FIN-3403 Lecture Notes - Lecture 14: Dividend Discount Model, Dividend Yield, United States Treasury Security
- Terms to Describe the % Interest Rate in Various Situations
o Required Return
▪ Iesto’s poit of ie
o Cost of Capital
▪ Fi’s poit of ie
o Discount Rate
▪ As used in time value of money calculation
- CAPM Provides the Expected (future) Required Return (from investing in the asset)
o Appropriate if valuing common equity (dividend discount model)
o Appropriate if valuing capital projects if firm is financed 100% with equity and
the project has similar risk as the company
o Most firms are not 100% equity financed
o Many projects have different risk than the firm
- Weighted Average Cost of Capital (WACC)
o WACC= (E/V)RE + (P/V)RP + (D/V)RD (1 – TC)
o All variables should be current market values – costs and dollars
o Cost of capital deployed by the business
o Market rate that is ased o the aket’s peeptio of the isk of the fi’s
assets
o Overall return the firm must earn on its assets to maintain the value of its stock
o A fi’s ost of apital eflets the aeage iskiess of all of the seuities it has
issued, which may be less risky (bonds) or more risky (common stock)
o To calculate the average costs of funds, the component costs must first be
calculated
- Cost of Equity
o Dividend Growth Model Approach
▪ RE= (D1/P0) + g
• = dividend yield + growth rate (capital gains yield)
▪ Price & dividend observed
▪ g ust e estiated use histoial goth ate o aalsts’ foeast
o SML/CAPM Approach
▪ More commonly used
▪ RE= Rf + BE(E(RM) – Rf)
▪ Betas are widely available
▪ The rate on 10-year Treasury securities is most commonly used for Rf
▪ Expected market risk premium is the more difficult number to estimate
- Cost of Preferred Stock
o Preferred stock is valued as a perpetuity
o P0= D/RP
o RP= D/P0
- Cost of Debt
o RD
o Yield to maturity on outstanding bonds
o Rates on new issues with the same rating
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