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Lecture Fundamentals of finance – Chapter 12: The cost of capital

Learning objectives of this chapter include: Know how to determine a firm’s cost of equity capital, know how to determine a firm’s cost of debt, know how to determine a firm’s overall cost of capital, understand pitfalls of overall cost of capital and how to manage them, understand the impact of an imputation tax system. | Chapter 12 Lecture – The Cost of Capital Learning Objectives Chapter 12 Lecture – The Cost of Capital After studying this chapter, you should be able to: LO1 Determine a firm's cost of equity capital. LO2 Determine a firm's cost of debt. LO3 Determine a firm's overall cost of capital. LO4 Identify some of the pitfalls associated with a firm's overall cost of capital and what to do about them. 12-1 12-2 What Types of Long-term Capital do Firms Use? Cost of Capital Basics • The cost to a firm for capital funding = the return to the providers of those funds – The return earned on assets depends on the risk of those assets – A firm’s cost of capital indicates how the market views the risk of the firm’s assets – A firm must earn at least the required return to compensate investors for the financing they have provided – The required return is the same as the appropriate discount rate Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock 12-3 12-4 1 Chapter 12 Lecture – The Cost of Capital The Dividend Growth Model Approach Cost of Equity Start with the dividend growth model formula and rearrange to solve for RE • The cost of equity is the return required by equity investors given the risk of the cash flows from the firm • Two major methods for determining the cost of equity - Dividend growth model - SML or CAPM P0 D1 RE g RE D1 g P0 12-5 12-6 Example: Estimating the Dividend Growth Rate Example: Dividend Growth Model • One method for estimating the growth rate is to use the historical average Year Dividend Percent Change • Your company is expected to pay a dividend of $4.40 per share next year. (D1) • Dividends have grown at a steady rate of 5.1% per year and the market expects that to continue. (g) • The current stock price is $50. (P0) • What is the cost of equity? RE 2009 2010 2011 2012 2013 4.40 .051 .139 50 1.23 1.30 1.36 1.43 1.50 (1.30 – 1.23) / 1.23 = 5.7% (1.36 – 1.30) /