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Cost of Capital Paper

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NOTE 10: COST OF CAPITAL  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 I. The Cost of Capital: Issues 1. 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. A.) The Dividend Growth Model Approach According to the constant growth model, P0 = D1 / (RE - g) Rearranging, RE = (D1 / P0) + g Example 1: Estimating the Dividend Growth Rate Year Dividend 1990 $4.00 1991 4.40 1992 4.75 1993 5.25 1994 5.65 Dollar Change Percentage Change B.) The SML Approach According to the CAPM: RE = Rf + β E x (RM - Rf) 1. Get the risk-free rate from financial press—many use the 1-year Treasury bill rate, say 5%. 2. Get estimates of market risk premium and security beta. a. Risk premium—historical 9.2% b. Beta—historical (1) Investment information services - e.g., S&P 1 (2) Estimate from historical data 3. Suppose the beta is 1.40, then, using the approach: RE = Rf + β E x (RM - Rf) II. Costs of Debt and Preferred Stock A.) Cost of debt 1. The cost of debt, RD, is the interest rate on new borrowing. 2. The cost of debt is observable ...
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