 - 2 ± Required Return and Cost of Capital The return earned on assets depends on the risk of those assets, which need to earn at least the return required to compensate the investors for the financing they have provided. z Required return is from an investor’s point of view, which, from the firm’s point of view, is the cost of capital. z The required return is the appropriate discount rate that we use in a present value calculation. Cost of capital, required return, and appropriate discount 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 Capital: Concept Slide 14 - 3 ± Cost of Capital and Capital structure z Capital structure is the composition of capital between debt and equity Major classes of financial securities a firm issues: ¾ Common stock: common shares of ownership ¾ Preferred stock: perpetual dividend payment ¾ Debt: coupon payment and face value z A firm’s cost of capital reflects the average riskiness of all of the securities it has issued, which may be less risky (e.g., with debt) or more risky (with common stock) Cost of Capital: Concept
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Slide 14 - 4 Cost of Equity ± Required Return by Equity Investors z The cost of equity is the return required by equity investors given the risk of the cash flows from the firm. z Two major methods for determining the cost of equity ¾ Dividend Growth Model ¾ SML (or CAPM) Slide 14 - 5 Cost of Equity ± The Dividend Growth Model z Solve the dividend growth model formula to obtain R E : Estimate the growth rate: g ¾ Use analysts forecast of the growth rate of a firm s earnings When the firm pays a fixed percentage of its earnings as dividends, the expected growth rate in dividend equals the growth rate in earnings. g P D R g R D P E E + = = 0 1 1 0 Slide 14 - 6 ¾ Use the plowback ratio: g = b × ROE b = Plowback ratio (the fraction of earnings retained in the firm) ROE = Return on equity (earnings divided by last year s book equity) 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? Cost of Equity % 1 . 11 111 . 051 . 25
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This note was uploaded on 04/18/2011 for the course FINA 1003 taught by Professor Lin during the Fall '11 term at HKU.

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ch 14 (Cost of Capital) - Key Concepts and Skills Know how...

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