Alan Kring Productions in association with Emergent Light Studio presents the Illinois
State Collegiate Compendium, Academic Lecture in Business and Economics.
This is Business Finance, FIL 240 for autumn semester 2023.
Today, the cost of capital.
And this is a subject that is mathy, but again, excel to the rescue as it were.
And I may even have enough time to do a couple of stupid pet tricks that might be worth your
while to know.
Now I've also got, I've been trying to get a guest speaker here all semester and an expert
in stock markets and so that will be coming up at 3 o'clock.
He should be here so we'll see.
I'm hopeful that I can get that.
So as a preliminary to that, just so we're on the same page here, as you can see we have
definitely a bull market today.
And of course, this kind of thwarts the idea that the end was here.
And you should see that I'm sure you don't follow the markets too closely or the news
networks, but I mean the doom's saying, yeah, we're about to go into the recession of a
lifetime.
No, we're not.
Quit it.
And of course today was one of those rally days that kind of knocked the bears back on
their heels because you had a lot of traders were getting into these bear positions and
sure enough you have a good strong day like this and that's about the end of them.
And I'm going to show you, I think I'll be able to do this next week, I want to show
you how you can take a bear position and a serious bear position.
And what happens though if you are wrong?
It is, it's not pretty.
And so you have a day like this, you have those short sellers just starting to line
up and here we go.
And all of a sudden these shorts are standing there saying, uh oh, and they can lose a lot
of money.
Of course you can lose the money in a bull position too, but in a short sell position
it can get really nasty sometimes.
So be cautious about being a bear, but don't ever forget that sometimes the bears come
out of the woods and they have a real bad attitude.
But as you can see, this is a little bit unusual if I'm looking at this correctly, the Dow
was up the most today at one point, almost 1.7%.
That's a strong up day.
But then the S&P 500 and the NASDAQ were both up really good, but not as much as the Dow.
The way you would interpret that I guess is to say look, there was obviously good news
and that good news was better news for ginormous companies, those 30 giants of the earth kind
of thing.
Not good for everyone, but it was strongly beneficial to the Dow.
So there's that.
Now here's crude.
Now here's the funniest thing about crude.
Remember I talked about that trading band, 82 to 88?
Well now we're at the bottom of the band pushing downward.
The war premium has drained out that agreement between the Arab nation and Russia.
Well we're going to cut our production and that will drive the prices clear through the
roof.
Well of course as I told you, those don't last.
And oil is flowing, you have the war premium that was there is easing out.
And a lot of the sentiment is that the war will be contained to a fight between a non-state
actor and a state in the Middle East.
But oil, I mean we could see oil, the price of gasoline slip a little bit more.
It's not going to slip a lot.
Don't get excited about $2.25 a gallon gasoline.
But it does have a little bit more room on the downside.
So long as this oil market continues to be filled with oil.
Gold, look at that.
The gold bugs are just convinced that the end is near.
They've broken the $2,000 an ounce resistance line by a good margin.
And they're holding that we're about at the end of the good times here.
So we'll see about that.
Euro and the pound were appreciating, so let me see the yen which should be red.
Yeah it's red.
So the euro, the pound and the yen all appreciated against the dollar.
Showing the strength of those currencies relative to the dollar.
However the one thing that I do notice is that they are in a range.
They're bouncing.
They're not plowing upward anywhere near where the euro was, $1.12 or $1.15.
They're bouncing back and forth in a range now to sort of ebbs and flows, bulls and bears
on the currency and all that.
No direction over a period of days.
And there we go.
The Nikkei took a whack right at the beginning.
And the rest of the day nothing happened.
There was some big news that in Japan before the markets opened and then when the markets
opened there was this drop but then it didn't go really anywhere from there.
So there was no continuing bad news.
There was just bad news that made the price, made the index, the Nikkei 225 drop at the
beginning but then nothing after that.
But that was a, you know, it was less than a percent but still.
And now in London there was good news.
When the sun rose there and it popped up and then it just kind of floated along.
Sometime after the midday in London there were this, it sank.
Some kind of news took it down but then that kind of got through it before the end of the
day and it stabilized again.
Now I do this with you because the more I say this, the more you think in a good way,
you don't look for these mysterious mathematical forces and complicated analytical tools.
You just think your way through.
What do I see?
What do I know about the environment, the business environment, global politics, global
conflict?
And actually it kind of gets fun because you're thinking more than just numbers.
You're thinking about the why and all of that.
And that's good news.
Having a look around, and I'm really kind of feeling around here.
Now the United Auto Workers just had an agreement with one of the automakers so just to have
a look to see if that had any impact on other car manufacturers today.
Oh gee, Ford took a toilet break.
I mean look at that.
Ford has been losing ground, nasty ground.
See its tie was clear up to 15 and a half and now it's near its 52 week low.
And that's not good news.
Look at the one year on it.
Well damn that thing is volatile.
But do you see how it's falling off a cliff here?
You notice descending tops, descending bottoms.
That's not good news at all.
I mean I don't want to do technical analysis too much but somehow Ford is just getting
a bad rap.
Again notice those declining tops in the intermediate.
And notice that the bottoms are declining too.
So that would tend to tell some analysts that there's still more room for it to go down.
And right now it's near its 52 week low and that might not be how far down it goes.
Just out of curiosity, see if GM did the same thing today.
Now GM was up.
It wasn't up as much as the market was.
And notice that the beta of GM should magnify the overall market.
The market was pretty strongly bullish today but for some reason General Motors was up
but it didn't really, not nearly as much as the market.
You know one and a half percent the market was up.
GM was up less than half a percent.
So there's, the automakers are in some issues now.
Just out of curiosity, Art Rivian, local, oh it's getting creamed, it's getting slapped.
There's some bad news.
You're getting a hard, there's a PR pushback I'm seeing in social media right now against
all electric vehicles.
And I'm wondering why now?
Usually the answer to that is there's some force behind it getting PR out there.
Positive PR or negative PR.
And it seems to be pretty negative on electric vehicles right now with supposed experts coming
in trashing the whole idea of electric vehicles because they will use more energy than power
plants are currently able to produce.
So who knows what that's all about.
Going over to something else, I don't know.
Lockheed Martin, see how the war stocks are doing.
Not very big, not very much.
So that's good news.
They'd be up a lot if there were real serious rumors of war.
So that's sort of like, kind of like confirmation that we're not in too much trouble.
And of course Tesla, just for a laugh.
Yeah, Tesla is really beginning to slide.
Look at the one year.
It had a surge upward, but then it topped.
Do you see how this top wasn't as strong, didn't make it?
It challenged the top neck line there and then it tried to do it again and it didn't
make it.
And then it began to slide off.
So you've got declining tops and you've got in the short run, declining bottoms in the
short run.
And you've got negative news that analysts are beginning to get real sour on Tesla right
now.
There was one article yesterday, pretty authoritative, that said the banks are just getting sick and
tired of just pouring money at Elon Musk.
They're sick of it, but they don't know how to get out of it.
The investment bankers are the same way.
It's what I was telling you earlier.
They've put such a massive stake into it that they can't cut it off now.
They've just got to keep fueling it because if they cut it off, then they would lose,
oh, god, awful amounts of money.
You might even buckle some of the big houses in the big banks if they cut them off now.
Make a deal with the devil and then wonder why your butt is on fire.
Anyway, enough of that.
Now like I said, I've got to set up a couple of Excel stupid pet tricks.
And I will put these into kind of another one of those templates.
I'll fix one up for it just so you can see how this works though.
As I had said earlier in the semester, when you're an accountant, cost is a dollar amount.
For most people, that's why accounting seems like it's real technical, it's real correct.
But as I had said before, in finance, we really don't care too much about numbers.
What we care about are percentages, and everything we do, we try to turn into a percentage.
Cost of goods sold, well, we are more interested in the gross margin, a percentage, and all
that kind of stuff.
A stock rises by a certain dollar amount.
Well, that doesn't mean anything to us.
We care about the percentage.
Well, the Dow fell 700 points.
Yeah, well, that was a percent.
Big whoop.
So, in finance, we're more interested in saying everything as a percentage.
And so when I say the cost of capital, and I wrote that on the board, the cost of capital,
I am going to be talking about percentages.
It's all percentages.
There's no dollars in here whatsoever.
But it does get a little bit odd, because you have to think in percentages in some places
where you wouldn't think that a percentage is appropriate.
So the cost of debt, well, that would be the interest that you pay on the debt in dollars.
For us, that doesn't really mean much at all.
So for example, with debt, let me talk about debt here for a second.
Suppose that we have some company, let's say, PZV, 5.50%, 2038.
Now you probably, I hope you remember, that means that the coupon is 5.5% of the face
value.
And face value is always, unless I say something otherwise, a thousand.
I'm looking for something here.
Oh, I got a calculator here.
What am I doing?
Let me pull up a calculator.
There.
I'll just leave that up on the screen for the time being.
So what that 5.5% means is that the dollar interest that would be paid, the coupon amount,
would be 5.50% times the face value of $1,000.
And that's the same thing that happens with preferred stock, the dividend percentage times
the face value of the preferred.
So there you go.
And what that would give you is $55.
Is the dollar cost of the debt per year.
And we do everything annualized if we can possibly.
Okay, well that's fine.
But two problems with that.
The first problem is that that's not the cost of debt.
Not exactly.
For two reasons.
One is that the company is going to be able to deduct that $55 from its taxable income.
The company subtracts interest expense before it calculates taxes.
So that cost of debt there is not exactly right.
The R sub D, now R's will be cost.
And that D will be debt.
Would be one minus the tax rate times, and this would be the after-tax cost of debt,
times the before-tax of debt.
This is the before-tax cost of debt, the coupon, for now.
So let's say that the tax rate is 21%, which it is right now.
So in other words, in this example, one minus 0.21 times 5.50%.
And if I did that, I would take one minus, let's try that again.
One minus 0.21 times 5.50%.
Well try that again.
One minus 0.21 times 5.50%.
4.345% So that would be the after-tax cost of debt.
But there's one more thing I must do.
And that goes to the fetish in finance for staying away from historical numbers.
That 5.50% is what the cost of debt was at the time that that bond was issued.
That bond might have been issued in 2028, 2018.
It might even have been in 2008.
That's not the cost of debt now.
That 5.50% is old history.
It doesn't have anything to do with what the current cost of debt is of the company.
So do we have to guess?
Oh, absolutely not.
We know what the current cost of debt would be.
What's the yield to maturity?
The YTM.
What investors are requiring now.
What the company would pay if it issued another round of debt like that one right there.
The yield to maturity is what the investors want now.
So in other words, this is not going to be good enough for us.
Let's say we ran the numbers on the yield to maturity.
You do that bond calculation on the Excel.
Let's say that the yield to maturity right now.
Interest rates have definitely gone up since then.
So the company is probably facing, well, we could just say, all right, run the numbers
on the price of the bonds right now and suppose that it is 6.35% is the current yield to maturity.
That's what we should be using.
So what we would want to do is say, okay, the after-tax cost of debt, that is what we
should be using, would be 1 minus.21 times 6.35%.
We use yield to maturity, not the coupon rate.
That's the one we should use.
That's the one that is happening now, not the one that happened years ago.
So if I run it again, 1 minus.21 quantity times 6.35, 5.0165.
So, we have the debt.
R sub D after-tax cost of debt is 5.0165% Well, that solved that problem.
Got that one out of the way.
My marker is dying, so let's try to find another one.
What do we got here?
Oh, that one's a good one.
Okay.
Oh, we got the debt.
Now you remember over here, I had, it was debt, and then there was equity.
And equity had preferred stock and common stock.
Preferred and common.
So we've got the debt taken care of.
That gives us that component cost of capital.
Just hang with me.
This isn't too bad, but I mean the second round of it, we'll go in and we'll do some
more calculations.
But it kind of all goes to the same thing here.
Preferred stock.
Remember that preferred stock is a no growth perpetuity.
The price right now of preferred stock, P0 preferred, PREF, should equal the flat dividend
divided by the required rate of return on preferred.
And I did that last week.
It's just a kind of no growth perpetuity.
The present value of an infinite stream of the same amount forever divided by, is the
dividend divided by required rate of return to preferred.
If I turn that around, I cross multiply.
The required rate of return to preferred would be the dividend divided by the current price
of the preferred.
That's all there is to it.
Nothing more.
Just get that formula into your Excel or into your notes somewhere.
So in other words, PZV 3.4% preferred par value.
$75 per share is currently priced at $58.20 per share.
Get that down.
I encourage you, don't think this is any more complicated than it is.
It's just step, get the numbers, take them out of the words and put them into the formula.
So in this case, okay, the required return to preferred, okay, we need the dividend.
So we can get the dividend is going to be just that 3.4% times $75.
So.034, I'm going to be lazy and just do it up here like this, divided by the current
price, $58.20.
That's all there is to it.
Get the dividend, divide it by the price.
That's all you do.
So in this case, what did I say,.034 times 75 divided by $58.20.
4.38%.
So preferred, R sub PRF I'll put it, is going to be, what did I say it was, 4.38%.
4.38%.
That's all.
And there's only one left.
Now I'll bring up, in the common stock, they sometimes call this the cost of retained earnings.
I hate that term, but it's very popular.
It's the cost of your shareholders, cost of retained earnings.
This one is the pain in the butt, because it's not as easy to calculate, because there's
not one formula to use.
Now a couple of ways that we can do it, a couple of ways we can do it.
The one way, if I've got an older company that's got a stable growth of the dividend,
you remember that the price I could do as V0 times 1 plus G over R minus G, the price
of the stock, I'll use an S for common stock.
You remember that one?
That one will work if the company has a dividend that has a stable growth from here to eternity.
Well, I can turn that around.
Let me write that a little bit simpler.
C1 over R sub S minus G.
Okay, so I've got the price right now of the stock is the dividend one period out divided
by R sub S minus G.
Now we're going to do a little cross multiplication.
First I'm going to say R sub S minus G equals D1 over P0.
Just put that over there, that down there.
And then R sub S, well there you go.
There's a cost of preferred, I'm sorry, of common stock if there's a constant growth
rate, which there isn't always, but we've got it here.
So PZV common stock just paid a $2.25 per share dividend
that is expected to grow at 3.0% for the foreseeable future.
The current price of the stock is $20.50 per share.
Okay, we're in business.
Write that down.
Okay, now first things first, I'm going to need D1, which is D0 times 1 plus G.
Now I just paid the dividend of $2.25 and we'll times that by 1 plus.03.
Try to keep this a little bigger here.
So get it all done and we have, let me do that, $2.25 times 1.03.
So the dividend D1 should be $2.31 and three quarters.
So the dividend at period one, $2.31, 2.3175.
So now we can just get the cost of the common stock, which is $2.3175 over P0, the current
stock price, $20.50 plus the growth rate,.03.
Make sure you add that growth rate out past the divide.
Now watch me screw this one up.
Divided by $20.50 plus.03, 14.30%.
So there we got it.
Common.
And again, the book calls this cost of retained earnings.
R sub S equals 14.30%.
There's a three.
Now we're right here, cost of common.
What I showed you is how we can get the cost of common stock, the cost of your retained
earnings, using the dividend growth model.
So that's method one.
If you've got an old company, stable growth of the dividends, then it's just that stupid
little formula right there.
If you don't, there's another way that I've actually shown you already.
You remember this equation, the expected return to stock is R sub F plus beta of the stock
times expected return to the market minus the risk free rate.
That's the cap M. You can use a cap M to get it.
You think, well wait a minute, is that easier?
Yeah, it is kinda.
But what usually happens, if you've got an old company, constant growth, the dividends
grow at a constant rate, you probably would, in real life, you would probably calculate
it by both the dividend growth model and the cap M. Make sure that they're pretty close.
If they were different, you might probably, well the most common thing would be to just
take the average of the two, if they're fairly close but not the same.
Yeah, you can use cap M.
What happens if you, okay this is great.
Method one, if there's a constant growth dividend.
Method two, if you don't have that luxury of a constant growth but you do have a beta.
If you have a beta, you're in business.
Or if you can get a comparable, a beta of a comparable company, you're in business.
What happens if you don't have either of those?
Then you go to a, kind of an odd method.
Seems to be awfully popular these days, not sure why.
PZV is in an industry where the average yield to maturity
on its bonds, on bonds, is 6.82%.
And the cost of common stock is 22.90%.
Again, this used to be one of the things that we kind of talked about, no one uses it, but
it's actually used instead of any other way these days.
Theoretically, the cost of common stock should be the cost of debt after tax, cost of debt
after taxes plus an equity risk premium, an EP.
In other words, the cost of common stock in the industry is 22.9%.
And that equals 6.82% plus some kind of equity premium for stock being riskier.
Now if I were to solve for equity premium here, I would find that the equity premium
is 16.08%.
In this industry, it appears that stock rides 16.08% on average above the cost of debt.
Well, suppose the PZV, the cost of common stock, whoops, I'm sorry, would be equal to
the cost of debt for PZV, which is 5.0165% plus an equity premium.
Let's say its equity premium is the same as the industry's, 16.08%.
It came from there.
It's a back ass way of doing it, but it's done.
So what you eventually find is that by this method, the cost of debt plus an equity premium
is 21.096%.
Notice that that way of doing it gives me a much different answer from the dividend
growth way of doing it.
That's why you pretty much are going to have to choose one or the other because they are
usually going to give you different answers that are noticeably different.
And this is the one that seems to be the most popular these days is that what we call the
cost of debt plus equity premium.
Now, which way do you use, well the book will tell you which way to use it for the homework.
When you get it for me on a quiz or an exam, I'll tell you which way to do it.
I won't mess around.
Now, I could give you wording that could point you to the right one, but I'm not going to
do it that way.
Not this early in your learning about finance.
I'll just say use the CAPM or use the dividend growth model or use the equity premium, cost
of debt plus equity premium model to get it.
This is an awful lot like work.
But take all that aside, I'm going to do this again on Wednesday.
We're just going to do this until you're sick of it.
And then I'll give you a surprise quiz on Wednesday of next week.
But let me show you something.
How does this get us to, the cost of capital is kind of important.
And you can see some things along the way.
Notice for example, that the cost of equity is inversely related to the price.
As the price of a company's stock goes down, its cost of equity goes up.
Now any of the models, it's not as obvious in the other model, in these last two for
the cost of common equity.
It's the most obvious when you look at it from the dividend growth model.
But whichever model you use, when the price of a stock goes down, its cost of equity capital
goes up.
That's why companies that pretend that they don't care what the stock price is doing should.
I had several consulting jobs where at a meeting I would just say, look, the stock price is
going down.
And they said, well, yeah, that's so what.
And they weren't trained in finance, so it wasn't like I could just say, well, the denominator
is going down, so that means that the fraction is going up.
And it's not felt right away in a company.
It's almost like a low level fever.
The company's stock price is going down, and they don't know why, but operations are suffering
from that.
Why are they suffering?
Well, it's because their cost of equity capital is in a hidden way rising on them.
They'll find out for sure if they try to do a seasoned offering, they won't be able to
sell their stock at a good price.
But even before that, the company will experience it because its overall cost of its capital
structure is going up.
So that's an important thing right there.
There's something else going on too.
See that G?
You notice that its growth rate of a company goes up, its cost of equity goes up?
That almost seems counterintuitive, but it's not.
As a company's growth rate increases, it's going to cost it more to raise equity capital.
As a matter of fact, I don't know if I mentioned in this class, I've been harping on it in
another class, in my short term cash management class, that in fact, there's an equation which
I will never show you that shows that there's a maximum growth rate a company can have before
the company actually buckles.
And we've got good examples.
We've got a lot of examples of companies that were just growing and growing, and as long
as you're growing, you're not, hey, we're growing so fast.
Isn't this awesome?
And of course, the news networks will say, look at this company.
Its growth rate is 40% over the last year.
And in fact, that is going to destroy the company.
It actually kills it.
The growth rate can break a company.
You sir, you're my son.
One day you're this little toddler, hi daddy.
Oh God, don't call me daddy.
But the next day, you're the incredible bulk.
Hi daddy.
And what happens?
You try to walk out the door, you hit your head on the ceiling, and you kill yourself.
Real examples for real people.
You get it though.
I mean, what's happening is that the company just cooks itself.
And it cooks itself because its cost of equity capital goes up so rapidly that it can't accommodate
it.
And then it's gone.
The cautionary tales from the past are quite impressive.
But we have a couple right now where the calculations for the growth of the company are right now
exceeding the sustainable growth rate of the company.
Now we can't say it's going to die because it might be able to turn it down.
We have to look to see if it's slowing down.
In other words, that curve is decelerating of growth.
But if it doesn't, well, we can pretty much call it, these companies will break.
So that's two things.
One is when the price of the company stock goes down, its cost of equity goes up.
That's a great quiz question, great midterm, a final exam question, hint, hint.
But also, if the growth rate of the company goes up, that increases the cost of equity
capital.
In either case, you don't have a good scenario.
Stock price falling or growth rate above a sustainable rate or growth rate accelerating,
that's a disaster over a period of time.
Now a growth rate that is really high for a couple of years is doable.
It slows down.
But if the growth rate doesn't, your cost of equity capital is going to kill you.
Now for the 800 pound gorilla, what all of this is about is the weighted average cost
of capital.
The WAC.
This is a big one in corporate America.
It's a big one.
It's used for lots of things, most notably for discounting cash flows, which it shouldn't
be used for, but it is.
The WAC is nothing but the weight of debt in the company's capital structure times the
after-tax cost of debt plus the weight of preferred times the cost of preferred plus
the weight of common stock, the weight of retained earnings times the cost of common
stock.
That is the weighted average cost of capital.
That is a really, really sweet way to do this really fast and excel.
Now a definition, and I'll repeat it a couple of times so you know it's important.
The capital structure of a corporation is the percentage of debt and percentage of equity
that makes up the total assets.
The percentage of debt and the percentage of equity that makes up the total assets.
So if I said the capital structure of a company is 25% debt and 75% equity, that would be
appropriate.
Now the equity could have preferred in common.
So it might be 25% debt, 5% preferred, 70% common, but we usually just put the two equities
together.
That's the capital structure.
The combination of debt and equity that makes up the total assets, the percentage of debt
plus the percentage of equity that makes up the total assets.
Now companies are generally, their capital structures are much more weighted toward equity
than debt.
30% debt, 80% equity.
10% debt, 90% equity.
You don't see debt very often as the dominant component.
There are however a few firms, their capital structure is nearly 100% debt and 0% equity.
Those are almost pure debt companies.
Then you see some that are almost 0% debt and 100% equity.
Ideally it's somewhere in between.
And I'll explain that on Wednesday.
But I will not do that, the Excel today, but I can assure you there are some things we
can do in Excel to make all of this work a lot faster and a lot cleaner.
And I'll actually build the template with you on Wednesday so that you understand how
it works.
But, when you see Tesla sliding in price, the most important part of that is, besides
anything else, that Tesla's cost of equity is skyrocketing.
Ultimately that is doom.
The banks and the investment bankers who've thrown so much money into it, sooner or later
they're going to have to make a choice.
Do we abandon the ship and let it go down with the baked ham on board showing off?
Or do we stay with it and go down with him?
That's what's going to come.
And that comes partly from just broad fundamental analysis, but it also comes from just the
technical mathematics of it.
You can defy gravity only so long as Wile E. Coyote found out when he finally looked
down and he was way off the cliff.
So there you are.
Let me see if my guest, who is an unrepentant bull, is here yet.
Hi, I'm a bull and I'm here to talk to you about bull markets.
Bull markets are where it's at.
The market is going to go up permanently and I should know because I'm a bull.
And don't believe anyone who tells you differently.
You hear these investors talking about bear markets, these experts talking about bear
markets, well I'm here to tell you that there is no such thing as a bear.
Bears do not exist.
They are a myth.
I have never heard of a bear in my life.
Mo?
No, no, no, leave me alone.
Get away, get away.
No, it's a bear market.
Help, no.
Mo, Mo.
That's all I have for you today.