COST OF CAPITAL COST OF CAPITAL ANDAND

Chapter 11

The Dividend Growth Model The Dividend Growth Model ApproachApproachCan be rearranged to solve for RE

2

P0 D1

RE g

RE D1

P0

g

Example Example Suppose that a company just

paid a dividend of $2.50 per share. There has been a steady growth in dividends of 7.1% per year and the market expects that to continue. The current price is $45. What is the cost of equity?

Solution:

3

Example: Estimating the Example: Estimating the Dividend Growth RateDividend Growth Rate

One method for estimating the growth rate is to use the historical average◦Year Dividend Percent Change◦19951.23◦19961.30◦19971.36◦19981.43◦19991.50Analysts’ forecast can be used

4

Alternative Approach to Alternative Approach to Estimating GrowthEstimating GrowthIf the company has a stable ROE, a stable

dividend policy and is not planning on raising new external capital, then the following relationship can be used:

A company has a ROE of 15% and payout ratio is 35%. If management is not planning on raising additional external capital, what is its growth rate?

Solution:

5

g = Retention ratio x ROE

The SML Approach (CAPM)The SML Approach (CAPM)Use the following information to

compute our cost of equity◦Risk-free rate, Rf

◦Market risk premium, E(RM) – Rf

◦Systematic risk of asset,

6

E(RA) = Rf + A(E(RM) – Rf)

SML exampleSML exampleSuppose the company has an

equity beta of .88 and the current risk-free rate is 3.1%. If the expected market risk premium is 7.6%, what is the cost of equity capital?

Solution:

7

Cost of EquityCost of EquitySuppose the company has a beta of

1.25. The market risk premium is expected to be 9.2% and the current risk-free rate is 4%. Dividends will grow at 5% per year and last dividend was $2. The stock is currently selling for $17.35. What is our cost of equity?

◦Using SML:

◦Using DGM:

8

Cost of Debt exampleCost of Debt exampleSuppose you have a bond issue

currently outstanding that has 15 years left to maturity. The coupon rate is 8% and coupons are paid annually. The bond is currently selling for $875.4729 per $1000 bond. What is the cost of debt?

Solution:

9

Cost of Preferred StockCost of Preferred StockPreferred stock generally pays a

constant dividend every period

Dividends are expected to be paid every period forever

Preferred stock is an annuity

10

RP = D / P0

Cost of Preferred Stock Cost of Preferred Stock exampleexampleA company has preferred stock

that has an annual dividend of $2. If the current price is $15, what is the cost of preferred stock?

Solution:

11

FINANCIAL LEVERAGE FINANCIAL LEVERAGE AND CAPITAL AND CAPITAL STRUCTURE POLICYSTRUCTURE POLICY

Chapter 12

Capital Structure TheoryCapital Structure TheoryModigliani and Miller Theory of

Capital Structure◦Proposition I – the pie model◦Proposition II – WACC

The value of the firm is determined by the cash flows to the firm and the risk of the assets

13

Static Theory and Firm Static Theory and Firm ValueValue

14

DIVIDENDS AND DIVIDENDS AND DIVIDEND POLICYDIVIDEND POLICY

Chapter 13

Residual Dividend Policy, Residual Dividend Policy, exampleexampleGiven

◦Need $5 million for new investments◦Target capital structure: D/E = 2/3◦Net Income = $4 million

Dividend - ?

16

MANAGING SHORT MANAGING SHORT TERM LIABILITIESTERM LIABILITIES

Chapter 16

18

Computing the Cost of Bank Computing the Cost of Bank LoansLoansSimple Interest Loan

◦ Both the amount borrowed and the interest charged on that amount are paid at the maturity of the loan

Face Value◦ The amount of the loan (the amount

borrowed)

ProblemProblemYou go to three different banks to borrow

$10,000 for one year. Each says it will lend you the money at 10 percent, but their terms differ as follows:

Bank A: Simple interestBank B: Add-on interestBank C: Discounted interest Banks A and C require a single payment at

the end of the year. Bank B requires 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rate in this case?

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SolutionSolution Simple interest (Bank A)

Effective rate = 10% Add-on interest (Bank B) Financial calculator solution: Calculate the total to be repaid and equal monthly

payments Repayment amount = $10,000 + (0.10 ´ $10,000) =

$11,000. Monthly payments = $11,000/12 = $916.67. Calculate the periodic interest rate (period = 1 month) Inputs: N = 12; PV = 10,000; PMT = -916.67; FV =0. Output: I = 1.4977%. Calculate EAR using interest rate conversion feature Simple annual rate = NOM% = 12 ´ 1.4977 = 17.97%. Inputs: P/YR = 12; NOM% = 17.97. Output EFF% =

19.53 19.5%.

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Solution Cont.Solution Cont.Discounted interest (Bank C)Effective rate = = 0.1111 =

11.11%.The difference between the

highest and lowest EARs, Bank B - Bank A, equals 19.5% - 10% = 9.5%.

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22

Computing the Annual Cost of Bank Computing the Annual Cost of Bank LoansLoansBorrowed Amount versus Required Borrowed Amount versus Required AmountAmount

Credit terms - ProblemCredit terms - ProblemA firm is offered trade credit terms of

2/8, net 45. The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? (Note: Do not use the approximate cost.)

Periodic rate =2/98 = 2.04%.Number of compounding periods

=360/50 = 7.20 (though negotiation payment was delayed until 58 days instead of 45)

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Solution contSolution contCalculate EAR using interest rate

conversion featureInput: NOM% = 14.69; P/YR =

7.20.Output: EFF% = EAR = 15.65%.

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ProblemProblemWicker Corporation is determining whether

to support $100,000 of its permanent current assets with a bank note or a short-term bond. The firm's bank offers a two-year note where the firm will receive $100,000 and repay $118,810 at the end of two years. The firm has the option to renew the loan at market rates. As an alternative, the firm can sell its own 8.5 percent annual coupon bonds, with $1,000 face value and 2-year maturity, at a price of $973.97. Comparing the cost of the two alternatives, how many percentage points lower is the interest rate on the less expensive debt instrument?

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SolutionSolutionCash flow time lines: Note that the cash

flows viewed from the firm's perspective involve inflows at time 0, and repayment of coupon and/or maturity value in the future.

Financial calculator solution:Banknote: Inputs: N = 2; PV = 100,000; FV = -

118,810.Output: I = 9.0%.Bond: Inputs: N = 2; FB = 973.97; PMT = -85; FV

= 1,000.Output: I = 10.0%.The difference is 10.0% - 9.0% = 1.0%.

21-26

Cash Flow Time linesCash Flow Time lines

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