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FINC-220 Lecture Notes - Lecture 11: Corporate Bond, Interest Expense, Capital Asset Pricing Model

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blackcrocodile4
8 May 2018
School
RIT
Department
Finance
Course
FINC-220
Professor
Archana Jain

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Chapter 14
Cost of capital
Chapter outline
• The Cost of Capital – Overview
• The Cost of Equity
• The Cost of Debt
• The Cost of Preferred Stock
• The Weighted Average Cost of Capital (WACC)
• Divisional and Project Costs of Capital
Determinants of cost of capital
• Capital structure
• Capital budgeting decisions
• Dividend payout policy
The cost of equity
• The cost of equity is the return required by equity investors given the risk of the cash
flows from the firm
• There are two major methods for determining the cost of equity:
o Dividend growth model
o SML, or the CAPM
The dividend growth model (the Gordon model)
• Start with the dividend growth model formula and rearrange to solve for RE
g
P
D
R
gR
D
P
E
E
+=
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1
1
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Dividend growth model example
• Suppose that your company is expected to pay a dividend of $1.50 per share next year.
• There has been a steady growth in dividends of 5.1% per year and the market expects that
to continue. The current price is $25.
• What is the cost of equity?
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%1.11111.051.
25
50.1
==+=
E
R
Dividend growth model
• Advantages:
o Easy to understand and use
• Disadvantages:
o Only applicable to companies currently paying dividends
o Not applicable if dividends aren’t growing at a reasonably constant rate
o Extremely sensitive to the estimated growth rate – an increase in g of 1% increases
the cost of equity by 1%
• Does not explicitly consider risk
The SML approach
• Use the following information to compute our cost of equity:
• Risk-free rate, Rf
• Market risk premium, E(RM) – Rf
• Systematic risk of asset,
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fMEfE
RRERR
-+=
b
Example- SML
• Suppose your company has:
o an equity beta of .58
o the current risk-free rate is 6.1%
o the expected market risk premium is 8.6%
o What is the cost of equity using the SML valuation technique?
o RE = 6.1 + .58(8.6) = 11.1%
SML
• Advantages:
o Explicitly adjusts for systematic risk
o Applicable to all companies, as long as we can estimate beta
• Disadvantages:
o Have to estimate the expected market risk premium, which does vary over time
o Have to estimate beta, which also varies over time
o We are using the past to predict the future, which is not always reliable
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Practice- cost of equity
• Our company has a beta of 1.5.
• The market risk premium is expected to be 9%, and the current risk-free rate is 6%.
• We have used analysts’ estimates to determine that the market believes our dividends will
grow at 6% per year and our last dividend was $2.
• Our stock is currently selling for $15.65.
• What is our cost of equity using the SML?
o 19.5%
• What is our cost of equity using the DGM?
o 19.55%
Cost of debt
• The cost of debt is the required return on our company’s debt
• The required return is best estimated by computing the yield-to-maturity on the existing
long-term debt (the YTM).
• The computation of the YTM was presented in the chapter on Bond Valuation
Example- cost of debt: computing the YTM
• Suppose we have a corporate bond issue currently outstanding that has 25 years left to
maturity.
o The coupon rate is 9%, and coupons are paid semiannually.
o The bond is currently selling for $908.72 per $1,000 bond.
• Finding R is a trial and error process without the calculator
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C Value Bond
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Document Summary

Chapter outline: the cost of capital overview, the cost of equity, the cost of debt, the cost of preferred stock, the weighted average cost of capital (wacc, divisional and project costs of capital. Determinants of cost of capital: capital structure, capital budgeting decisions, dividend payout policy. The dividend growth model (the gordon model: start with the dividend growth model formula and rearrange to solve for re. E g g: suppose that your company is expected to pay a dividend of . 50 per share next year, there has been a steady growth in dividends of 5. 1% per year and the market expects that to continue. The sml approach: use the following information to compute our cost of equity, risk-free rate, rf, market risk premium, e(rm) rf, systematic risk of asset, . Practice: cost of debt: jimin"s cricket farm issued a 30-year, 8 percent, semiannual bond 6 years ago. The bond currently sells for 114 percent of its face value.

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Related Questions

Need

WACC calculations in Excel with (a) Cost of Equity calculated in both Dividend Growth Model and CAPM (aka SML), (b) Cost of Debt calculated from Bond Table weighted average,WACC calculation including weighted average Bond Table for Debt Calculations, Equity from both Dividend Growth Model and CAPM Model, and Preferred Stock (if any).

information for calucations provided below.

BONDS FOR ____Mattel -r_________________
A B C D E F
(A * B) / 100 (D * E)/100
SYMBOL AMOUNT OUTSTANDING LAST TRADE PRICE MARKET VALUE % of TOTAL YTM WEIGHTED YTM
1 Mattel 2.35% 500,000,000 100.7 503,500,000 0.229 1.99 0.456%
2 Mattel 2.35% 350,000,000 97.8 342,300,000 0.156 2.89 0.451%
3 Mattel 5.45% 300,000,000 102.9 308,700,000 0.141 5.24 0.737%
4 Mattel 4.35% 250,000,000 106.2 265,500,000 0.121 2.48 0.300%
5 Mattel 6.2% 250,000,000 111.1 277,750,000 0.127 5.36 0.678%
6 Mattel 1.7% 250,000,000 99.0 247,500,000 0.113 2.83 0.319%
7 - 0.000 0.000%
8 - 0.000 0.000%
9 - 0.000 0.000%
10 Mattel 3.15% 250,000,000 99.9 249,750,000 0.114 3.18 0.362%
TOTAL 2,195,000,000 1.000 3.303%
po 25.01
D 2,195,000,000
RD 3.30%
shares outstanding 342,510,000
beta 0.74
g 10.56%
10 year bond yield rf 2.21
rm 12.44%
d1 .38*4 = 1.52
Re Rf+Beta(Rm-Rf)

Most of this question was answered the tax rate was missing. The tax rate is now included. 22.38%Thank you

Need

WACC calculations in Excel with (a) Cost of Equity calculated in both Dividend Growth Model and CAPM (aka SML), (b) Cost of Debt calculated from Bond Table weighted average,WACC calculation including weighted average Bond Table for Debt Calculations, Equity from both Dividend Growth Model and CAPM Model, and Preferred Stock (if any).

BONDS FOR ____Mattel -r_________________
A B C D E F
(A * B) / 100 (D * E)/100
SYMBOL AMOUNT OUTSTANDING LAST TRADE PRICE MARKET VALUE % of TOTAL YTM WEIGHTED YTM
Mattel 2.35% 500,000,000 100.7 503,500,000 0.229 1.99 0.456%
Mattel 2.35% 350,000,000 97.8 342,300,000 0.156 2.89 0.451%
Mattel 5.45% 300,000,000 102.9 308,700,000 0.141 5.24 0.737%
Mattel 4.35% 250,000,000 106.2 265,500,000 0.121 2.48 0.300%
Mattel 6.2% 250,000,000 111.1 277,750,000 0.127 5.36 0.678%
Mattel 1.7% 250,000,000 99.0 247,500,000 0.113 2.83 0.319%
- 0.000 0.000%
- 0.000 0.000%
- 0.000 0.000%
Mattel 3.15% 250,000,000 99.9 249,750,000 0.114 3.18 0.362%
TOTAL 2,195,000,000 1.000 3.303%
po 25.01
D 2,195,000,000
RD 3.30%
shares outstanding 342,510,000
beta 0.74
g 10.56%
10 year bond yield rf 2.21
rm 12.44%
d1 .38*4 = 1.52
Re Rf+Beta(Rm-Rf)
tax rate 22.38%

Question

Please help thanks

For Kellog

Rating Fitch: BBB

Price 103.12

Coupon(%) 3.125

Maturity 17-May-2022

YTM(%) 2.661

Current yield(%) 3.030

Cost of Debt

-Use the yield to maturity from either your company’s actual bond or from the similarly rated company’s bond as an estimate for your company’s pre-tax cost of debt.

-Calculate your company’s after-tax cost of debt using a 35% marginal tax rate. (Pre-tax cost of debt)(1 – marginal tax rate). Note bond rating for each company.

Cost of Equity

-Estimate the cost of equity at least two ways:

CAPM (You must use CAPM as one of your methods.)

Reworked Gordon Model: (D1/P) + G

Bond yield + risk premium

-Remember to use the current RFR (10 year Treasury Bond). Assume Required Return on the Market is 11%. Get current stock price. Get estimated D1 and G from either Valueline or Yahoo Finance (analyst estimates).

-Decide on your best estimate of cost of equity to use in calculating WACC.

Calculate the Weights of each Component of the Company’s Capital Structure

-Look at the company’s balance sheet and assume their current capital structure is their target capital structure.

-Use only Long Term Debt and any Capitalized Leases in the weighting for debt.

-See if the company has any preferred stock to weight.

-Use total common shareholder’s equity for the weight of common equity.

Calculate the Company’s Weighted Average Cost of Capital (WACC).