Cost of Capital by Binam Ghimire
Learning Objectives • Concept of cost of capital • Significance of cost of capital • Concept debt, preferred and common stock • Understand stock market • Dividend Growth Model and Capital Asset Pricing Model • Compute component costs of different types of capital • Determine weighted average cost of capital
Cost of CapitalConcept: • Funds from long-term sources of financing • Compensation • Different Names: Required rate of return, hurdle rate, opportunity cost, discount rate
Concept: • Overall cost of capital (Excel File) – pronounced similar to Quack – W_ _ _
Cost of Capital Basic Assumptions: • Constant Business Risk • Constant Financial Risk • Constant Dividend Policy • Constant Tax Rate
Cost of Capital Financing decision: • Investment Decision • Capital Structure Decision • Dividend Policy Decision
Capital Components: • Debt + • Preferred + • Common Stock ______________ Total Capital • The order of capital components (based on their cost)
Capital Components: • The cost of capital components (is based on degree of risk) Source: Airplane-Pictures.net
Debt Capital:Concept • Debt: Bank Loan, Bond, Notes,Debenture
Debt Capital:Concept • A Bond Source: historycooperative.org
Debt Capital Terminologies: • Bondholders: Lenders/ Investors • Bond Issuers: Company raising the money • Coupon: The fixed interest payment (as a % of face value – “C”) • Bond’s face value: principal or par value (“F” or “P”). Par/ Nominal value of £ 100. The market value is relative to the nominal value. Say 110% when traded at £110 • Maturity/ Redemption • Call Provision • Sinking Fund Provision
Bond:Types • Treasury Bond: Government • Corporate Bond: Companies • Municipal Bond: State or local government • Foreign Bond: Foreign government/ companies
Bond:Types • Pure Discount Bonds • Level Coupon Bonds • Consols
BondsTypes: • Redeemable • Irredeemable • Convertible • Non-convertible • Extendable/ Retractable • Zero coupon/ Strip • Junk/ high yield/ non investment grade • Eurobonds • Inflation linked
Bond Ratings • Bond Ratings evaluate the debt issuer to determine the risk of default • The leading rating agencies, Standard & Poor's and Moody's Investors Services • Moody's ratings, from highest to lowest. Investment grade: Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3. Speculative grade: Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C1 • S&P's ratings. Investment grade: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-. Speculative grade: BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC-, CC, D
Preference Shares:Concept/ Characteristics • Hybrid • Higher risk than ……………… Capital but Lower than ……………… Capital • Provided that there are sufficient profits, available, preference shares will normally be given a fixed rate of dividend each year and preference dividends will be paid before ordinary dividends are paid. • If a business is wound up, preference shareholders may be given priority over the claims of ordinary shareholders. • Preference shareholders are not usually given voting rights, although these may be granted when the preference dividend is in arrears. • Similar to Debt as both offer a fixed rate of return. But less popular why?
Ordinary Shares:Concept/ Characteristics • Backbone • There is no fixed rate of dividend and ordinary shareholders will receive a dividend only if profits available for distribution still remain after other investors (preference shareholders and lenders) have received their returns in the form of dividend payments or interests. • If the business is “wound-up” the ordinary shareholders will receive any proceeds from asset disposal only after lenders and creditors, and after preference shareholders, have received their entitlements. • On the other hand the potential returns facing ordinary shareholders are …………………...
Ordinary Shares:Concept/ Characteristics • Ordinary shareholders exercise control over the business through their voting rights. This gives them the power to elect the directors and to remove them from office.
Stocks and the Stock Market: An IPO • Initial Public Offering (IPO), also referred to simply as a "public offering", is when a company issues common stock or shares to the public for the first time.
Stocks and the Stock Market: An IPO • In addition, once a company is listed, it will be able to issue further shares via a rights issue, thereby again providing itself with capital for expansion without incurring any debt. • This regular ability to raise large amounts of capital from the general market, rather than having to seek and negotiate with individual investors, is a key incentive for many companies seeking to list
Stocks and the Stock Market: An IPO • There is competition amongst stock exchanges for IPO’s. • In April 2008 Fresnillo, the world's largest producer of silver, listed on the London Stock Exchange (LSE). • The company, the first Mexican one to be listed in London, raised some $2 billion, but its initial public offering had broader ramifications. You might have expected a Mexican company to head straight for Wall Street. That it did not both shows the success of the LSE's efforts in Latin America and also highlights the extent to which London now dominates mining finance. • Four of the five largest mining companies in the world are listed in London. A decade ago, Toronto might have been their favoured destination, if it was not New York. • But compared with Toronto, London has more liquidity, as well as more analysts, bankers and lawyers specialising in natural resources. • Fresnillo's boss, Jaime Lomelín, said in the Economist that London's appeal has grown over New York because of the way it treats taxes, and because he prefers the LSE's approach to corporate governance.
Stocks and the Stock Market: The FTSE 100 • The FTSE 100 Index is a share index of the 100 most highly capitalised companies listed on the London Stock Exchange. • The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6930.2, on 30 December 1999. • FTSE 100 companies represent about 80% of the market capitalisation of the whole London Stock Exchange. • Even though the FTSE All-Share Index is more comprehensive, the FTSE 100 is by far the most widely used UK stock market indicator. • The constituents of the index are determined quarterly; the largest companies in the FTSE 250 Index are promoted if their market capitalisation would place them in the top 90 firms of the FTSE 100 Index • As of July 2009 that threshold would be £1.97bn.
Stocks and the Stock Market: The FTSE 100 • As of 23/7/2009 the largest companies in the FTSE100 are: • The FTSE100 is dominated by a small number of sectors: • Oil Industry = 18.86% • Banks = 16.23% • Mining = 11.55%
Stocks and the Stock Market: NASDAQ • The NASDAQ-100 is a stock market index of 100 of the largest domestic and international non-financial companies listed on the NASDAQ stock exchange. • It is a modified market value-weighted index; the companies weights in the index are based on their market capitalization, with certain rules capping the influence of the largest components. • It does not contain financial companies, and includes companies incorporated outside the United States; both of these factors differentiate this index from the S&P 500 and the Dow Jones Industrial Average.
Stocks and the Stock Market: NASDAQ • The NASDAQ 100 is also dominated by a small number of sectors: • Software = 21.24% • Telecommunications Equipment = 13.7 5% • Semiconductors = 10.02 • As of 23/7/2009 the largest companies in the NASDAQ 100 are:
Stocks and the Stock Market: S&P 500 • Compare this to the S&P 500:
Stocks Valuation :Book Value • Book valueis an accounting concept • The firm’s book value of equity includes common stock + share premium (paid in capital) + retained earning • Book value per share is simply the amount per share of common stock to be received if all of the firm’s assets are sold for their exact book value and all liabilities (including preference stock) are paid • Book value per share is computed by dividing total book value by number of shares outstanding
Stocks Valuation : • Balance sheet of ABC Company on 31st December, 2009 is shown in table • What is the book value of the company and book value per share? • Liquidation value
Stocks Valuation : • Market Value • Market value of a stock is the current (actual) price at which the stock is being traded in the market • Company’s future growth, earnings, earning power, level of risk etc. are reflected in market price of the security • Therefore, common stock’s price fluctuates widely
Stocks Valuation :Intrinsic Value • Intrinsic value: Present value of expected future cash flows discounted at appropriate required rate of return • Intrinsic valueof a security is theoretical value or fair value. It is based on future cash flows, future prospects, future state of the economy and other factors that affect the valuation of the security or asset • Intrinsic value of a security is its economic value. In an efficient market there is no significant difference between market value and intrinsic value of the security
Stocks Valuation Concept:Book, Liquidation, and Market Value • Which value will be higher for a profitable, and growing firm? (among book, liquidation and market)
Cost of Equity:Methods • Dividend Growth Model (DGM) • Capital Asset Pricing Model (CAPM)
DGM • The most common is the constant growth model • Assumes that dividend will grow forever at a constant rate, g, and it is less than required return, ks • Also known as Gordon Model • If a firm’s future dividend payments per share are expected to grow at a constant rate, g, per period forever then the dividend at any future time period t can be forecasted as follows: Dt = D0 (1+g)t • Example – ABC Co. stock paid a dividend £ 10 per-share last year, which is expected to grow at a constant rate of 5 percent forever. What will be the Dividend for next year and the year after next?
DGM • Formula for Price of stock (applies the TVM concept) • Rearranging the above, the formula for Gordon’s model: • Where D1 = D0(1+g)
DGM • Or, Gordon Model =
DGM:Example (No Growth) • ABC Company's common stock is currently trading at £80 a share. • The stock paid a dividend of £ 5 a share recently. • The dividend is not expected to grow. • What is the cost of ABC stock ?
DGM:Example (With Growth) • ABC Company's common stock is currently trading at £80 a share. • The stock paid a dividend of £ 5 a share recently. • The dividend is expected to grow by 6%. • What is the cost of ABC stock ?
DGM:More Examples • But first two terminologies • Ex Dividend • Cum Dividend • A security which no longer carries the right to the most recently declared dividend • The payment of a dividend is due in the near future and investors who buy the share now will receive the dividend
DGM:Example 1 • The ordinary shares of Kewell Ltd are quoted at £5 per share ex div. A dividend of 40p per share has just been paid and there is expected to be no growth in dividends. What is the cost of equity?
DGM:Example 2 • The ordinary shares of Gerrard Ltd are quoted at £2 per share. A dividend of 15p is about to be paid and there is expected to be no growth in dividends. What is the cost of equity?
DGM:Example 3 • Alonso Ltd. has a share price of £4 ex div and has recently paid out a dividend of 20p. Dividends are expected to grow at an annual rate of 5%. What is the cost of equity?
DGM:Example 4 • X Ltd. Is planning to pay a dividend of 30p per share. The share price is £3.50 cum div. Dividends are expected to grow by 5% per annum. What is the cost of equity?