Chapter_14_FI311_FA2011_SS

Chapter_14_FI311_FA2011_SS - Click to edit Master title...

Info iconThis preview shows pages 1–9. Sign up to view the full content.

View Full Document Right Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full DocumentRight Arrow Icon
This is the end of the preview. Sign up to access the rest of the document.

Unformatted text preview: Click to edit Master title style 12/29/11 1 12/29/11 Chapter 14 Cost of Capital Click to edit Master title style 12/29/11 2 12/29/11 Key Concepts and Skills Know how to determine a firms cost of equity capital Know how to determine a firms cost of debt Know how to determine a firms overall cost of capital Understand pitfalls of overall cost of capital and how to manage them Click to edit Master title style 12/29/11 3 12/29/11 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 Cost of capital provides an indication of how the market views the risk of our assets Knowing the cost of capital can also help determine the required return for capital budgeting projects Click to edit Master title style 12/29/11 4 12/29/11 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 Click to edit Master title style 12/29/11 5 12/29/11 Cost of Equity The cost of equity is the return required by equity investors given the risk of the cash flows from the firm Business risk Financial risk There are two approaches for determining the cost of equity: Dividend growth model Security Market Line (SML) or CAPM Click to edit Master title style 12/29/11 6 12/29/11 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 + =- = 1 1 Click to edit Master title style 12/29/11 7 12/29/11 Example Dividend Growth Model 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? % 1 . 11 111 . 051 . 25 50 . 1 = = + = E R Click to edit Master title style 12/29/11 8 12/29/11 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 arent 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 at least 1% Does not explicitly consider risk Click to edit Master title style...
View Full Document

Page1 / 28

Chapter_14_FI311_FA2011_SS - Click to edit Master title...

This preview shows document pages 1 - 9. Sign up to view the full document.

View Full Document Right Arrow Icon
Ask a homework question - tutors are online