COST OF CAPITAL AND Chapter 11

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Chapter 11
COST OF CAPITAL AND
The Dividend Growth Model
Approach

Can be rearranged to solve for RE
D1
P0 
RE  g
D1
RE 
g
P0
1
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:

2
Example: Estimating the Dividend
Growth Rate

One method for estimating the growth
rate is to use the historical average
◦
◦
◦
◦
◦
◦

Year
1995
1996
1997
1998
1999
Dividend
1.23
1.30
1.36
1.43
1.50
Percent Change
Analysts’ forecast can be used
3
Alternative Approach to Estimating
Growth

If 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:
g = Retention ratio x ROE
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:

4
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, 
E(RA) = Rf + A(E(RM) – Rf)
5
SML example
Suppose 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:

6
Cost of Equity

Suppose 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:
7
Cost of Debt example
Suppose 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:

8
Cost of Preferred Stock

Preferred stock generally pays a constant
dividend every period

Dividends are expected to be paid every
period forever

Preferred stock is an annuity
RP = D / P0
9
Cost of Preferred Stock example
A 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:

10
Chapter 12
FINANCIAL LEVERAGE
AND CAPITAL
STRUCTURE POLICY
Capital Structure Theory

Modigliani 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
12
Static Theory and Firm Value
13
Chapter 13
DIVIDENDS AND
DIVIDEND POLICY
Residual Dividend Policy, example

Given
◦ Need $5 million for new investments
◦ Target capital structure: D/E = 2/3
◦ Net Income = $4 million

Dividend - ?
15
Chapter 16
MANAGING SHORT TERM
LIABILITIES
Computing the Cost of Bank Loans

Simple 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)
17
Problem
You 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 interest
 Bank B: Add-on interest
 Bank 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?
2118
Solution












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%.
2119
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%.

2120
Computing the Annual Cost of Bank Loans
Borrowed Amount versus Required Amount
21
Credit terms - Problem
A 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)

2122
Solution cont
Calculate EAR using interest rate conversion
feature
 Input: NOM% = 14.69; P/YR = 7.20.
 Output: EFF% = EAR = 15.65%.

2123
Problem

Wicker 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?
2124
Solution









Cash 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%.
2125
Cash Flow Time lines
2126
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