Slide 11 Cost of Capital

Slide 11 Cost of Capital - Cost of Capital Outline The Cost...

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Cost of Capital
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Outline The Cost of Capital: The Cost of Equity The Costs of Debt The Weighted Average Cost of Capital
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Cost of Capital-Motivation We look at the whole firm as an Asset. This asset generates income. How ? Then, ask the question “what is the return on investment in a firm” ?. There are two sources of raising capital: (1) borrowing (debt) – firm pays interest and (2) issuing stocks (equity) – firm pays dividends
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Why Cost of Capital Is Important Cost of Capital is the return required by investor to invest in a firm Or Firm’s overall cost of capital will reflect required return on the firm’s asset as a whole Cost of capital provides us with an indication of how the market views the risk of our assets, not set by firm
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Cost of Capital The return (cost of capital) specific to each investor - Returns to creditors (debt): Cost of Debt - Returns to stockholders: Cost of Equity So cost of capital reflects (or linear conbination of) both cost of debt capital and equity capital. Firm as asset is formed by two other different assets : debt and equity Cost of Capital should reflect the market opinion if firms are in the market, not set by the firm.
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The Cost of Equity Cost of equity: The return that equity investors require (i.e., buying stocks) How to get Cost of Equity ? +Dividend growth model approach +Security Market Line Approach (beta) So, we need to know the market data to problem
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Cost of equity – Dividend Growth The formula is: • So, R E is the return that shareholders require on equity or cost of equity capital. g P D R Therefore g R D g R g D P E E E + = - = - + = 0 1 1 0 0 , ) 1 (
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Example A stock currently sells for $60/share, dividend in last year is $4. The dividend grows at 6% (estimated). Then just apply the previous formula • R E = D 1 /P 0 +g= =($4*(1+.06))/60+.06 =13.07% So if an investor decides to finance the company in the form of equity, then he requires return of 13.07%. Note that this return is paired with “some level of risk”
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This note was uploaded on 02/29/2012 for the course 322 394 taught by Professor H during the Summer '11 term at Rutgers.

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Slide 11 Cost of Capital - Cost of Capital Outline The Cost...

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