Class 16

Class 16 - CostofCapital Theryouvebeen Whyisitimportant?

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Cost of Capital The “r” you’ve been 
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Why is it important? § The required return on an asset depends on  the risk level of that asset § What investors require as a return on their  investment in the company is a measure of  how the market sees the risk associated with  the company’s assets, which we call the  cost of  capital  for the company § The cost of capital is going to determine what  return we’re going to require on capital  budgeting projects
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Cost of Capital – Required Return § The required return is the appropriate  discount rate that is based on the riskiness 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 § At a minimum, we need to earn at least the  required return to compensate our investors  for the financing they have provided
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Different Sources of Capital § Investors require different returns on  different types of assets Equity Ø Common Stock Ø Preferred Stock Debt § A combination of these returns is going  to determine the overall cost of capital  of the company
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Cost of Equity § How much does the market – do the  investors – require for holding company  stock? § The cost of equity is the return required  by equity investors given the risk of the  cash flows from the firm
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Two methods § There are two major methods for  determining the cost of equity We’ve actually already seen both of them It’s just a matter of putting everything  together § Dividend growth model Remember our discussion of stocks § SML, or CAPM Remember our discussion of CAPM
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The Dividend Growth Model g P D R g R D P E E + = - = 0 1 1 0
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§ 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
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Class 16 - CostofCapital Theryouvebeen Whyisitimportant?

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