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Alan Kring Productions in association with Emergent Light Studio presents the Illinois

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State Collegiate Compendium, Academic Lecture in Business and Economics.

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This is Business Finance, FIL 240 for autumn semester 2023.

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Today, the cost of capital.

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And this is a subject that is mathy, but again, excel to the rescue as it were.

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And I may even have enough time to do a couple of stupid pet tricks that might be worth your

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while to know.

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Now I've also got, I've been trying to get a guest speaker here all semester and an expert

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in stock markets and so that will be coming up at 3 o'clock.

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He should be here so we'll see.

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I'm hopeful that I can get that.

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So as a preliminary to that, just so we're on the same page here, as you can see we have

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definitely a bull market today.

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And of course, this kind of thwarts the idea that the end was here.

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And you should see that I'm sure you don't follow the markets too closely or the news

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networks, but I mean the doom's saying, yeah, we're about to go into the recession of a

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lifetime.

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No, we're not.

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Quit it.

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And of course today was one of those rally days that kind of knocked the bears back on

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their heels because you had a lot of traders were getting into these bear positions and

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sure enough you have a good strong day like this and that's about the end of them.

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And I'm going to show you, I think I'll be able to do this next week, I want to show

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you how you can take a bear position and a serious bear position.

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And what happens though if you are wrong?

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It is, it's not pretty.

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And so you have a day like this, you have those short sellers just starting to line

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up and here we go.

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And all of a sudden these shorts are standing there saying, uh oh, and they can lose a lot

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of money.

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Of course you can lose the money in a bull position too, but in a short sell position

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it can get really nasty sometimes.

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So be cautious about being a bear, but don't ever forget that sometimes the bears come

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out of the woods and they have a real bad attitude.

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But as you can see, this is a little bit unusual if I'm looking at this correctly, the Dow

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was up the most today at one point, almost 1.7%.

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That's a strong up day.

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But then the S&P 500 and the NASDAQ were both up really good, but not as much as the Dow.

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The way you would interpret that I guess is to say look, there was obviously good news

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and that good news was better news for ginormous companies, those 30 giants of the earth kind

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of thing.

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Not good for everyone, but it was strongly beneficial to the Dow.

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So there's that.

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Now here's crude.

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Now here's the funniest thing about crude.

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Remember I talked about that trading band, 82 to 88?

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Well now we're at the bottom of the band pushing downward.

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The war premium has drained out that agreement between the Arab nation and Russia.

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Well we're going to cut our production and that will drive the prices clear through the

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roof.

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Well of course as I told you, those don't last.

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And oil is flowing, you have the war premium that was there is easing out.

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And a lot of the sentiment is that the war will be contained to a fight between a non-state

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actor and a state in the Middle East.

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But oil, I mean we could see oil, the price of gasoline slip a little bit more.

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It's not going to slip a lot.

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Don't get excited about $2.25 a gallon gasoline.

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But it does have a little bit more room on the downside.

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So long as this oil market continues to be filled with oil.

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Gold, look at that.

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The gold bugs are just convinced that the end is near.

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They've broken the $2,000 an ounce resistance line by a good margin.

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And they're holding that we're about at the end of the good times here.

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So we'll see about that.

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Euro and the pound were appreciating, so let me see the yen which should be red.

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Yeah it's red.

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So the euro, the pound and the yen all appreciated against the dollar.

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Showing the strength of those currencies relative to the dollar.

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However the one thing that I do notice is that they are in a range.

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They're bouncing.

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They're not plowing upward anywhere near where the euro was, $1.12 or $1.15.

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They're bouncing back and forth in a range now to sort of ebbs and flows, bulls and bears

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on the currency and all that.

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No direction over a period of days.

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And there we go.

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The Nikkei took a whack right at the beginning.

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And the rest of the day nothing happened.

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There was some big news that in Japan before the markets opened and then when the markets

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opened there was this drop but then it didn't go really anywhere from there.

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So there was no continuing bad news.

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There was just bad news that made the price, made the index, the Nikkei 225 drop at the

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beginning but then nothing after that.

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But that was a, you know, it was less than a percent but still.

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And now in London there was good news.

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When the sun rose there and it popped up and then it just kind of floated along.

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Sometime after the midday in London there were this, it sank.

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Some kind of news took it down but then that kind of got through it before the end of the

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day and it stabilized again.

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Now I do this with you because the more I say this, the more you think in a good way,

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you don't look for these mysterious mathematical forces and complicated analytical tools.

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You just think your way through.

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What do I see?

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What do I know about the environment, the business environment, global politics, global

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conflict?

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And actually it kind of gets fun because you're thinking more than just numbers.

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You're thinking about the why and all of that.

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And that's good news.

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Having a look around, and I'm really kind of feeling around here.

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Now the United Auto Workers just had an agreement with one of the automakers so just to have

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a look to see if that had any impact on other car manufacturers today.

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Oh gee, Ford took a toilet break.

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I mean look at that.

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Ford has been losing ground, nasty ground.

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See its tie was clear up to 15 and a half and now it's near its 52 week low.

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And that's not good news.

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Look at the one year on it.

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Well damn that thing is volatile.

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But do you see how it's falling off a cliff here?

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You notice descending tops, descending bottoms.

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That's not good news at all.

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I mean I don't want to do technical analysis too much but somehow Ford is just getting

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a bad rap.

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Again notice those declining tops in the intermediate.

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And notice that the bottoms are declining too.

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So that would tend to tell some analysts that there's still more room for it to go down.

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And right now it's near its 52 week low and that might not be how far down it goes.

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Just out of curiosity, see if GM did the same thing today.

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Now GM was up.

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It wasn't up as much as the market was.

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And notice that the beta of GM should magnify the overall market.

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The market was pretty strongly bullish today but for some reason General Motors was up

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but it didn't really, not nearly as much as the market.

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You know one and a half percent the market was up.

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GM was up less than half a percent.

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So there's, the automakers are in some issues now.

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Just out of curiosity, Art Rivian, local, oh it's getting creamed, it's getting slapped.

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There's some bad news.

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You're getting a hard, there's a PR pushback I'm seeing in social media right now against

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all electric vehicles.

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And I'm wondering why now?

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Usually the answer to that is there's some force behind it getting PR out there.

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Positive PR or negative PR.

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And it seems to be pretty negative on electric vehicles right now with supposed experts coming

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in trashing the whole idea of electric vehicles because they will use more energy than power

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plants are currently able to produce.

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So who knows what that's all about.

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Going over to something else, I don't know.

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Lockheed Martin, see how the war stocks are doing.

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Not very big, not very much.

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So that's good news.

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They'd be up a lot if there were real serious rumors of war.

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So that's sort of like, kind of like confirmation that we're not in too much trouble.

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And of course Tesla, just for a laugh.

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Yeah, Tesla is really beginning to slide.

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Look at the one year.

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It had a surge upward, but then it topped.

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Do you see how this top wasn't as strong, didn't make it?

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It challenged the top neck line there and then it tried to do it again and it didn't

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make it.

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And then it began to slide off.

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So you've got declining tops and you've got in the short run, declining bottoms in the

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short run.

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And you've got negative news that analysts are beginning to get real sour on Tesla right

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now.

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There was one article yesterday, pretty authoritative, that said the banks are just getting sick and

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tired of just pouring money at Elon Musk.

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They're sick of it, but they don't know how to get out of it.

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The investment bankers are the same way.

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It's what I was telling you earlier.

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They've put such a massive stake into it that they can't cut it off now.

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They've just got to keep fueling it because if they cut it off, then they would lose,

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oh, god, awful amounts of money.

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You might even buckle some of the big houses in the big banks if they cut them off now.

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Make a deal with the devil and then wonder why your butt is on fire.

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Anyway, enough of that.

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Now like I said, I've got to set up a couple of Excel stupid pet tricks.

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And I will put these into kind of another one of those templates.

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I'll fix one up for it just so you can see how this works though.

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As I had said earlier in the semester, when you're an accountant, cost is a dollar amount.

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For most people, that's why accounting seems like it's real technical, it's real correct.

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But as I had said before, in finance, we really don't care too much about numbers.

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What we care about are percentages, and everything we do, we try to turn into a percentage.

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Cost of goods sold, well, we are more interested in the gross margin, a percentage, and all

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that kind of stuff.

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A stock rises by a certain dollar amount.

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Well, that doesn't mean anything to us.

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We care about the percentage.

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Well, the Dow fell 700 points.

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Yeah, well, that was a percent.

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Big whoop.

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So, in finance, we're more interested in saying everything as a percentage.

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And so when I say the cost of capital, and I wrote that on the board, the cost of capital,

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I am going to be talking about percentages.

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It's all percentages.

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There's no dollars in here whatsoever.

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But it does get a little bit odd, because you have to think in percentages in some places

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where you wouldn't think that a percentage is appropriate.

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So the cost of debt, well, that would be the interest that you pay on the debt in dollars.

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For us, that doesn't really mean much at all.

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So for example, with debt, let me talk about debt here for a second.

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Suppose that we have some company, let's say, PZV, 5.50%, 2038.

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Now you probably, I hope you remember, that means that the coupon is 5.5% of the face

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value.

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And face value is always, unless I say something otherwise, a thousand.

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I'm looking for something here.

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Oh, I got a calculator here.

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What am I doing?

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Let me pull up a calculator.

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There.

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I'll just leave that up on the screen for the time being.

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So what that 5.5% means is that the dollar interest that would be paid, the coupon amount,

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would be 5.50% times the face value of $1,000.

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And that's the same thing that happens with preferred stock, the dividend percentage times

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the face value of the preferred.

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So there you go.

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And what that would give you is $55.

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Is the dollar cost of the debt per year.

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And we do everything annualized if we can possibly.

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Okay, well that's fine.

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But two problems with that.

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The first problem is that that's not the cost of debt.

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Not exactly.

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For two reasons.

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One is that the company is going to be able to deduct that $55 from its taxable income.

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The company subtracts interest expense before it calculates taxes.

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So that cost of debt there is not exactly right.

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The R sub D, now R's will be cost.

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And that D will be debt.

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Would be one minus the tax rate times, and this would be the after-tax cost of debt,

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times the before-tax of debt.

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This is the before-tax cost of debt, the coupon, for now.

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So let's say that the tax rate is 21%, which it is right now.

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So in other words, in this example, one minus 0.21 times 5.50%.

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And if I did that, I would take one minus, let's try that again.

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One minus 0.21 times 5.50%.

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Well try that again.

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One minus 0.21 times 5.50%.

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4.345% So that would be the after-tax cost of debt.

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But there's one more thing I must do.

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And that goes to the fetish in finance for staying away from historical numbers.

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That 5.50% is what the cost of debt was at the time that that bond was issued.

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That bond might have been issued in 2028, 2018.

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It might even have been in 2008.

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That's not the cost of debt now.

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That 5.50% is old history.

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It doesn't have anything to do with what the current cost of debt is of the company.

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So do we have to guess?

238
00:20:26,000 --> 00:20:27,960
Oh, absolutely not.

239
00:20:27,960 --> 00:20:31,480
We know what the current cost of debt would be.

240
00:20:31,480 --> 00:20:34,200
What's the yield to maturity?

241
00:20:34,200 --> 00:20:37,280
The YTM.

242
00:20:37,280 --> 00:20:40,660
What investors are requiring now.

243
00:20:40,660 --> 00:20:47,200
What the company would pay if it issued another round of debt like that one right there.

244
00:20:47,200 --> 00:20:51,920
The yield to maturity is what the investors want now.

245
00:20:51,920 --> 00:20:57,600
So in other words, this is not going to be good enough for us.

246
00:20:57,600 --> 00:21:00,420
Let's say we ran the numbers on the yield to maturity.

247
00:21:00,420 --> 00:21:03,520
You do that bond calculation on the Excel.

248
00:21:03,520 --> 00:21:07,760
Let's say that the yield to maturity right now.

249
00:21:07,760 --> 00:21:11,040
Interest rates have definitely gone up since then.

250
00:21:11,040 --> 00:21:16,960
So the company is probably facing, well, we could just say, all right, run the numbers

251
00:21:16,960 --> 00:21:28,200
on the price of the bonds right now and suppose that it is 6.35% is the current yield to maturity.

252
00:21:28,200 --> 00:21:30,680
That's what we should be using.

253
00:21:30,680 --> 00:21:39,680
So what we would want to do is say, okay, the after-tax cost of debt, that is what we

254
00:21:39,680 --> 00:21:50,320
should be using, would be 1 minus.21 times 6.35%.

255
00:21:50,320 --> 00:21:59,760
We use yield to maturity, not the coupon rate.

256
00:21:59,760 --> 00:22:02,760
That's the one we should use.

257
00:22:02,760 --> 00:22:08,960
That's the one that is happening now, not the one that happened years ago.

258
00:22:08,960 --> 00:22:31,600
So if I run it again, 1 minus.21 quantity times 6.35, 5.0165.

259
00:22:31,600 --> 00:22:43,840
So, we have the debt.

260
00:22:43,840 --> 00:23:09,000
R sub D after-tax cost of debt is 5.0165% Well, that solved that problem.

261
00:23:09,000 --> 00:23:12,640
Got that one out of the way.

262
00:23:12,640 --> 00:23:17,200
My marker is dying, so let's try to find another one.

263
00:23:17,200 --> 00:23:19,600
What do we got here?

264
00:23:19,600 --> 00:23:23,560
Oh, that one's a good one.

265
00:23:23,560 --> 00:23:24,560
Okay.

266
00:23:24,560 --> 00:23:36,000
Oh, we got the debt.

267
00:23:36,000 --> 00:23:53,160
Now you remember over here, I had, it was debt, and then there was equity.

268
00:23:53,160 --> 00:24:05,440
And equity had preferred stock and common stock.

269
00:24:05,440 --> 00:24:07,000
Preferred and common.

270
00:24:07,000 --> 00:24:11,720
So we've got the debt taken care of.

271
00:24:11,720 --> 00:24:15,840
That gives us that component cost of capital.

272
00:24:15,840 --> 00:24:19,400
Just hang with me.

273
00:24:19,400 --> 00:24:25,160
This isn't too bad, but I mean the second round of it, we'll go in and we'll do some

274
00:24:25,160 --> 00:24:27,520
more calculations.

275
00:24:27,520 --> 00:24:36,280
But it kind of all goes to the same thing here.

276
00:24:36,280 --> 00:24:39,880
Preferred stock.

277
00:24:39,880 --> 00:24:47,840
Remember that preferred stock is a no growth perpetuity.

278
00:24:47,840 --> 00:25:03,440
The price right now of preferred stock, P0 preferred, PREF, should equal the flat dividend

279
00:25:03,440 --> 00:25:11,280
divided by the required rate of return on preferred.

280
00:25:11,280 --> 00:25:14,200
And I did that last week.

281
00:25:14,200 --> 00:25:18,520
It's just a kind of no growth perpetuity.

282
00:25:18,520 --> 00:25:27,320
The present value of an infinite stream of the same amount forever divided by, is the

283
00:25:27,320 --> 00:25:33,440
dividend divided by required rate of return to preferred.

284
00:25:33,440 --> 00:25:40,760
If I turn that around, I cross multiply.

285
00:25:40,760 --> 00:25:54,280
The required rate of return to preferred would be the dividend divided by the current price

286
00:25:54,280 --> 00:26:02,120
of the preferred.

287
00:26:02,120 --> 00:26:04,520
That's all there is to it.

288
00:26:04,520 --> 00:26:05,520
Nothing more.

289
00:26:05,520 --> 00:26:13,120
Just get that formula into your Excel or into your notes somewhere.

290
00:26:13,120 --> 00:26:42,560
So in other words, PZV 3.4% preferred par value.

291
00:26:42,560 --> 00:27:11,120
$75 per share is currently priced at $58.20 per share.

292
00:27:11,120 --> 00:27:17,520
Get that down.

293
00:27:17,520 --> 00:27:22,720
I encourage you, don't think this is any more complicated than it is.

294
00:27:22,720 --> 00:27:31,800
It's just step, get the numbers, take them out of the words and put them into the formula.

295
00:27:31,800 --> 00:27:48,600
So in this case, okay, the required return to preferred, okay, we need the dividend.

296
00:27:48,600 --> 00:28:04,000
So we can get the dividend is going to be just that 3.4% times $75.

297
00:28:04,000 --> 00:28:13,960
So.034, I'm going to be lazy and just do it up here like this, divided by the current

298
00:28:13,960 --> 00:28:20,360
price, $58.20.

299
00:28:20,360 --> 00:28:22,760
That's all there is to it.

300
00:28:22,760 --> 00:28:26,400
Get the dividend, divide it by the price.

301
00:28:26,400 --> 00:28:30,040
That's all you do.

302
00:28:30,040 --> 00:28:46,920
So in this case, what did I say,.034 times 75 divided by $58.20.

303
00:28:46,920 --> 00:28:57,340
4.38%.

304
00:28:57,340 --> 00:29:21,240
So preferred, R sub PRF I'll put it, is going to be, what did I say it was, 4.38%.

305
00:29:21,240 --> 00:29:29,960
4.38%.

306
00:29:29,960 --> 00:29:38,440
That's all.

307
00:29:38,440 --> 00:29:40,600
And there's only one left.

308
00:29:40,600 --> 00:29:55,560
Now I'll bring up, in the common stock, they sometimes call this the cost of retained earnings.

309
00:29:55,560 --> 00:30:05,300
I hate that term, but it's very popular.

310
00:30:05,300 --> 00:30:15,140
It's the cost of your shareholders, cost of retained earnings.

311
00:30:15,140 --> 00:30:23,640
This one is the pain in the butt, because it's not as easy to calculate, because there's

312
00:30:23,640 --> 00:30:27,500
not one formula to use.

313
00:30:27,500 --> 00:30:37,800
Now a couple of ways that we can do it, a couple of ways we can do it.

314
00:30:37,800 --> 00:30:50,020
The one way, if I've got an older company that's got a stable growth of the dividend,

315
00:30:50,020 --> 00:31:05,560
you remember that the price I could do as V0 times 1 plus G over R minus G, the price

316
00:31:05,560 --> 00:31:09,200
of the stock, I'll use an S for common stock.

317
00:31:09,200 --> 00:31:10,720
You remember that one?

318
00:31:10,720 --> 00:31:18,600
That one will work if the company has a dividend that has a stable growth from here to eternity.

319
00:31:18,600 --> 00:31:23,680
Well, I can turn that around.

320
00:31:23,680 --> 00:31:27,840
Let me write that a little bit simpler.

321
00:31:27,840 --> 00:31:32,240
C1 over R sub S minus G.

322
00:31:32,240 --> 00:31:41,840
Okay, so I've got the price right now of the stock is the dividend one period out divided

323
00:31:41,840 --> 00:31:43,160
by R sub S minus G.

324
00:31:43,160 --> 00:31:48,800
Now we're going to do a little cross multiplication.

325
00:31:48,800 --> 00:31:57,160
First I'm going to say R sub S minus G equals D1 over P0.

326
00:31:57,160 --> 00:32:00,320
Just put that over there, that down there.

327
00:32:00,320 --> 00:32:11,920
And then R sub S, well there you go.

328
00:32:11,920 --> 00:32:18,600
There's a cost of preferred, I'm sorry, of common stock if there's a constant growth

329
00:32:18,600 --> 00:32:22,920
rate, which there isn't always, but we've got it here.

330
00:32:22,920 --> 00:32:51,920
So PZV common stock just paid a $2.25 per share dividend

331
00:32:51,920 --> 00:33:12,520
that is expected to grow at 3.0% for the foreseeable future.

332
00:33:12,520 --> 00:33:41,640
The current price of the stock is $20.50 per share.

333
00:33:41,640 --> 00:33:48,760
Okay, we're in business.

334
00:33:48,760 --> 00:33:54,520
Write that down.

335
00:33:54,520 --> 00:34:17,600
Okay, now first things first, I'm going to need D1, which is D0 times 1 plus G.

336
00:34:17,600 --> 00:34:30,240
Now I just paid the dividend of $2.25 and we'll times that by 1 plus.03.

337
00:34:30,240 --> 00:34:44,120
Try to keep this a little bigger here.

338
00:34:44,120 --> 00:35:02,320
So get it all done and we have, let me do that, $2.25 times 1.03.

339
00:35:02,320 --> 00:35:10,680
So the dividend D1 should be $2.31 and three quarters.

340
00:35:10,680 --> 00:35:22,520
So the dividend at period one, $2.31, 2.3175.

341
00:35:22,520 --> 00:35:39,120
So now we can just get the cost of the common stock, which is $2.3175 over P0, the current

342
00:35:39,120 --> 00:35:45,080
stock price, $20.50 plus the growth rate,.03.

343
00:35:45,080 --> 00:35:53,680
Make sure you add that growth rate out past the divide.

344
00:35:53,680 --> 00:35:56,560
Now watch me screw this one up.

345
00:35:56,560 --> 00:36:23,320
Divided by $20.50 plus.03, 14.30%.

346
00:36:23,320 --> 00:36:25,520
So there we got it.

347
00:36:25,520 --> 00:36:26,760
Common.

348
00:36:26,760 --> 00:36:31,720
And again, the book calls this cost of retained earnings.

349
00:36:31,720 --> 00:36:42,200
R sub S equals 14.30%.

350
00:36:42,200 --> 00:36:47,200
There's a three.

351
00:36:47,200 --> 00:37:05,000
Now we're right here, cost of common.

352
00:37:05,000 --> 00:37:11,360
What I showed you is how we can get the cost of common stock, the cost of your retained

353
00:37:11,360 --> 00:37:21,840
earnings, using the dividend growth model.

354
00:37:21,840 --> 00:37:23,680
So that's method one.

355
00:37:23,680 --> 00:37:31,120
If you've got an old company, stable growth of the dividends, then it's just that stupid

356
00:37:31,120 --> 00:37:34,960
little formula right there.

357
00:37:34,960 --> 00:37:41,960
If you don't, there's another way that I've actually shown you already.

358
00:37:41,960 --> 00:37:53,720
You remember this equation, the expected return to stock is R sub F plus beta of the stock

359
00:37:53,720 --> 00:38:03,360
times expected return to the market minus the risk free rate.

360
00:38:03,360 --> 00:38:11,800
That's the cap M. You can use a cap M to get it.

361
00:38:11,800 --> 00:38:16,600
You think, well wait a minute, is that easier?

362
00:38:16,600 --> 00:38:18,760
Yeah, it is kinda.

363
00:38:18,760 --> 00:38:25,000
But what usually happens, if you've got an old company, constant growth, the dividends

364
00:38:25,000 --> 00:38:33,040
grow at a constant rate, you probably would, in real life, you would probably calculate

365
00:38:33,040 --> 00:38:40,120
it by both the dividend growth model and the cap M. Make sure that they're pretty close.

366
00:38:40,120 --> 00:38:44,600
If they were different, you might probably, well the most common thing would be to just

367
00:38:44,600 --> 00:38:48,880
take the average of the two, if they're fairly close but not the same.

368
00:38:48,880 --> 00:38:52,880
Yeah, you can use cap M.

369
00:38:52,880 --> 00:38:56,160
What happens if you, okay this is great.

370
00:38:56,160 --> 00:39:00,000
Method one, if there's a constant growth dividend.

371
00:39:00,000 --> 00:39:05,840
Method two, if you don't have that luxury of a constant growth but you do have a beta.

372
00:39:05,840 --> 00:39:07,840
If you have a beta, you're in business.

373
00:39:07,840 --> 00:39:13,800
Or if you can get a comparable, a beta of a comparable company, you're in business.

374
00:39:13,800 --> 00:39:18,600
What happens if you don't have either of those?

375
00:39:18,600 --> 00:39:24,240
Then you go to a, kind of an odd method.

376
00:39:24,240 --> 00:39:34,160
Seems to be awfully popular these days, not sure why.

377
00:39:34,160 --> 00:40:01,200
PZV is in an industry where the average yield to maturity

378
00:40:01,200 --> 00:40:30,680
on its bonds, on bonds, is 6.82%.

379
00:40:30,680 --> 00:40:56,400
And the cost of common stock is 22.90%.

380
00:40:56,400 --> 00:41:13,760
Again, this used to be one of the things that we kind of talked about, no one uses it, but

381
00:41:13,760 --> 00:41:19,240
it's actually used instead of any other way these days.

382
00:41:19,240 --> 00:41:33,680
Theoretically, the cost of common stock should be the cost of debt after tax, cost of debt

383
00:41:33,680 --> 00:41:45,960
after taxes plus an equity risk premium, an EP.

384
00:41:45,960 --> 00:41:58,880
In other words, the cost of common stock in the industry is 22.9%.

385
00:41:58,880 --> 00:42:13,280
And that equals 6.82% plus some kind of equity premium for stock being riskier.

386
00:42:13,280 --> 00:42:26,160
Now if I were to solve for equity premium here, I would find that the equity premium

387
00:42:26,160 --> 00:42:36,120
is 16.08%.

388
00:42:36,120 --> 00:42:54,160
In this industry, it appears that stock rides 16.08% on average above the cost of debt.

389
00:42:54,160 --> 00:43:17,440
Well, suppose the PZV, the cost of common stock, whoops, I'm sorry, would be equal to

390
00:43:17,440 --> 00:43:31,840
the cost of debt for PZV, which is 5.0165% plus an equity premium.

391
00:43:31,840 --> 00:43:42,760
Let's say its equity premium is the same as the industry's, 16.08%.

392
00:43:42,760 --> 00:43:48,520
It came from there.

393
00:43:48,520 --> 00:43:53,400
It's a back ass way of doing it, but it's done.

394
00:43:53,400 --> 00:44:03,240
So what you eventually find is that by this method, the cost of debt plus an equity premium

395
00:44:03,240 --> 00:44:16,320
is 21.096%.

396
00:44:16,320 --> 00:44:23,720
Notice that that way of doing it gives me a much different answer from the dividend

397
00:44:23,720 --> 00:44:27,720
growth way of doing it.

398
00:44:27,720 --> 00:44:33,760
That's why you pretty much are going to have to choose one or the other because they are

399
00:44:33,760 --> 00:44:39,840
usually going to give you different answers that are noticeably different.

400
00:44:39,840 --> 00:44:50,680
And this is the one that seems to be the most popular these days is that what we call the

401
00:44:50,680 --> 00:45:00,360
cost of debt plus equity premium.

402
00:45:00,360 --> 00:45:10,560
Now, which way do you use, well the book will tell you which way to use it for the homework.

403
00:45:10,560 --> 00:45:18,680
When you get it for me on a quiz or an exam, I'll tell you which way to do it.

404
00:45:18,680 --> 00:45:19,680
I won't mess around.

405
00:45:19,680 --> 00:45:24,040
Now, I could give you wording that could point you to the right one, but I'm not going to

406
00:45:24,040 --> 00:45:26,320
do it that way.

407
00:45:26,320 --> 00:45:29,920
Not this early in your learning about finance.

408
00:45:29,920 --> 00:45:39,400
I'll just say use the CAPM or use the dividend growth model or use the equity premium, cost

409
00:45:39,400 --> 00:45:47,680
of debt plus equity premium model to get it.

410
00:45:47,680 --> 00:45:50,400
This is an awful lot like work.

411
00:45:50,400 --> 00:45:54,520
But take all that aside, I'm going to do this again on Wednesday.

412
00:45:54,520 --> 00:45:57,400
We're just going to do this until you're sick of it.

413
00:45:57,400 --> 00:46:01,800
And then I'll give you a surprise quiz on Wednesday of next week.

414
00:46:01,800 --> 00:46:09,960
But let me show you something.

415
00:46:09,960 --> 00:46:15,400
How does this get us to, the cost of capital is kind of important.

416
00:46:15,400 --> 00:46:18,800
And you can see some things along the way.

417
00:46:18,800 --> 00:46:28,600
Notice for example, that the cost of equity is inversely related to the price.

418
00:46:28,600 --> 00:46:34,880
As the price of a company's stock goes down, its cost of equity goes up.

419
00:46:34,880 --> 00:46:42,400
Now any of the models, it's not as obvious in the other model, in these last two for

420
00:46:42,400 --> 00:46:44,100
the cost of common equity.

421
00:46:44,100 --> 00:46:48,320
It's the most obvious when you look at it from the dividend growth model.

422
00:46:48,320 --> 00:46:56,000
But whichever model you use, when the price of a stock goes down, its cost of equity capital

423
00:46:56,000 --> 00:46:59,120
goes up.

424
00:46:59,120 --> 00:47:07,840
That's why companies that pretend that they don't care what the stock price is doing should.

425
00:47:07,840 --> 00:47:15,280
I had several consulting jobs where at a meeting I would just say, look, the stock price is

426
00:47:15,280 --> 00:47:17,000
going down.

427
00:47:17,000 --> 00:47:21,080
And they said, well, yeah, that's so what.

428
00:47:21,080 --> 00:47:27,360
And they weren't trained in finance, so it wasn't like I could just say, well, the denominator

429
00:47:27,360 --> 00:47:34,540
is going down, so that means that the fraction is going up.

430
00:47:34,540 --> 00:47:37,040
And it's not felt right away in a company.

431
00:47:37,040 --> 00:47:39,480
It's almost like a low level fever.

432
00:47:39,480 --> 00:47:45,680
The company's stock price is going down, and they don't know why, but operations are suffering

433
00:47:45,680 --> 00:47:46,880
from that.

434
00:47:46,880 --> 00:47:47,880
Why are they suffering?

435
00:47:47,880 --> 00:47:55,840
Well, it's because their cost of equity capital is in a hidden way rising on them.

436
00:47:55,840 --> 00:48:00,760
They'll find out for sure if they try to do a seasoned offering, they won't be able to

437
00:48:00,760 --> 00:48:02,920
sell their stock at a good price.

438
00:48:02,920 --> 00:48:08,480
But even before that, the company will experience it because its overall cost of its capital

439
00:48:08,480 --> 00:48:11,440
structure is going up.

440
00:48:11,440 --> 00:48:17,080
So that's an important thing right there.

441
00:48:17,080 --> 00:48:19,600
There's something else going on too.

442
00:48:19,600 --> 00:48:22,360
See that G?

443
00:48:22,360 --> 00:48:30,360
You notice that its growth rate of a company goes up, its cost of equity goes up?

444
00:48:30,360 --> 00:48:35,120
That almost seems counterintuitive, but it's not.

445
00:48:35,120 --> 00:48:45,120
As a company's growth rate increases, it's going to cost it more to raise equity capital.

446
00:48:45,120 --> 00:48:50,680
As a matter of fact, I don't know if I mentioned in this class, I've been harping on it in

447
00:48:50,680 --> 00:48:58,600
another class, in my short term cash management class, that in fact, there's an equation which

448
00:48:58,600 --> 00:49:05,440
I will never show you that shows that there's a maximum growth rate a company can have before

449
00:49:05,440 --> 00:49:08,200
the company actually buckles.

450
00:49:08,200 --> 00:49:09,920
And we've got good examples.

451
00:49:09,920 --> 00:49:15,680
We've got a lot of examples of companies that were just growing and growing, and as long

452
00:49:15,680 --> 00:49:19,440
as you're growing, you're not, hey, we're growing so fast.

453
00:49:19,440 --> 00:49:20,440
Isn't this awesome?

454
00:49:20,440 --> 00:49:23,400
And of course, the news networks will say, look at this company.

455
00:49:23,400 --> 00:49:27,760
Its growth rate is 40% over the last year.

456
00:49:27,760 --> 00:49:32,480
And in fact, that is going to destroy the company.

457
00:49:32,480 --> 00:49:34,020
It actually kills it.

458
00:49:34,020 --> 00:49:36,880
The growth rate can break a company.

459
00:49:36,880 --> 00:49:40,040
You sir, you're my son.

460
00:49:40,040 --> 00:49:42,400
One day you're this little toddler, hi daddy.

461
00:49:42,400 --> 00:49:45,800
Oh God, don't call me daddy.

462
00:49:45,800 --> 00:49:49,640
But the next day, you're the incredible bulk.

463
00:49:49,640 --> 00:49:51,600
Hi daddy.

464
00:49:51,600 --> 00:49:52,600
And what happens?

465
00:49:52,600 --> 00:49:57,720
You try to walk out the door, you hit your head on the ceiling, and you kill yourself.

466
00:49:57,720 --> 00:50:00,840
Real examples for real people.

467
00:50:00,840 --> 00:50:01,840
You get it though.

468
00:50:01,840 --> 00:50:06,360
I mean, what's happening is that the company just cooks itself.

469
00:50:06,360 --> 00:50:14,360
And it cooks itself because its cost of equity capital goes up so rapidly that it can't accommodate

470
00:50:14,360 --> 00:50:15,400
it.

471
00:50:15,400 --> 00:50:18,920
And then it's gone.

472
00:50:18,920 --> 00:50:25,520
The cautionary tales from the past are quite impressive.

473
00:50:25,520 --> 00:50:33,560
But we have a couple right now where the calculations for the growth of the company are right now

474
00:50:33,560 --> 00:50:38,320
exceeding the sustainable growth rate of the company.

475
00:50:38,320 --> 00:50:42,080
Now we can't say it's going to die because it might be able to turn it down.

476
00:50:42,080 --> 00:50:45,080
We have to look to see if it's slowing down.

477
00:50:45,080 --> 00:50:50,260
In other words, that curve is decelerating of growth.

478
00:50:50,260 --> 00:50:57,800
But if it doesn't, well, we can pretty much call it, these companies will break.

479
00:50:57,800 --> 00:50:59,320
So that's two things.

480
00:50:59,320 --> 00:51:05,080
One is when the price of the company stock goes down, its cost of equity goes up.

481
00:51:05,080 --> 00:51:11,460
That's a great quiz question, great midterm, a final exam question, hint, hint.

482
00:51:11,460 --> 00:51:19,260
But also, if the growth rate of the company goes up, that increases the cost of equity

483
00:51:19,260 --> 00:51:21,320
capital.

484
00:51:21,320 --> 00:51:28,200
In either case, you don't have a good scenario.

485
00:51:28,200 --> 00:51:36,400
Stock price falling or growth rate above a sustainable rate or growth rate accelerating,

486
00:51:36,400 --> 00:51:40,080
that's a disaster over a period of time.

487
00:51:40,080 --> 00:51:47,800
Now a growth rate that is really high for a couple of years is doable.

488
00:51:47,800 --> 00:51:49,640
It slows down.

489
00:51:49,640 --> 00:51:56,560
But if the growth rate doesn't, your cost of equity capital is going to kill you.

490
00:51:56,560 --> 00:52:10,040
Now for the 800 pound gorilla, what all of this is about is the weighted average cost

491
00:52:10,040 --> 00:52:15,720
of capital.

492
00:52:15,720 --> 00:52:23,320
The WAC.

493
00:52:23,320 --> 00:52:25,480
This is a big one in corporate America.

494
00:52:25,480 --> 00:52:27,160
It's a big one.

495
00:52:27,160 --> 00:52:32,880
It's used for lots of things, most notably for discounting cash flows, which it shouldn't

496
00:52:32,880 --> 00:52:35,480
be used for, but it is.

497
00:52:35,480 --> 00:52:46,480
The WAC is nothing but the weight of debt in the company's capital structure times the

498
00:52:46,480 --> 00:53:04,960
after-tax cost of debt plus the weight of preferred times the cost of preferred plus

499
00:53:04,960 --> 00:53:11,520
the weight of common stock, the weight of retained earnings times the cost of common

500
00:53:11,520 --> 00:53:15,720
stock.

501
00:53:15,720 --> 00:53:20,040
That is the weighted average cost of capital.

502
00:53:20,040 --> 00:53:32,720
That is a really, really sweet way to do this really fast and excel.

503
00:53:32,720 --> 00:53:39,960
Now a definition, and I'll repeat it a couple of times so you know it's important.

504
00:53:39,960 --> 00:54:09,880
The capital structure of a corporation is the percentage of debt and percentage of equity

505
00:54:09,880 --> 00:54:17,360
that makes up the total assets.

506
00:54:17,360 --> 00:54:26,000
The percentage of debt and the percentage of equity that makes up the total assets.

507
00:54:26,000 --> 00:54:40,240
So if I said the capital structure of a company is 25% debt and 75% equity, that would be

508
00:54:40,240 --> 00:54:43,280
appropriate.

509
00:54:43,280 --> 00:54:47,960
Now the equity could have preferred in common.

510
00:54:47,960 --> 00:54:58,720
So it might be 25% debt, 5% preferred, 70% common, but we usually just put the two equities

511
00:54:58,720 --> 00:55:04,640
together.

512
00:55:04,640 --> 00:55:08,520
That's the capital structure.

513
00:55:08,520 --> 00:55:16,360
The combination of debt and equity that makes up the total assets, the percentage of debt

514
00:55:16,360 --> 00:55:23,720
plus the percentage of equity that makes up the total assets.

515
00:55:23,720 --> 00:55:32,760
Now companies are generally, their capital structures are much more weighted toward equity

516
00:55:32,760 --> 00:55:33,920
than debt.

517
00:55:33,920 --> 00:55:37,480
30% debt, 80% equity.

518
00:55:37,480 --> 00:55:41,040
10% debt, 90% equity.

519
00:55:41,040 --> 00:55:49,480
You don't see debt very often as the dominant component.

520
00:55:49,480 --> 00:55:59,960
There are however a few firms, their capital structure is nearly 100% debt and 0% equity.

521
00:55:59,960 --> 00:56:02,680
Those are almost pure debt companies.

522
00:56:02,680 --> 00:56:12,680
Then you see some that are almost 0% debt and 100% equity.

523
00:56:12,680 --> 00:56:14,120
Ideally it's somewhere in between.

524
00:56:14,120 --> 00:56:20,980
And I'll explain that on Wednesday.

525
00:56:20,980 --> 00:56:27,320
But I will not do that, the Excel today, but I can assure you there are some things we

526
00:56:27,320 --> 00:56:32,180
can do in Excel to make all of this work a lot faster and a lot cleaner.

527
00:56:32,180 --> 00:56:38,720
And I'll actually build the template with you on Wednesday so that you understand how

528
00:56:38,720 --> 00:56:42,480
it works.

529
00:56:42,480 --> 00:56:57,400
But, when you see Tesla sliding in price, the most important part of that is, besides

530
00:56:57,400 --> 00:57:06,200
anything else, that Tesla's cost of equity is skyrocketing.

531
00:57:06,200 --> 00:57:09,600
Ultimately that is doom.

532
00:57:09,600 --> 00:57:15,240
The banks and the investment bankers who've thrown so much money into it, sooner or later

533
00:57:15,240 --> 00:57:17,500
they're going to have to make a choice.

534
00:57:17,500 --> 00:57:26,340
Do we abandon the ship and let it go down with the baked ham on board showing off?

535
00:57:26,340 --> 00:57:31,600
Or do we stay with it and go down with him?

536
00:57:31,600 --> 00:57:33,200
That's what's going to come.

537
00:57:33,200 --> 00:57:39,920
And that comes partly from just broad fundamental analysis, but it also comes from just the

538
00:57:39,920 --> 00:57:42,540
technical mathematics of it.

539
00:57:42,540 --> 00:57:48,040
You can defy gravity only so long as Wile E. Coyote found out when he finally looked

540
00:57:48,040 --> 00:57:51,920
down and he was way off the cliff.

541
00:57:51,920 --> 00:57:52,920
So there you are.

542
00:57:52,920 --> 00:58:00,280
Let me see if my guest, who is an unrepentant bull, is here yet.

543
00:58:00,280 --> 00:58:06,080
Hi, I'm a bull and I'm here to talk to you about bull markets.

544
00:58:06,080 --> 00:58:08,640
Bull markets are where it's at.

545
00:58:08,640 --> 00:58:14,480
The market is going to go up permanently and I should know because I'm a bull.

546
00:58:14,480 --> 00:58:17,760
And don't believe anyone who tells you differently.

547
00:58:17,760 --> 00:58:21,880
You hear these investors talking about bear markets, these experts talking about bear

548
00:58:21,880 --> 00:58:27,120
markets, well I'm here to tell you that there is no such thing as a bear.

549
00:58:27,120 --> 00:58:28,680
Bears do not exist.

550
00:58:28,680 --> 00:58:30,080
They are a myth.

551
00:58:30,080 --> 00:58:33,680
I have never heard of a bear in my life.

552
00:58:33,680 --> 00:58:34,680
Mo?

553
00:58:34,680 --> 00:58:37,680
No, no, no, leave me alone.

554
00:58:37,680 --> 00:58:39,680
Get away, get away.

555
00:58:39,680 --> 00:58:42,680
No, it's a bear market.

556
00:58:42,680 --> 00:58:45,680
Help, no.

557
00:58:45,680 --> 00:58:48,680
Mo, Mo.

558
00:58:48,680 --> 00:59:06,680
That's all I have for you today.