25300 Lecture Notes - Lecture 10: Preferred Stock, Bond Valuation, Capital Budgeting
The risk of making a bad decision is forecast risk
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The level of forecast risk can be assessed by using sensitivity and simulation analysis
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Forecast risk
Weighted average cost of capital (WACC) is the overall return the firm must earn on its
investments
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Cost of capital
The MARKET required rate of return on: debt and equity
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The MARKET VALUE of each type of security (ordinary or preference share)
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The proportions of the firm financed by each type of capital
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Need:
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Calculate WACCC
Current return that shareholders require to invest in a firm
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Po: current share price
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D: constant dividend payment
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Re: required rate of return
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To find return:
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Share price assuming zero growth:
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D1: next period's dividend
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g: dividend constant growth rate
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To find return:
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Share price assuming constant dividend growth:
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Advantages: simple to use, info easy to obtain
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Disadvantages: only applies to companies that pay dividends, assumes dividends
grow at a constant rate, does not explicitly consider risk
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Dividend Growth Model:
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Can give different figures to Dividend Growth Models
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Advantages: adjusts for risk, can be used for companies that do not pay
dividends and/or do not have constant growth
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Disadvantages: requires the market risk premium, need to be able to calculate
beta, rely on past observations to predict future
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Security Market Line:
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Can be estimated in two ways:
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Cost of Equity
Is the yield to maturity on its bonds (YTM)
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The coupon rate is irrelevant
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Cost of Debt
Assume preference shares have a fixed dividend
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D: dividend per share
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Po: preference share price
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Cost of preference shares:
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Cost of Preference Shares
Lec 10 The Cost of Capital
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Document Summary
The risk of making a bad decision is forecast risk. The level of forecast risk can be assessed by using sensitivity and simulation analysis. Weighted average cost of capital (wacc) is the overall return the firm must earn on its investments. The market required rate of return on: debt and equity. The market value of each type of security (ordinary or preference share) The proportions of the firm financed by each type of capital. Current return that shareholders require to invest in a firm. D1: next period"s dividend g: dividend constant growth rate. Advantages: simple to use, info easy to obtain. Disadvantages: only applies to companies that pay dividends, assumes dividends grow at a constant rate, does not explicitly consider risk. Can give different figures to dividend growth models. Advantages: adjusts for risk, can be used for companies that do not pay dividends and/or do not have constant growth.
