Chapter 14: Cost of Capital

advantages of SML

-it adjusts for risk -applicable to companies other than those with steady dividend growth

problems with the dividend growth model

-only applicable to companies that pay dividends -estimated cost of equity is sensitive to the estimated growth rate -does not explicitly consider risk

how to find g in the dividend growth model

1. historical growth rates 2. use analysts forecasts of future growth rates

if we divide both sides by V, we can calculate the percentages of total capital represented by debt and equity

100% = E/V + D/V

Value =

Equity + Debt

pure play

a company that focuses on a single line of business

cost of capital

also known as the required return or the appropriate discount rate. Percentage that a firm has to get back on its investment just to compensate investors for the investment.

Primary advantage of the dividend growth model

it is simple. It is easy to understand and use. it is the easiest way to estimate the cost of equity. formula on page 451

the cost of preferred stock can be estimated by

observing required returns on other, similarly rated shares of preferred stock.

subjective approach

partitioning projects into different categories in order to establish discount rates for individual projects

cost of preferred stock

preferred stock has a fixed dividend paid every year forever, so a share of preferred stock is essentially a perpetuity formula on page 456

Security Market Line (SML)

required or expected return depends on -the risk-free rate -the market risk premium -the systematic risk of the asset relative to average (beta coefficient) formula on page 453

in determining cost of capital,

short-term liabilities are ignored

Capital structure weights

the percentages of total capital represented by debt and equity

Using the WACC as a discount for future cash flows is appropriate only when

the proposed investment is similar to the firm's existing activities

cost of equity

the return that equity investors require on their investment in the firm

cost of debt

the return that lenders require on the firm's debt (simply the interest rate the firm must pay on new borrowing with bonds)

pure play approach

the use of the WACC that is unique to a particular project, based on companies in similar lines of business

cost of capital depends mostly on

the use of the funds and not the source

weighted average cost of capital (WACC)

the weighted average of the cost of equity and the aftertax cost of debt the overall return the firm must earn on its existing assets to maintain the value of its stock can be used for performance evaluation