COST OF CAPITAL AND Chapter 11

The Dividend Growth Model Approach Can be rearranged to solve for R E 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 ◦ YearDividendPercent 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: 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 g = Retention ratio x ROE

The SML Approach (CAPM) Use the following information to compute our cost of equity ◦ Risk-free rate, R f ◦ Market risk premium, E(R M ) – R f ◦ Systematic risk of asset,  5 E(R A ) = R f +  A (E(R M ) – R f )

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 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 $ 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 $ 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 9 R P = D / P 0

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

FINANCIAL LEVERAGE AND CAPITAL STRUCTURE POLICY Chapter 12

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 Static Theory and Firm Value 13

DIVIDENDS AND DIVIDEND POLICY Chapter 13

Residual Dividend Policy, example Given ◦ Need $5 million for new investments ◦ Target capital structure: D/E = 2/3 ◦ Net Income = $4 million Dividend - ? 15

MANAGING SHORT TERM LIABILITIES Chapter 16

17 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)

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?

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

Solution Cont. Discounted interest (Bank C) Effective rate = = = 11.11%. The difference between the highest and lowest EARs, Bank B - Bank A, equals 19.5% - 10% = 9.5%

21 Computing the Annual Cost of Bank Loans Borrowed Amount versus Required Amount

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)

Solution cont Calculate EAR using interest rate conversion feature Input: NOM% = 14.69; P/YR = Output: EFF% = EAR = 15.65%

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 $ Comparing the cost of the two alternatives, how many percentage points lower is the interest rate on the less expensive debt instrument?

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 = ; PMT = -85; FV = 1,000. Output: I = 10.0%. The difference is 10.0% - 9.0% = 1.0%

Cash Flow Time lines