After studying this chapter in the lecture, you should be able to: Explain what the cost of capital represents and why it is so important, estimate the cost of equity using the dividend growth model approach and the security market line approach, estimate the cost of debt and the cost of preferred stock, understand when it is appropriate and to use the WACC as a measure of the firm's required rate of return,. | Chapter Outline Chapter 14 Cost of Capital Chapter Organization 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 Flotation Costs and the WACC Calculating WACC for Bombardier Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, The Cost of Capital: Issues Key issues: What do we mean by “cost of capital” How can we come up with an estimate? Preliminaries 1. Vocabulary—the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money) 2. The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. 3. For now, assume the firm’s capital structure (mix of debt and equity) is fixed. The Dividend Growth Model Approach Estimating the cost of equity: the dividend growth model approach According to the constant growth model, D1 P0 = RE - g Rearranging, D1 RE = + g P0 Example: Estimating the Dividend Growth Rate Percentage Year Dividend Dollar Change Change 1990 $ - - 1991 $ 1992 1993 1994 Average Growth Rate ( + + + )/4 = Example: The SML Approach According to the CAPM: RE = Rf + bE (RM - Rf) 1. Get the risk-free rate (Rf ) from financial press—many use the 1-year Treasury bill rate, say 6%. 2. Get estimates of market risk premium and security beta. a. Historical risk premium — % b. Beta—historical (1) Investment information services - ., S&P, Value Line (2) Estimate from historical data 3. Suppose the beta is , then, using the approach: RE = Rf + b E (RM - Rf) = 6% + _ = _ Example: The SML Approach According to the CAPM: RE = Rf + bE (RM - Rf) 1. Get the risk-free rate (Rf ) from . | Chapter Outline Chapter 14 Cost of Capital Chapter Organization 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 Flotation Costs and the WACC Calculating WACC for Bombardier Summary and Conclusions CLICK MOUSE OR HIT SPACEBAR TO ADVANCE copyright © 2002 McGraw-Hill Ryerson, The Cost of Capital: Issues Key issues: What do we mean by “cost of capital” How can we come up with an estimate? Preliminaries 1. Vocabulary—the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money) 2. The cost of capital is an opportunity cost—it depends on where the money goes, not where it comes from. 3. For now, assume the firm’s capital structure (mix of debt and equity) is fixed. The Dividend Growth Model Approach Estimating the cost of equity: the dividend
