Remind students that D 1 = D 0 x (1 + g) You may also want to take this time to remind them that return is comprised of the dividend yield (D 1 / P 0 ) and the capital gains yield (g)
So, investors are currently requiring a return of 11.1% on our equity capital.
Our historical growth rates are reasonably close, so we could feel reasonably comfortable that the market will expect our dividend to grow at around 5.1%. Note that when we are computing our cost of equity, it is important to consider what the market expects our growth rate to be, not what we may know it to be internally. The market price is based on market expectations, not our private information. Another way to estimate the market consensus estimate is to look at analysts’ forecasts and take an average.
Point out that there is no allowance for the uncertainty about the growth rate
You will often hear this referred to as the Capital Asset Pricing Model Approach as well. www: Click on the Web surfer to go to Bloomberg’s Website. To get the T-bill rates, go to Market Data, Rates and Bonds, and then look under US Treasuries. To get betas, go to moneycentral.msn.com and enter a ticker symbol to get the stock quote and Beta can be found at the bottom. Other sites that provide betas include http://finance.yahoo.com
Since the two models are reasonably close, we can assume that our cost of equity is around 19.5%
Point out that the coupon rate was the cost of debt for the company when the bond was issued. We are interested in the rate we would have to pay on newly issued debt, which could be very different from past rates.
Remind students that it is a trial and error process to find the YTM if they do not have a financial calculator or spreadsheet.
Note that for bonds we would find the market value of each bond issue and then add them together. Also note that preferred stock would just become another component of the equation if the firm has preferred stock outstanding. Finally, we generally ignore current liabilities in our computations. However, if a company finances a substantial portion of its assets with current liabilities, they should be included in the process.
Point out that if we have other financing that is a significant part of our capital structure, we would just add additional terms to the equation
Remind students that bond prices are quoted as a percent of par value
Point out that students do not have to compute the YTM based on the entire face amount. They can still use a single bond.
Video Note: This is a good place to show the “Economic Value Added” video to reinforce the contents of the Reality Bytes box in the text.
It is important to point out that the WACC is not very useful for companies that have several disparate divisions. www : Click on the Web surfer icon to go to an index of business owned by General Electric. Ask the students if they think that projects proposed by “GE Infrastructure” should have the same discount rate as projects proposed by “GE Healthcare.” You can go through the list and illustrate why the divisional cost of capital is important for a company like GE. If GE’s WACC was used for every division, then the riskier divisions would get more investment capital and the less risky divisions would lose the opportunity to invest in positive NPV projects.
Ask students which projects would be accepted if they used the WACC for the discount rate? Compare 15% to IRR and accept projects A and B. Now ask students which projects should be accepted if you use the required return based on the risk of the project? Accept B and C. So, what happened when we used the WACC? We accepted a risky project that we shouldn’t have and rejected a less risky project that we should have accepted. What will happen to the overall risk of the firm if the company does this on a consistent basis? Most students will see that the firm will become riskier.
MV of debt = 10,000 x $1,100 = $11,000,000 Cost of debt = YTM: 8 N; -1,100 PV; 60 PMT; 1,000 FV; CPT I/Y = 4.48% MV of preferred = 100,000 x $30 = $3,000,000 Cost of preferred = 3/30 – 10% MV of common = 500,000 x $25 = $12,500,000 Cost of common = .04 + 1.5 x (.12 - .04) = 16% Total MV of all securities = $11M + $3M + $12.5M = 26.5M Weight of debt = 11M/26.5M = .4151 Weight of preferred = 3M/26.5M = .1132 Weight of common = 12.5M/26.5M = .4717 WACC = .4151 x .0448 x (1 - .4) + .1132 x .10 + .4717 x .16 = .0979 = 9.8%
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?
Suppose your company has an equity beta of .58 and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?
R E = 6.1 + .58(8.6) = 11.1%
Since we came up with similar numbers using both the dividend growth model and the SML approach, we should feel pretty good about our estimates
Suppose 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?
Suppose we have a bond issue currently outstanding that has 25 years left to maturity. The coupon rate is 9% and coupons are paid semiannually. The bond is currently selling for $908.72 per $1,000 bond. What is the cost of debt?
Consider the project’s risk relative to the firm overall
If the project is riskier than the firm, use a discount rate greater than the WACC
If the project is less risky than the firm, use a discount rate less than the WACC
You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
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Example: Subjective Approach Very High Risk High Risk Same Risk as Firm Low Risk Very Low Risk Risk Level WACC + 10% WACC + 5% WACC WACC – 3% WACC – 8% Discount Rate
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