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Chapter 14
COST OF CAPITAL
SLIDES
14.1 Key Concepts and Skills
14.2 Chapter Outline
14.3 Why Cost of Capital Is Important
14.4 Required Return
14.5 Cost of Equity
14.6 The Dividend Growth Model Approach
14.7 Dividend Growth Model Example
14.8 Example: Estimating the Dividend Growth Rate
14.9 Advantages and Disadvantages of Dividend Growth Model
14.10 The SML Approach
14.11 Example SML
14.12 Advantages and Disadvantages of SML
14.13 Example Cost of Equity
14.14 Cost of Debt
14.15 Example: Cost of Debt
14.16 Cost of Preferred Stock
14.17 Example: Cost of Preferred Stock
14.18 The Weighted Average Cost of Capital
14.19 Capital Structure Weights
14.20 Example: Capital Structure Weights
14.21 Taxes and the WACC
14.22 Extended Example WACC I
14.23 Extended Example WACC II
14.24 Extended Example WACC III
14.25 Eastman Chemical I
14.26 Eastman Chemical II
14.27 Eastman Chemical III
14.28 Example: Work the Web
14.29 Table 14.1 Cost of Equity
14.30 Table 14.1 Cost of Debt
14.31 Table 14.1 WACC
14.32 Divisional and Project Costs of Capital
14.33 Using WACC for All Projects Example
14.34 The Pure Play Approach
14.35 Subjective Approach
14.36 Subjective Approach Example
14.37 Flotation Costs
14.38 NPV and Flotation Costs - Example
14.39 Quick Quiz
14.40 Ethics Issues
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CHAPTER ORGANIZATION
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P0 = D1 / (RE g)
RE = (D1 / P0) + g
which is equal to the dividend yield plus the growth rate (capital
gains yield).
Lecture Tip: It is noted in the text that there are other ways to
compute g. Rather than use the arithmetic mean, as in the example,
the geometric mean (which implies a compound growth rate) can
be used. OLS regression with the log of the dividends as the
dependent variable and time as the independent variable is also an
option. Another way to estimate g is to assume that the ROE and
retention rate are constant. If this is the case, then g =
ROE*retention rate.
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Example:
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Slide 14.10 The SML Approach Click on the web surfer icon to go to the
finance.yahoo.com web site and show students how to find the beta and T-
bill rate.
Slide 14.11 Example SML
Slide 14.12 Advantages and Disadvantages of SML
Slide 14.13 Example Cost of Equity
Implementing the Approach
Betas are widely available, and T-bill rates or the rate on long-
term Treasury securities are often used for R f. The expected
market risk premium is the more difficult number to come up
with make sure that the market risk premium used is
consistent with the risk-free rate chosen. One of the problems
is that we really do need an expectation, but we only have past
information and market risk premiums do vary through time.
Early in 2000, Federal Reserve Chairman, Alan Greenspan,
indicated that part of his concern with the state of the U.S.
stock markets at that time was the reduction in the market risk
premium. He felt that investors were either becoming less risk
averse, or they did not truly understand the risk they were
taking by investing in the stock. Nonetheless, the historical
average is often used as an estimate for the expected market
risk premium.
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Lecture Tip: Students are often surprised when they find that the
two approaches typically result in different estimates. Suggest that
it would be more surprising if the results were identical. Why? The
underlying assumptions of the two approaches are very different.
The constant growth model is a variant of a growing perpetuity
model and requires that dividends are expected to grow at a
constant rate forever and that the discount rate is greater than the
growth rate. The SML approach requires assumptions of normality
of returns and/or quadratic utility functions. It also requires the
absence of taxes, transaction costs, and other market
imperfections.
Cost of debt (RD) the interest rate on new debt can easily be
estimated using the yield to maturity on outstanding debt or by
knowing the bond rating and looking up rates on new issues with
the same rating.
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RP = D / P0
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WACC overall return the firm must earn on its assets to maintain
the value of its stock. It is a market rate that is based on the
markets perception of the risk of the firms assets.
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Video Note: Economic Value Added (EVA) can be used to reinforce the concepts.
Slide 14.32 Divisional and Project Costs of Capital Click on the web surfer
icon to go to an index of businesses owned by General Electric. You can use
this to generate discussion about why it is not appropriate to use the overall
firm WACC for every division.
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Lecture Tip: You may wish to point out here that the divisional
concept is no more than a firm-level application of the portfolio
concept introduced in the section on risk and return. And, not
surprisingly, the overall firm beta is therefore the weighted
average of the betas of the firms divisions.
Pure play a company that has a single line of business. The idea
is to find the required return on a near substitute investment.
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Example:
Suppose ABC Company is considering opening another office.
The expansion will cost $50,000 and is expected to generate after-
tax cash flows of $10,000 per year in perpetuity. The firm has a
target debt/equity ratio of .5. New equity has a flotation cost of
10% and a required return of 15%, while new debt has a flotation
cost of 5% and a required return of 10%. The tax rate is 34%.
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