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Cost of Capital Components of Capital Summarized Balance Sheet December 31, 1998 - $ Millions Note: Current Liabilities includes a total of $346 million of permanent short-term debt. Summarized Balance Sheet December 31, 1994 - $ Millions

Cost of Capital

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Cost of Capital

MBA 402

Note: Current Liabilities includes a total of $346 million of permanent short-term debt.

MBA 402

Note: Current Liabilities includes a total of $8 million of permanent short-term debt.

MBA 402

MBA 402

- Cost of Individual Components
- Cost of Debt
- Cost of Preferred Stock
- Cost of Equity

- Weighting Approaches
- Book vs. Market Weights
- Current vs. Target

- Weighted Average Cost of Capital
- Capital Structure Theory
- Hurdle Rates

MBA 402

MBA 402

MBA 402

- Book (or Historical) vs. Market Cost of Debt
- Previous Example was Book or Historical Cost of Debt
- Cost of Previously Issued Debt
- In This Example: 4.05%

- Cost of Previously Issued Debt
- Market Cost
- Current Cost of Similar Debt
- As of July 1999
- Pre-Tax Cost of Similar Debt: 6.75%
- After-Tax Market Cost of Debt: 4.13%

MBA 402

- Special Form of Ownership That Has a Fixed Periodic Dividend Payment That Must Be Paid Before Any Payment of Common Stock Dividends
- Hybrid Security
- Characteristics of Debt, but
- Considered Equity

- Limited Participation in the Growth of the Firm
- Dividends Are Not Tax Deductible
- Unlike Tax Deductible Interest

- Popular with Utility Companies

MBA 402

MBA 402

- What Price for the Preferred Shares
- Par Value
- Set “Value” When Issued
- Related to Book (or Historical) Value
- Related to Book (or Historical) Cost of Preferred Stock

- Market Value
- Current “Value” in the Market
- Related to Market Value
- Related to Market Cost of Preferred Stock

- Par Value

MBA 402

- Cost of Equity Includes:
- All Stockholder Equity Components
- Common Stock
- Paid in Excess
- Retained Earnings
- Miscellaneous

- All Stockholder Equity Components
- Shareholders’ Required Return
- Three Techniques
- Gordon Dividend Growth Model
- Capital Asset Pricing Model
- William Sharpe Won Part of a Nobel Prize

- Arbitrage Pricing Theory

MBA 402

MBA 402

Note: Dividends are assumed to grow at 10% annually. This is my assumption. Do NOT buy stock in Hershey based upon this illustrative growth rate.

The stock price in July 1999 was $58.

MBA 402

MBA 402

- For Most Effective Use, Company Needs to Pay Dividend with Steady Stable Growth
- Can Be Used for Zero Dividend Companies by Estimating First Dividend Payment
- Difficulty in Defining Growth
- Long-Term, Perpetual Growth Rate

MBA 402

Stock Return = Risk-Free Rate + Beta (Excess Market Return)

Excess Return = Capital Appreciation +Dividend Yield - Risk Free Rate

MBA 402

Beta = 2

Beta = 2

Beta = 1

Beta = 1

Stock C

Beta = .5

Beta = .5

C

Stock B

B

Stock A

A

MBA 402

MBA 402

MBA 402

MBA 402

- Conceptual Appeal
- Determining Market Risk Premium
- Conceptual Appeal
- Portfolio Technique With Limited Statistical Properties for Single Company Application
- Conceptual Appeal
- CAPM Rejected Theoretically:
- Alpha Term 0
- Other Things Explain Return

- Conceptual Appeal
- Lead to Arbitrage Pricing Theory

MBA 402

- Multiple Regression Model
- Factors May Include
- Inflation
- GNP Growth
- Interest Rates
- Difference Between Long and Short-Term Rates
- Difference Between High Quality (AA) and Lower Quality (BB) Rates

- Others

- Focussed on Surprise in the Factors

MBA 402

- Three Techniques - With Limitations
- Dividend Growth Model
- Capital Asset Pricing Model
- Arbitrage Pricing Theory

- Systematic Estimation
- Largest Cost Component
- Not Tax Deductibility

MBA 402

- Cost of Debt
- Historical vs. Marginal

- Cost of Preferred Stock
- Par Value vs. Current Market Price

- Cost of Equity
- Dividend Growth
- Capital Asset Pricing Model
- Arbitrage Pricing Theory

MBA 402

MBA 402

MBA 402

- Weighting Basis
- Book Basis
- Market Basis

- Time Focus
- Historical
- Current
- Projected

- Related Topics
- Capital Structure
- Hurdle Rates

MBA 402