COMMERCE 3FA3 Study Guide - Midterm Guide: Dividend Yield, Net Present Value, Weighted Arithmetic Mean
5 Jun 2018
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The return that equity investors require on their investment in a firm
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Required return, appropriate discount rate, and cost of capital synonymous
○
Cost of capital dependent on risk of an investment (also known as the use of the fund), not how
(or where) capital is used
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Is the risk-free rate in a risk-free investment, and is greater than the risk-free rate in a risky investment
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Managerial variable of capital structure composed of debt-equity mixture
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Assume fixed debt/equity variable (D/E) to reflect firm target capital structure - cost of capital reflects
cost of debt, and cost of equity capital
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Cost of Capital
Cost of Equity
Dividend Growth Model
= return shareholders require on a stock/cost of equity capital
= dividend paid 1 year from today
= price of stock today
= annual growth rate of dividend
Alternative Approaches to Determining g
Retention ratio is the retained earnings divided by net income.
Simple, but is most applicable to dividend-paying companies (g can be estimated in non-dividend paying
companies from growth in earnings)
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Requires assumptions that dividends will be paid and will grow at a constant rate
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Cost of equity becomes very sensitive to estimated growth rate and does not explicitly consider risk
unlike the CAPM/SML approach
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Advantages and Disadvantages to the DGM
CAPM/SML Model
During booms market risk premium decreases and during crashes, it increases due to being driven by
emotion
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= estimated beta = statistical measure of risk/volatility of stock over
time
= riskfree rate/T-bill return
= average expected stock market (TSX 300) return
= market risk premium = on average
A of
Implies that
< 1
Company risk is less than the average risk in the market
1
Company risk equals average risk in the market
> 1
Company risk is greater than the average risk in the market
Explicitly adjusts for risk and is applicable to companies without steady dividend growth, is more widely
used by CFOs while the DGM may be used to check reasonableness of estimates
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Requires estimates to market risk premium and beta which can affect resulting cost of equity
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Relies on past economic conditions which change rapidly
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Advantages and Disadvantages to the CAPM/SML Model
Cost of Capital
January 4, 2018
3:28 PM
Managerial Finance Page 1
Document Summary
The return that equity investors require on their investment in a firm. Is the risk-free rate in a risk-free investment, and is greater than the risk-free rate in a risky investment. Required return, appropriate discount rate, and cost of capital synonymous. Cost of capital dependent on risk of an investment (also known as the use of the fund), not how (or where) capital is used. Managerial variable of capital structure composed of debt-equity mixture. Assume fixed debt/equity variable (d/e) to reflect firm target capital structure - cost of capital reflects cost of debt, and cost of equity capital. = return shareholders require on a stock/cost of equity capital. Retention ratio is the retained earnings divided by net income. Simple, but is most applicable to dividend-paying companies (g can be estimated in non-dividend paying companies from growth in earnings) Requires assumptions that dividends will be paid and will grow at a constant rate.
