Chapter 14: Cost of Capital
14.1 the cost of capital: some preliminaries
● Look at how these returns and securities look from the viewpoint of the companies that issue
them
● The return an investor in a security receives is the cost of that security to the company that
issued it
Required return vs. cost of capital
● When we say that the required return on an investment is 10% (ex.), we mean that the
investment will have a positive NPYV only if its return exceeds 10%
● Required return =
○ The firm must earn 10% 10% on the investment to compensate its investors for the use
of the capital needed to finance the project
○ 10% is the cost of capital associated with the investment
● When evaluating a risk-free project:
○ Look at the capital markets and observe the current rate offered by risk-free investments
○ Use this rate to discount the project's cash clows
○ The cost of capital for a risk-free investment is the risk-free rate
● If a project is risky:
○ The required return is higher
○ The cost of return of that risky project is greater than the risk-free rate
○ The appropriate discount rate would exceed the risk-free rate
● Required return <=> appropriate discount rate <=> cost of capital
● The cost of capital associated with an investment depends on the risk of that investment
● The cost of capital depends primarily on the use of the funds, not the source
14.2 the cost of equity, RE
● What is the firm's overall cost of equity?
● 2 approaches to determine the cost of equity
1. The dividend growth model approach
2. Security market line (SML) approach (or CAPM)
The dividend growth model approach
● Assume that the firm's dividend will grow at a constant rate, g, the price per share of the stock
P0 is:
1
, ● D0 = the dividend just paid
● D1 = the next period's projected dividend
● RE = required return on the stock = the firm's cost of equity capital
RE = D1/P0 + g
Implementing the approach
● Need 3 pieces of information:
1. P0
2. D0
3. g
Ex:
● Supposed Greater States Public Service paid a dividend of $4 per share last year. The stock
currently sells for $60 per share. You estimate that the dividend will grow steadily at a rate of 6%
per year into the indefinite future. What is the cost of equity capital for Greater States?
D0 = $4
G = 6%
D1 = D0 x (1 + g)
D1 = $4 x (1 + 6%) = $4.24
Cost of equity:
RE = D1/P0 + g
= 4.24/60 + 6%
= 13.07%
Estimating g
● 2 ways to estimate the growth rate
1. Use historical growth rates
2. Use analysts' forecasts of future growth rates
■ Obtain multiple estimates and average them
■ Arithmetic average
■ Geometric average
Ex:
2
14.1 the cost of capital: some preliminaries
● Look at how these returns and securities look from the viewpoint of the companies that issue
them
● The return an investor in a security receives is the cost of that security to the company that
issued it
Required return vs. cost of capital
● When we say that the required return on an investment is 10% (ex.), we mean that the
investment will have a positive NPYV only if its return exceeds 10%
● Required return =
○ The firm must earn 10% 10% on the investment to compensate its investors for the use
of the capital needed to finance the project
○ 10% is the cost of capital associated with the investment
● When evaluating a risk-free project:
○ Look at the capital markets and observe the current rate offered by risk-free investments
○ Use this rate to discount the project's cash clows
○ The cost of capital for a risk-free investment is the risk-free rate
● If a project is risky:
○ The required return is higher
○ The cost of return of that risky project is greater than the risk-free rate
○ The appropriate discount rate would exceed the risk-free rate
● Required return <=> appropriate discount rate <=> cost of capital
● The cost of capital associated with an investment depends on the risk of that investment
● The cost of capital depends primarily on the use of the funds, not the source
14.2 the cost of equity, RE
● What is the firm's overall cost of equity?
● 2 approaches to determine the cost of equity
1. The dividend growth model approach
2. Security market line (SML) approach (or CAPM)
The dividend growth model approach
● Assume that the firm's dividend will grow at a constant rate, g, the price per share of the stock
P0 is:
1
, ● D0 = the dividend just paid
● D1 = the next period's projected dividend
● RE = required return on the stock = the firm's cost of equity capital
RE = D1/P0 + g
Implementing the approach
● Need 3 pieces of information:
1. P0
2. D0
3. g
Ex:
● Supposed Greater States Public Service paid a dividend of $4 per share last year. The stock
currently sells for $60 per share. You estimate that the dividend will grow steadily at a rate of 6%
per year into the indefinite future. What is the cost of equity capital for Greater States?
D0 = $4
G = 6%
D1 = D0 x (1 + g)
D1 = $4 x (1 + 6%) = $4.24
Cost of equity:
RE = D1/P0 + g
= 4.24/60 + 6%
= 13.07%
Estimating g
● 2 ways to estimate the growth rate
1. Use historical growth rates
2. Use analysts' forecasts of future growth rates
■ Obtain multiple estimates and average them
■ Arithmetic average
■ Geometric average
Ex:
2
