Cost of Capital | Corporate Finance | CMA Exam | CPA Exam BEC |

These lectures cover cost of equity, cost of debt, cost of preferred stock, dividend growth model and weighted average cost of capital.

Cost of Equity Using Dividend Growth Model | Corporate Finance

Cost of Equity Using the Security Market Line Approach | Corporate Finance

Cost of Debt and Cost of Preferred Stock | Corporate Finance

Weighted Average Cost of Capital | WACC | Corporate Finance

 

The cost of capital depends primarily on the use of the funds, not the source.
Advantages and Disadvantages of the Approach
The Securities market Line (SML) approach has two primary advantages. First, it explicitly adjusts for risk. Second, it is applicable to companies other than just those with steady dividend growth. Thus, it may be useful in a wider variety of circumstances.

There are drawbacks, of course. The SML approach requires that two things be estimated: the market risk premium and the beta coefficient. To the extent that our estimates are poor, the resulting cost of equity will be inaccurate. For example, our estimate of the market risk premium, 7 percent, is based on about 100 years of returns on particular stock portfolios and markets. Using different time periods or different stocks and markets could result in very different estimates.

With the dividend growth model, we essentially rely on the past to predict the future when we use the SML approach. Economic conditions can change quickly; so as always, the past may not be a good guide to the future. In the best of all worlds, both approaches (the dividend growth model and the SML) are applicable and the two result in similar answers. If this happens, we might have some confidence in our estimates. We might also wish to compare the results to those for other similar companies as a reality check.

The security market line (SML) is a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM), which shows different levels of systematic, or market, risk of various marketable securities plotted against the expected return of the entire market at a given point in time.

 

determining the cost of equity.

THE COST OF DEBT
The cost of debt is the return the firm’s creditors demand on new borrowing. In principle, we could determine the beta for the firm’s debt and then use the SML to estimate the required return on debt just as we estimated the required return on equity.

Preferred stock has a fixed dividend paid every period forever, so a share of preferred stock is essentially a perpetuity.

Weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. All sources of capital, including common stock, preferred stock, bonds and any other long-term debt, are included in a WACC calculation.