Beruflich Dokumente
Kultur Dokumente
Cost of Capital
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McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
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Chapter Outline
• The Cost of Capital: Some Preliminaries
• The Cost of Equity
• The Costs of Debt and Preferred Stock
• The Weighted Average Cost of Capital
• Divisional and Project Costs of Capital
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Capital Components
3 sources of capital:
1) Common stock (Equity) - RE
2) Debts - RD
3) Preferred stock - RP
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Example: Estimating the
Dividend Growth Rate
• One method for estimating the growth rate is to use the
historical average
Year Dividend Percent Change
– 2000 1.23
– 2001 1.30
– 2002 1.36
– 2003 1.43
– 2004 1.50
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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 aren’t 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 1%
– Does not explicitly consider risk
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R E = R f + β E [E(R M ) − R f ]
– Rf = Risk-free rate
– E(RM)= Market return
– E(RM) – Rf = Market risk premium,
β = beta = Systematic risk of asset,
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Example - SML
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Capital Structure Weights
• Suppose you have a market value of equity equal to
$500mil, market value of debt = $475mil and
preferred market value = 25mil:
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Weighted Average Cost of
Capital (WACC)
E D P
WACC = R E + R D (1 − Tc) + R P
V V V
where: E/V = Weight for Equity
RE = Cost of Equity
D/V = Weight for Debt
RD = Cost of Debt
Tc = Corporate tax rate
P/V = Weight for Preferred
Rp = Cost of Preferred
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Example – WACC
• Equity Capital: • Debt Capital:
– 50,000 shares – $1 million in outstanding
– $80 per share debt (at face value)
– Beta = 1.15 – Current quote = 118.39%
– Market risk premium = 9% – Coupon rate = 9%,
– Risk-free rate = 5% semiannual coupons
– 15 years to maturity
• Preferred Capital: – Tax rate = 40%
– 10,000 shares
– $110 per share
– Dividend rate of 5.5%
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Example – WACC
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Example – WACC
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Subjective Approach
• Consider the project’s risk relative to the firm
overall
• Assume WACC=15% for average risk class
• If the project is more risky than the firm, use a
discount rate greater than the WACC (r>15%)
• If the project is less risky than the firm, use a
discount rate less than the WACC (r<15%)
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Quick Quiz
• What are the two approaches for computing the cost
of equity?
• How do you compute the cost of debt and the after-
tax cost of debt?
• How do you compute the capital structure weights
required for the WACC?
• What is the WACC?
• What happens if we use the WACC for the discount
rate for all projects?
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Tutorial
• Problem 4, 10 & 18 from page 397
• Problem 18:
- under Debt:
“…a quoted price of 108.” change to
“…a quoted price of 105.34.”
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