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. | 12- Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 12- Key Concepts and Skills Know how to determine: A firm’s cost of equity capital A firm’s cost of debt A firm’s overall cost of capital Understand pitfalls of overall cost of capital and how to manage them 12- 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 12- 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 12- Cost of | 12- Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin 12- Key Concepts and Skills Know how to determine: A firm’s cost of equity capital A firm’s cost of debt A firm’s overall cost of capital Understand pitfalls of overall cost of capital and how to manage them 12- 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 12- 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 12- Cost of Equity 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 Return to Quick Quiz 12- The Dividend Growth Model Approach Start with the dividend growth model formula and rearrange to solve for RE 12- Example: Dividend Growth Model Your company is expected to pay a dividend of $ per share next year. (D1) Dividends have grown at a steady rate of per year and the market expects that to continue. (g) The current stock price is $50. (P0) What is the cost of equity? 12- Example: Estimating the Dividend Growth Rate One method for estimating the growth rate is to use the historical average Year Dividend Percent Change 2003 2004 2005 2006 2007 ( – ) / = ( – ) / = ( – ) / = ( – ) / = Average = ( + + + ) / 4 = .
