11 - Chapter 14: Cost of Capital Faculty of Business and...

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Faculty of Business and Economics University of Hong Kong Dr. T. Lin Chapter 14: Cost of Capital
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Project NPV Analysis Cost of Debt Cost of Capital Cash Flow Flotation Cost Cost of Equity Cost of Preferred Stock Firm Level WACC Divisional or Project Cost of Capital
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Cost of Capital Project cost of capital: the rate of return offered by the financial market on investments of similar risk. The cost of capital depends on the use of the funds (risk of the cash flow), not the source. It is the opportunity cost of funds tied up in the project.
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Cost of Equity Not directly observed. The dividend growth model approach The security market line approach
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The Dividend Growth Model R E = D 1 /P 0 + g Advantages: Simplicity Disadvantages: Applicable to a subset of stocks. Sensitive to the estimated growth rate. Does not explicitly consider risk.
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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
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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%
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The SML Approach The Capital Asset Pricing Model (CAPM) can be used to obtain the cost of capital for a capital budgeting project. Risk-free rate, R f Market risk premium, E(R M ) R f Systematic risk of equity, ) ) ( ( f M E f E R R E R R  
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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? R
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11 - Chapter 14: Cost of Capital Faculty of Business and...

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