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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

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Summarized balance sheet december 31 1998 millions l.jpg
Summarized Balance SheetDecember 31, 1998 - $ Millions

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

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Summarized balance sheet december 31 1994 millions l.jpg
Summarized Balance SheetDecember 31, 1994 - $ Millions

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

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Cost of Capital Agenda

  • 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

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Cost of Debt

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Cost of Debt Issues

  • 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%

  • 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%

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Preferred Stock

  • 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

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Preferred Stock Issues

  • 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

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Cost of Equity

  • Cost of Equity Includes:

    • All Stockholder Equity Components

      • Common Stock

      • Paid in Excess

      • Retained Earnings

      • Miscellaneous

  • Shareholders’ Required Return

  • Three Techniques

    • Gordon Dividend Growth Model

    • Capital Asset Pricing Model

      • William Sharpe Won Part of a Nobel Prize

    • Arbitrage Pricing Theory

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Interpretation of GordonDividend Growth Model

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.

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Cost of Hershey’s Equity:Dividend Growth Model

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Dividend Growth Model Issues

  • 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

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Capital Asset Pricing Model (CAPM)Graphical Overview

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

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

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CAPMThree Different Stocks

Beta = 2

Beta = 2

Beta = 1

Beta = 1

Stock C

Beta = .5

Beta = .5

C

Stock B

B

Stock A

A

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CAPM RealityHershey Foods vs. Market

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CAPM Issues

  • 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

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Arbitrage Pricing Theory

  • 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

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Cost of Equity Issues

  • Three Techniques - With Limitations

    • Dividend Growth Model

    • Capital Asset Pricing Model

    • Arbitrage Pricing Theory

  • Systematic Estimation

  • Largest Cost Component

  • Not Tax Deductibility

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Cost of Capital Components

  • 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

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Hershey’s Cost of CapitalHistorical Book Basis Weights

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Hershey’s Cost of CapitalMarket Basis Weights

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Weighted Average Cost of Capital

  • Weighting Basis

    • Book Basis

    • Market Basis

  • Time Focus

    • Historical

    • Current

    • Projected

  • Related Topics

    • Capital Structure

    • Hurdle Rates

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