Notes: Chapter 14 Finance 2
- The correct discount rate = riskiness.
- WACC: Cost of Capital of the firm as a whole = required return on the overall firm
(stockholder, bondholders).
- Return depends on risk.
- Return to an investor = Cost of the company
- Premium of risk: the extra return on top of the rf rate
- REQUIRED RETURN= RF + PREMIUM FOR MARKET RISK
- The important fact to note is that the return an investor in a security receives = cost of that
security to the company that issued it
- Good cost of capital is important for: 1- Good capital budgeting decisions 2- Financing
decisions (optimal capital structure) 3- Operating decisions
- Cost of capital = 10% => The firm must earn 10% on the investment to compensate its
investors for the use of the capital needed to finance the project
- When we say that the RR on an investment is 10%, we usually mean that the investment will
have a positive NPV only if its returns exceed 10% (if above 10% it means that the firm is
making profit).
- The required return = appropriate discount rate or cost of capital.
- Total cost of capital = cost of debt (creditors) + cost of equity (stockholders)
- A firm needs to earn AT LEAST the RR to compensate its investors for the financing they have
provided.
- COST OF EQUITY = RR by equity investors given the risk of the CF of firms.
- Calculated through = Dividend growth model DGM, SML or CAPM.
D0 (1+ g) D1
- R (E) =
P0
+ g =>
P0
+g => Firm’s dividend
Dividend yield Capital gains yield will grow at a constant
D1
- P0 = R−g rate g.
- D1 = D0(1+g)
- G = growth rate can be calculated through historical data.
1- Taking the average of the returns in all years.
, 2- Or through ROE and Retention Ratio
G = ROE * Retention Ratio
Look at analysts’ forecasts and take an average
Advantages: easy to understand
Disadvantages of DGM:
1- Only applied to firms CURRENTLY paying Dividends
2- Not applicable if dividends aren’t growing at reasonably
constant rate.
3- Extremely sensitive to increase in g. e.g., 1% increase, cost of
equity increases 1%.
4- No risk consideration.
CAPM: SML approach can be used to calculate Cost of Equity
RF: risk free rate
Erm – Rf = Market risk premium
β = Systematic risk of asset = market risk
RE = Rf + βE (ERM - Rf)
Advantages: 1- Adjusts for systematic/market risk
2- Applicable to all sorts of companies with the
estimation of Beta
Disadvantages: 1- Need of estimation of EXPECTED
market risk premium (which can be difficult and vary).
2- Need of estimating beta => also changes.
3- Using past to predict future. Not reliable
sometimes
LAST DIVIDEND MEANS D AT T=0
AND TO FIND D1 WE MULTIPLY IT WITH (1+G)
- The correct discount rate = riskiness.
- WACC: Cost of Capital of the firm as a whole = required return on the overall firm
(stockholder, bondholders).
- Return depends on risk.
- Return to an investor = Cost of the company
- Premium of risk: the extra return on top of the rf rate
- REQUIRED RETURN= RF + PREMIUM FOR MARKET RISK
- The important fact to note is that the return an investor in a security receives = cost of that
security to the company that issued it
- Good cost of capital is important for: 1- Good capital budgeting decisions 2- Financing
decisions (optimal capital structure) 3- Operating decisions
- Cost of capital = 10% => The firm must earn 10% on the investment to compensate its
investors for the use of the capital needed to finance the project
- When we say that the RR on an investment is 10%, we usually mean that the investment will
have a positive NPV only if its returns exceed 10% (if above 10% it means that the firm is
making profit).
- The required return = appropriate discount rate or cost of capital.
- Total cost of capital = cost of debt (creditors) + cost of equity (stockholders)
- A firm needs to earn AT LEAST the RR to compensate its investors for the financing they have
provided.
- COST OF EQUITY = RR by equity investors given the risk of the CF of firms.
- Calculated through = Dividend growth model DGM, SML or CAPM.
D0 (1+ g) D1
- R (E) =
P0
+ g =>
P0
+g => Firm’s dividend
Dividend yield Capital gains yield will grow at a constant
D1
- P0 = R−g rate g.
- D1 = D0(1+g)
- G = growth rate can be calculated through historical data.
1- Taking the average of the returns in all years.
, 2- Or through ROE and Retention Ratio
G = ROE * Retention Ratio
Look at analysts’ forecasts and take an average
Advantages: easy to understand
Disadvantages of DGM:
1- Only applied to firms CURRENTLY paying Dividends
2- Not applicable if dividends aren’t growing at reasonably
constant rate.
3- Extremely sensitive to increase in g. e.g., 1% increase, cost of
equity increases 1%.
4- No risk consideration.
CAPM: SML approach can be used to calculate Cost of Equity
RF: risk free rate
Erm – Rf = Market risk premium
β = Systematic risk of asset = market risk
RE = Rf + βE (ERM - Rf)
Advantages: 1- Adjusts for systematic/market risk
2- Applicable to all sorts of companies with the
estimation of Beta
Disadvantages: 1- Need of estimation of EXPECTED
market risk premium (which can be difficult and vary).
2- Need of estimating beta => also changes.
3- Using past to predict future. Not reliable
sometimes
LAST DIVIDEND MEANS D AT T=0
AND TO FIND D1 WE MULTIPLY IT WITH (1+G)
