Chapter 14

Estimating g

1) use historical growth rates 2) use analysts forecasts of future growth rates. calculate percentage change

flotation Cost

If a company accepts a new project, it may be required to issue, or float, new bonds and stocks. This means that the firm will incur some costs

Cost of equity

The return that equity investors require on their investment in the firm. difficult question is that there is no way of directly observing the return that the firm's equity investors require on their investment. Instead, we must somehow estimate it

cost of debt

The return that lenders require on the firm's debt. imply the interest rate the firm must pay on new borrowing. current debt use book value, private debt use similar

The SML Approach

The risk-free rate, The market risk premium, The systematic risk of the asset relative to average

pure play

a company that focuses on only one type of business

SML Advantages

adjusts for risk, applicable to companies other than just those with steady dividend growth

pure play approach

appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities.

Dividend Growth Model

find D1 then Re.

THE COST OF PREFERRED STOCK

has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity

interest

is tax deductible

cost of capital/required return/appropriate discount rate

minimum required return for the project. depends primarily on the use of the funds, not the source

Disadvantages of Dividend Growth Model

only applicable to companies that pay dividends. constant growth is not always likely to occur. cost of equity is very sensitive to the estimated growth rate. does not consider risk

SML disadvantages

requires that two things be estimated: the market risk premium and the beta coefficient. rely on the past to predict the future

risk class

similar project. appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities.

Advantages of Dividend Growth Model

simple easy to use and interpret

WACC

the minimum return a company needs to earn to satisfy all of its investors, including stockholders, bondholders, and preferred stockholders. cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm.

Capital Structure Weights

weights of equity, debt and preferred stock.