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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
Summarized Balance SheetDecember 31, 1998 - $ Millions

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

MBA 402

summarized balance sheet december 31 1994 millions
Summarized Balance SheetDecember 31, 1994 - $ Millions

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

MBA 402

cost of capital agenda
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

MBA 402

cost of debt issues
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%

MBA 402

preferred stock
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

MBA 402

preferred stock issues
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

MBA 402

cost of equity
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

MBA 402

interpretation of gordon dividend growth model
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.

MBA 402

dividend growth model issues
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

MBA 402

capital asset pricing model capm graphical overview
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

MBA 402

capm three different stocks
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 issues
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

MBA 402

arbitrage pricing theory
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

MBA 402

cost of equity issues
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

MBA 402

cost of capital components
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

MBA 402

weighted average cost of capital
Weighted Average Cost of Capital
  • Weighting Basis
    • Book Basis
    • Market Basis
  • Time Focus
    • Historical
    • Current
    • Projected
  • Related Topics
    • Capital Structure
    • Hurdle Rates

MBA 402

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