Alan Cring Productions in association with the Emergent Light Studio presents
the Illinois State Collegiate Compendium, academic lectures in business and economics.
This is business finance, FIL 341 for Autumn Semester 2024.
Today, the weighted average cost of cap and this has to do with the component cost of capital.
Now you did this in FIL 240.
The version this time is very similar, but I dig in a little deeper and I do have an Excel spreadsheet
to do the unholy thing of getting a weighted average cost of capital.
I'm also, and I just thought about this, I'm trying to get finished fairly quickly.
A nice little Excel template in finding the actual component cost of capital.
It's pretty easy to put it together and if you don't have it, it's just some quick formula.
So it's not a panic situation if I don't get it ready for you.
By the way, I do have a quiz.
It will open at 5 p.m. tonight and I can't remember when it closes.
It closes tomorrow in the afternoon.
And once we're getting close to when it opens, I'll send you the passcode for it.
It's a pretty straightforward quiz.
It's nothing major, but it'll catch us up to where we were last week in the course
as far as giving you some forewarnings of what the final exam will be like.
But look at the numbers real quick here.
There was a big day tomorrow and then there's some degree of buyer's remorse.
It's not too terrible right now, but it will get quite significant in the one to two year period
because if we do close down the, not the boards, if we do assess tariffs on all our trading partners,
they will reciprocate and this was what happened in 1929, exactly the same thing.
When the Congress and the President at the time blamed the rest of the world for the problems
that were building because of economic policies in the 1920s.
So they shut down the imports with giant tariffs.
The rest of the world retaliated and that act was called the Smoot-Hawley Act of 1929.
And that was what buckled the markets, it snapped.
And that was what caused the crash.
They were building toward a downturn because there was so much underlying rot in the economic system of the 1920s.
But past Smoot-Hawley, everyone retaliated against every, the United States, and we all went into the Great Depression.
So if that happens, we're going to see an awful situation.
And that will be, from my forecasting model, six to eight quarters.
So that'd be about when you're out there getting a job.
So brace yourselves, get ready to get ready for a real hard ride here over the next couple of years.
And of course, Wall Street was all giddy, but at the same time, there are the analysts that I know, they say,
this is going to be a fun ride here.
Now, interestingly enough, crude is concerning me a little bit because there's more rumblings of a more aggressive stance by Israel in the Middle East.
And there is, I got a rumor last night, and I don't know how to take this one,
but apparently there is some talk in Iran of using a nuclear option.
And if that happens, well, the fun begins.
But anyway, oil is on the way up.
That'll probably push gas prices up a little bit, maybe over the next week, two weeks, unless it calms back down.
Gold is having a really hard move upward.
Now, the big thing with gold is there is, I mean, almost anyone I talk to, they say there is a threshold.
There is a neckline we don't want to see with gold.
That is $3,000 an ounce.
Now, we're still $300 away from that, $294 away from that.
However, keep an eye on the price of gold.
That is considered to be the clarion of the four horsemen if it gets to $3,000 an ounce before maybe the spring.
So we're on our way up, but anyway, bond yields have taken a real good tumble.
They're down seven, actually eight basis points now, which is good news, and that is on buying of bonds.
In other words, there is a movement of capital into bonds right now.
Now, it's certainly not a flight to quality, I wouldn't say, because you don't see equity prices going down.
There's buying of equities, but there is a sufficiently strong purchase of bonds to push up the price of bonds,
which drives the yields down.
So if you start to see the yields falling, that means the price of bonds rising,
and concomitantly the prices of stock indices falling, that's the flight to quality.
I don't foresee it happening for a while yet, a true flight to quality, but keep an eye on, stay tuned for some fun.
Now, moving over here to the Nikkei really didn't do anything today.
It just popped at the beginning, and then it dropped, pop and drop, and then it just sort of floated along,
growling and grumbling, and lost down a quarter of a percent, which isn't anything notable.
Now, London, just in the last maybe 15, 20 minutes, has taken a nasty sour turn downward.
Not sure why, I haven't talked to anyone for a while, so I don't know why, but it's taken a turn.
It was just sort of floating and bouncing, and then something started to sell off.
I don't know how bad the sell off is going to be, but it has turned downward,
and it looks like in maybe 15 minutes you've lost a third of a percent.
I don't know if that's just a quick sell off by a couple of big investors or what, I just don't know.
But this is what we do in our business, in finance we're always watching numbers.
That's what we do in our job.
And not just looking at the numbers, but interpreting them, and that's why networking is so important.
I am hopeful that next semester I'll be able to get a couple of speakers,
at least in front of the Illinois State students in finance, some of my former students,
from recently and long ago, to give some insights from the perspective of finance professionals,
which they are. They're in the big towers in Chicago and Manhattan.
I'm trying to think of how I can coordinate a Zoom with all of them there, or at least a series,
so you can hear them, hear how we talk, how we think.
You're seeing it with me, but you'll definitely see it with them if I can get them in.
But they're very excited about meeting you guys, and so we'll try to do that next semester at some point.
Or if you want to, we can just drive up to Chicago, have some Chicago hot dogs,
and go to the financial district, and on the way back stop at Joliet and get some White Castles.
Or not.
Okay, let me take you to this.
Like I said, this is component cost of capital building up to the weighted average cost of capital.
Now, the thing about weighted average cost of capital is that it is not, the arithmetic is pretty straightforward.
However, it is such a tedious exercise that you may recall I built a weighted average cost of capital spreadsheet to do it for us.
Excel works hard so we don't have to.
Now, this is not the one that I give to the 240 students.
This is a little bit souped up with, you see, well, I'll get to that in a minute here.
But the component cost of capital, and I also dig in a little deeper on the components themselves.
So when I say component cost of capital, that means the different sources of capital that a company can bring to bear for its operations.
And those fall into two broad categories.
The debt, and I may be repeating myself here, but I'm going to get a running start.
And the equity.
Now, the debt is simply, well, I shouldn't say simply because the first thing you would think of, what's the debt?
What's the cost of debt?
Well, you'd say the coupon.
Okay, can you be a little clearer on that?
Well, the coupon on the last issue of debt that they've made, because if you've done your seniors, maybe at 5%,
then your senior subordinates are going to have a higher coupon because there's a slightly higher risk default premium in them.
And getting along the way here, eventually you say, okay, so the after-tax cost of debt,
and my notation isn't quite like the books, but the after-tax cost of debt is the before-tax cost of debt times 1 minus the tax rate.
And I did this last time.
I'm just getting a running start here.
I think I did it last time.
Okay, so, but the problem with this is, the problem with this one is that do you use the coupon on the last issue of debt?
The answer is no.
You would never use the coupon.
What you would use is the yield to maturity, because that's what the market's current required rate of return is.
In other words, if you went out there and just issued debt right now,
the YTM of this, of the company's yield to maturity, is the signal of what the market expects the debt to pay.
Okay, so, but it would be the yield to maturity on the last issue of debt, again,
because, and also, that yield to maturity might itself be a little on the low side,
because that's the yield the market expects on what it has already issued.
Now, if it issues more debt before it retires some, then that would mean that the next debt would probably be at a higher rate
than the yield to maturity on its current highest rate debt.
So, this is actually not the best, it's better than anything else you can get.
It's the one we use.
And when you see the weighted average cost of capital spreadsheet,
we see it's just classic calculation of a bond yield, and I put a little panel in there for you to be able to do it.
Now, that is generally how you get the R sub D, and then because interest is tax deductible, you do 1 minus T on it.
This is one of the big reasons why debt is cheaper than equity, because we can, debt is tax deductible.
The other reason debt is cheaper than equity is because it has the prior claim to the cash flows.
Now, interestingly enough, and I think the book brings this up, I'm not sure,
there are actually, in practical terms, there are a couple of other ways, besides getting the YTM, that you can get this.
One is, if you've got a relationship with an investment bank, and you've got contacts there,
you can call them and say, hey, we're not going to do it, but we need to know,
what would you think, estimate, would be the coupon on debt if we were to issue new debt right now?
And there are companies that actually do that, and they say, oh, where are you?
Okay, probably I'm seeing maybe about 5.85% coupon.
They know what they're talking about, so that might, some companies would use that as the R sub D,
and it would be a pretty solid estimate.
Another way to do it, which is kind of dodgy, but it's used, at least for back of the envelope calculations,
is to, what is your debt rating with S&P, Moody's, or Fitch, right now?
What's your, okay, we're AA.
Well, what you would do is look at some very new AA issues, corporate issues that have just come out.
Take their average.
That's a pretty good estimate of what your current cost of debt is, if you're a AA,
if your rating is AA on Standard & Poor's or Moody's or something like that, that's used.
And actually, that one works, and there are even services that are free.
You can see what is the current rate on AA debt or the yield to maturity,
and you can just calculate them up and see what looks like the right one to use for you.
Maybe you see AA debt, the average reported by one of these places, like several places.
I think there's one called bank.com or something like that that issues current rates on all kinds of things.
And you could pull that up and have a look at it, see what the current yield to maturity is on AA, on average.
And that you could use for R sub D as well.
So there are different avenues, and all of them are used to one extent or another out there in the real world.
If you get into this part of finance, you'll find that there's a preferred one in your company to use.
And it's certainly not always finding the yield to maturity on your current debt, on your most riskiest current debt.
But anyway, that's the first one.
Now that's debt.
Now in terms of equity, and again I'm just repeating myself a little bit here too, there is preferred equity.
Preferred equity is super simple, but there are two different parts to it.
Now in FIL 240, I talk about just one part to it.
There is a second part as well.
But basically you start with how to price preferred stock.
The price of preferred stock right now currently is going to be the dividend on the preferred,
excuse me, divided by the price of the preferred, current price of the preferred.
I'm sorry, the rate of return, the required rate of return on preferred.
Sorry about that.
The required rate of return on preferred.
So in other words, well I won't do that, we already did that.
But you can just cross multiply and you can say that the current price,
the current required rate of return on preferred stock is going to be nothing but the dividend
over the current price of the preferred stock.
So in other words, if you have $80 par value preferred,
let me say, let's say 2.00% preferred,
and the current price is $60 on it,
then the required rate of return to the preferred stock would be the dividend 2% times the par value
divided by the current price of $60.
So if you do that, that's what? Point.
Okay, that's $1.60 divided by $60.
Let me hit that real quick here for you.
Oh, I have a calculator right there. Okay, good.
Okay, so I take $1.60 divided by $60,
and I get 2.67% on preferred stock.
Now, interestingly enough, you can see preferred stocks required rate of return
be lower than the after-tax cost of debt.
That's almost a topsy-turvy because that is the safest.
Well, preferred stock tends to be, not always, but quite frequently,
preferred stock is actually cheaper than debt,
and that's one of those mysteries,
why do companies no longer use preferred stock as a means of raising capital?
It's just the way it is.
There are two schools of thought on this.
One I've told you before is preferred stock is forever.
You're stuck with a dividend.
You get no choice.
You pay the dividend, or two things could happen.
One is, if you don't pay the preferred dividend, you can't pay a common dividend,
and that's going to piss off your common shareholders.
There's another thing that can happen, and I recall a couple of examples of this.
A company had preferred stock.
It didn't pay the dividend for like three, four, five years,
and it didn't pay, of course, its common shareholders either,
but the preferred shareholders, they started selling off their preferred
and acquiring common stock, and they then got together with the other common stockholders,
and they threw out the board of directors.
Essentially, it was an owner's takeover of the corporation.
So you don't want to honk off your preferred shareholders.
So that's another reason why companies don't push out preferred stock anymore,
because you have a dividend forever.
It's a perpetuity, and if you don't pay it, well, they can't sue you or anything,
but they could turn on you and get together with the common shareholders
and kick the board of directors out.
So those two things deter preferred stock as a means of raising capital these days.
Now, I want to take you to another little aspect of this,
and this is an odd thing.
I have a written example here.
Okay.
It's called the exclusion.
You see, a corporate buyer, now corporations are big investors in stocks that pay dividends,
and they buy common stock.
They buy preferred stock.
Now, if you're a corporate investor, you get an exclusion on preferred of 50%.
It's not taxed.
So in other words, and the other part is taxed at the corporate tax rate.
So in this case, the required preferred stock dividend after tax and exclusion
is going to be the, before all of this, the R sub PS minus the R sub PS times 1 minus the exclusion
times the tax rate.
It's a tax shield like that, not to the company that's issuing the preferred,
but to investors who invest in it.
So, and by the way, the exclusion, we can put here that it is 50%,.50.
Now, I wouldn't hold you to this on a quiz or an exam, but it is out there,
and how much you should pay attention to it, you pay attention to it only if you are the investor,
not the company itself, realistically.
I don't think I've ever seen a company actually calculate this for its own purposes,
but it might, you know, a corporation is considering, you know, we've got extra retained earnings,
let's buy some stock of some companies.
That is why they're going to consider that to be kind of an attractive thing,
because then they can gobble up some of that preferred stock that's out there floating around.
They get half of it is not taxed, so that saves, that's why it's minus the tax rate times half of your holding.
And again, I won't ask you about this part of it, but it is out there.
It's something that if you get into the corporate, if you're a corporate, not an investment,
but if you're corporate, this is something that you might want to keep an eye on.
And that's kind of interesting too, because corporate holders of debt and equity,
in other words, they invest in debt, they invest in equity,
they are great because they've got all this capital, they can buy stock, buy your debt and all this.
The downside is that they have teeth that a normal investor, an individual or something like that doesn't have,
because they, if you don't pay that preferred dividend, well, wow, who cares?
It's not required to pay a dividend, it's common, or to prefer.
But if you don't, they, a corporate investor, is going to be knocking on your door with all kinds of tools to use on you.
So it's a great thing on one side, yeah, we've got this whole investment community called corporations,
flush with funds to buy our stock and all this, but the downside of it is,
they're not exactly the most pleasant people to work with if you screw the pooch in your operations in your company,
and you don't have earnings to pay your dividends.
So anyway, I put that up there just as a side note.
Now the next thing is that we go to equity.
The other side of equity is we have, we distinguish between internally generated equity,
that's your retained earnings, cost of, that's your existing common shareholders,
and then you have your externally generated equity.
That would be if you sell stock to new investors.
Internally generated equity is that making money, bringing funds in the old fashioned way,
you actually sell a product or a service.
It is your retained earnings.
As you build up, you've got your net income, and then into retained earnings that are already there,
you add that net income minus your dividends.
Think about it from the perspective of your owners, your shareholders.
If you don't pay them a dividend, you put it into the retained earnings.
Well, that is going to grow the corporation,
but it also represents an opportunity cost to your owners, your shareholders.
So every penny that you put back into the company is a penny that the owners don't have for their own purposes.
What are their own purposes?
They could invest in something else.
They could invest those dividends somewhere else.
Or they could just buy themselves a Grand Slam breakfast at Denny's.
Whatever it is, they don't have it.
That's why retained earnings are a cost.
They are in fact an opportunity cost to your owners, to the shareholders.
So there is an internal cost of capital, R sub S.
And then there is another cost of capital for new shareholders.
Now, they are going to be more expensive than your existing shareholders simply because you have to bring them in.
You have to find that therein lies a direct cost and an opportunity cost.
You go to an investment banker.
You've got a stock that is running at, let's say, $40 a share.
Investment bankers are going to say, yeah, we'll bring it in.
We'll sell your new stock.
But they are going to keep some of that.
So you are on the hook for $40 a share for those new shareholders when in fact all you got was, let's say, $37, $36.
Because investment bankers are going to say, well, we've got our brokerage fees.
We've got our to-do-this offering.
We've got our accountants, our lawyers, our consultants.
So they are going to whack you for some of that money.
That's why the new shareholders, the cost of new equity is higher than the cost of existing equity.
Now, what are we talking about in terms of how much more expensive?
Sometimes it's not much.
You might have existing shareholders cost you 12%.
Your new shareholders cost you 12.87%.
It could, however, be more dramatic than that.
Especially, okay, a couple of situations where it could happen.
One is if you are, if it's the very, it's your IPO, okay, they are going to beat the hell out of you.
They are going to bleed you.
It's always a question, why in the hell does any company go public with the costs, the fees that the I.B.'s charge to do it?
It's just madness.
There's also another side to it too.
Well, there's two other sides.
One other side is that oftentimes getting the attention of one of those transnational ginormous I.B.'s is even just getting their attention.
They are going to say, nah, like that.
So you're going to end up with a regional, a regional I.B.
Now, there's nothing wrong with them.
They just are second tier.
And so in that regard, a second tier is probably going to cost you more than a first tier would.
Because a first tier has the infrastructure to do whatever it wants.
It could do an IPO for God.
A regional is not quite as powerful.
So it's going to cost you more because it's going to cost them more because they don't have that infrastructure to do it the way a giant I.B. would.
It's kind of back and forth.
Now there's another one.
In my side, end of the business, finding any I.B. that would do an IPO for a small company was a joke.
It was a laugh.
Blah, no.
And I mean, some of these were actually pretty reputable operations.
But trying to do, these were private companies.
They wanted to go public.
And like hell, anyone was going to do an IPO for them.
So what we had to do, there was, we did what was called a Western style offering.
That was one.
Another term for it is a best efforts.
You find a low end I.B. and they'll say, okay, we will try to sell this issue.
No guarantee, but you'll have our traders, our facilities will try to do it.
That's called a Western style offering.
As opposed to Eastern, which is the I.B., the real ones that do firm underwritings.
So I did a couple of Western styles out of maybe about half a dozen, two subscribed, fully subscribed.
The others fizzled out.
But it was all I could do at that time or any time really.
Okay, now there's another one that is really risky.
It's called a self offering.
Where the company people themselves try to sell the new issue.
And some states over the years, since I got out of consulting, have banned self offerings.
They've just banned them.
And of those that I did that were self offerings, in two rather dramatic cases, it was they violated law when they did them.
They sold them in an incorrect manner or something like that.
And especially the state regulators were watching like a hawk to see if the company would make a mistake.
And then nail them to the wall, seize all their stuff, and then put them out of business.
In one case, I had a company that did a self offering.
And it was an impressive technology.
This was the 90s. And they had a machine.
They had developed a technology so that a computer that was, I'll give you an example, a computer that was used by, was in a police car.
There was a computer, this contraption, and a printer.
And they could have a judge remotely sign a warrant, a search warrant.
And he'd sign it, and this pen would replicate his signature on a warrant that was printed out on this printer.
Now I'm sure that can be done very easily, but at the time it was holy cow.
And in fact, two states had authorized this as valid signature by a judge for a warrant.
Well, that state they were in, I'll be damned if those guys were not the state regulator.
There was one ambitious son of a bitch.
And he casually said, could we talk for a while? I want to find out all about this. This is cool.
And these guys had no idea what he was doing.
He asked them questions, and one of the questions he said was, are you going to use any of the proceeds of this offering to give yourselves money?
And one of the guys said, well, we've got to eat. Yeah. That was enough.
Operation was shut down. They were charged, convicted, and sent to prison.
And the technology disappeared into the ether.
Of course it didn't, but that was what it was.
The regulator who pulled this off got a feather in his cap.
Those guys were destroyed, ruined for life, and all that.
So you don't want to do a self-offering. Don't do it.
No matter how much, yeah, I'm going to sell some stock. I've got a company. Would you like to buy some stock?
Don't. For God's sake.
Anyway, internally generated equity.
There are a couple of different ways that you can do it.
One way is to use the dividend growth model.
You remember that the price of common stock would be the dividend in period one over R minus R, the required rate of return of the stock, minus G.
Well, you can cross-multiply that one and get the cost of internally generated equity retained earnings would be the dividend at period one,
which is dividend now times one minus G, one plus G, over the price of the stock right now plus G.
That's called the dividend growth model approach.
It's the most common one.
And don't sweat it. If you have to do this, it's not hard. It's just arithmetic mostly.
But it's also, if you're doing the weighted average cost of capital, I've got it baked in there.
It'll calculate it for you along the way.
Okay, now there are a couple of other ways here to do it.
Let me erase this.
So cost of retained earnings, I'll put it over here.
The first way is the cost of retained earnings is, like I said, the dividend one period out divided by the current price of the common stock plus the growth rate.
And the dividend in period one is the dividend that has just been issued, grown one period.
The only place that's really, this is best if the company is stable, it has a stable growth rate of its dividends.
Every company tries to get there, but some companies aren't there yet, but there it is.
Now I'm going to put a side note here.
Growth rate.
Two ways that you could look at growth rate.
What's the growth rate?
Well, you could say the dividends from year to year, you know, just take dividends now divided by the dividends a year earlier, minus one.
You can get a growth rate that way.
There's another way.
One minus the dividend ratio.
In other words, this is the plow back ratio times your return on equity.
That's a way that you can get the growth rate of dividends as well.
You can calculate that way.
I'm going to tell you right now, the book shows us, says, yeah, this is good.
In practice, this gives you really wonky growth rates, really wonky.
You get growth rates of 16, 18 percent.
No, it can't be that high.
It'd be better to just pull a growth rate out of your butt than to do that.
But it's in the book and it's part of knowing the things that you should know to be a finance major.
That, yes, you can theoretically calculate a growth rate by taking the plow back amount, one minus the dividend ratio, times the return on equity.
So, for example, if I had, let's say that the company, the dividend ratio of the company.
In other words, dividend divided by dividend ration.
In other words, the dividend amount divided by the net earnings, let's say that that comes out to be.60.
In other words, 60 percent of income is given back to the shareholders.
That means that 40 percent is retained by the company.
So, in this case, you would take, let's say that the ROE, the return on equity of this company, is a respectable 18 percent.
So, the growth rate by this model, and you're going to see why I tell you that it gives wonky results.
You do this one and you're going to get, okay, one minus.6 is.4 times.18.
Seven point two percent growth rate. That's pretty darn high.
So, yeah, it might be, a company might have a growth rate of dividends of seven point two percent.
But I really have not ever seen a company have dividends grow at seven point two percent on a sustained basis.
So, even though this is there, the book promotes it, says here's a great idea for defining growth rate.
Don't do that.
The best way to do it is just to look at the pattern of growth of dividends over a period of years.
So, for example, suppose that I see a company, its dividends, it started out with a two dollar dividend.
Then the next year it had a two dollar and three cent dividend.
Then a year later it had a two dollar and seven cent dividend.
Okay, so the growth rate here is two point oh three over two point oh oh minus one.
The dividend here was two point zero seven over two point oh three minus one.
You take the average of those two. Those are both growth rates.
You take the average growth rate over the last three years or five years, whatever you want.
That's a cleaner way to do it.
And the results will be more real because it's actually based on the historic pattern of dividends in a case like that.
Okay, now, moving on from that, the next way that you can get the cost of retained earnings is like this.
There's the dividend growth model, that one.
Then you could just use cap M.
Remember, R sub S plus beta of the stock times the expected return to the market minus the risk free rate.
In other words, this thing right in here, that's called the risk premium.
That's a way you can do it too.
Couple of things about this, a warning.
Couple of warnings.
First of all, the beta.
Well, what happens if your company doesn't have a beta?
Well, you get companies that are comparable to it, comps, and you take the average of their betas,
public companies, and then you just take the average of their betas if you don't have a beta of your own.
There's another thing about this application of the cap M.
The R sub F.
Now, you would hear me normally say use a one year T bill yield.
We looked at that chart.
As a matter of fact, let me pull that up right now.
Pull up an instance of Firefox here.
We're going to go to Google here.
Really? I don't want to do that. Come on.
Go to Google here and Google.com.
Pull it up and you have your, now I usually just do a search, Treasury.
Treasure Island yield curve, yield curve, and I go to the horse's mouth.
Okay.
Now, if we look here, what I would do is, oh no, whoa, that's definitely not what I want to see.
Let's go the current month.
Okay. Well, that's okay.
Now, I would probably look at a one year T bill.
What?
Whoa, that can't be right.
That cannot be right.
Wait, let me see that. Those rates can't be right.
Par value, Treasury bill, right.
For the current month.
What is it?
It says for the current month. Let's try this.
I saw that and I thought, no.
Say that again.
Oh, okay, apply. I always forget that.
Now, I want to go back to the par value yield curve and apply.
Yeah.
I am sorry.
I gave myself a heart attack there doing that.
Now, let's go down here.
You would look at the one year.
That's how you use CAPM.
For the R sub F, you use the one year, and right now, as you can see, it stands at, if I can get down here, about 4.31%.
That's what you would use for R sub F.
And then expect your return to the market.
You just go with one of those services that gives a forecast for the next year for the market.
However, if you're using this for equity, CAPM to get your required rate of return, you use the consensus now is to use at least a seven year yield.
The yield on the seven year.
This guy here.
And if possible, and some say, use the 10 or the 20.
Now, I'll take the middle road here for seven years.
Here's the logic.
Stock is a long term thing.
I mean, it's forever in a way.
And you are using equity to invest.
Now, let's say you've got a project. A project would surely have a life more than a year.
Four, five, seven, ten, twenty years.
It's certainly not going to be comparable to yields on a one year treasury.
So a balance, the seven year is popular because it's a balance between shorter projects, three, four year and longer projects, ten, fifteen, twenty.
So that's the one that is I have heard from others.
They saw me using a one year, some years back, and they said, you don't use that.
You use a seven year.
And I heard seven year repeatedly.
So whatever you want to use, but it's certainly not going to be a one year.
Now, in the normal use of CAPM, you use a one year.
But in this, you're dealing with long term funds, but capital budgeting.
So you would want to use a long term R sub F. Ouch, I almost heard something I care about.
Okay.
There's that.
Okay.
That's the CAPM.
Now, there's one other one, and I can't even remember what the book uses for the term for it.
But it's normally called bond yield plus equity premium, the EP.
In other words, the equity premium is the, in general, is the cost of equity minus the cost of debt.
So let's, in your industry, in your industry, let's say that the average cost of equity is 14% in your industry.
And the average cost of debt in your industry is, let's say, 8%.
Then the equity premium would be 14% less 8%, or 6%.
Now, you take that and you say, okay, our cost of debt right now is 10%.
So in other words, our cost of equity would be 10% plus the industry average equity premium of 6%, which comes out to be 16%.
There's your little box right there.
It's cost of debt plus an equity premium.
So in other words, you get the equity premium from your industry numbers, and then you apply that equity premium to your own cost of debt.
And that should give you a decent shot.
Now, which one do you use?
You use all of them if you can.
And then you take the average of them.
Or you at least use two of them and take the average of the two.
And that's very popular.
This is not as exact a science as I might try to promote it as.
But this gets you pretty darn close to much, much more complex mathematical models that you wouldn't even see until you got to the Ph.D. level.
I don't even show the more complex ones at the MBA level.
These are the things that are used in the corporate anyway.
Now, cost of new.
The cost of new equity, we applied this one.
And the cost of new equity is nothing but the dividend in period one over the current price of your common stock minus a float plus G.
That float is how much the brokers are going to take from you.
It can be expressed as a dollar amount or percent.
So in other words, I could say, okay, the current price of my stock is $40.
The investment bankers have given me a float and you usually use a small F if it's a percentage of 6%.
So in other words, you would take $40 times 1 minus 6% for it.
That's about how you do it.
Now, for my purposes in doing this with you, I would not ask you for new.
Because we are driving toward the all famous weighted average cost of capital.
And some of this I know I've repeated, but it's important enough to make sure that you've got it baked in your mind.
And it's simply like this.
The weighted average cost of capital is the weight of debt in your capital structure times the after-tax cost of debt
plus the weight of equity in your capital structure times the cost of equity.
Doesn't look too bad yet, but let me tell you, it is a tedious arithmetic exercise.
So put expanding this for the different types of equity.
The weight of equity is the weight of preferred in your capital structure times the cost of preferred stock
plus the weight of existing retained earnings times the cost of those retained earnings
plus the weight of new common stock times the cost of new common stock.
Now, I'm not going to worry about this one. I won't test you on that one. It makes it really complicated.
MBA level complicated. For our purposes here, we have enough fun to work with.
The problem is this. These weights here, they have to be market weights, the current market weight of your debt,
the current market weight of your preferred, the current market weight of your common stock.
And that's where it can get hairy because you have to find their prices.
And here's what we do.
We go to Canvas, which I showed done anyway.
We go to Canvas and you go into your files folder.
Now, like I said, if you were my student for 240, oops, go to your spreadsheets.
And then there was you had a version of this. This one is a little more sophisticated, a little more.
And mainly this.
Okay, leave student view. Let me get this out of the way. Edit.
And let me take this down a few notches so you can see the whole thing.
Now, I've got this is a template and you can follow through.
And if you put the numbers from the narrative in the right places, it will spit out your whack.
The difference between this one and the one in 240 is that in this one, a company could put target weights.
In other words, it could define its capital structure, find its optimal capital structure,
and then see what its existing whack is compared to what it wants as its target capital structure.
So this panel you wouldn't have.
Now, normally what we'll do is we'll just push it out.
You've got to just put the numbers in the right places and it will do all of those little arithmetic things that I just showed you.
One after the other. So we've got SPK Corporation, 22 million shares, that common stock. That goes there.
Well, its market price, currently priced at $34 a share. That goes there.
Just pay the dividend, that's D0, of $1.80, that goes there. And it's expected to grow at 2% there.
That's the D1 over the P0. And then you work your way along here and it's got some preferred stock.
120,000 shares goes there. And it is 1.5% preferred, that's the dividend there.
The current market price, which is how you calculate the dividends of $85 a share, goes there.
I'm sorry, the par value goes there. And then the current market price of $63 goes there.
And then we need to get the yield to maturity. So we can get the cost of debt, after-tax cost of debt.
Well, that, we've got $12 million, that's the face value of the bonds.
Now, right now, those 12 million are 4.25% coupon. They're due in 2031, so that's seven years to maturity, the term.
And on the 100, they're $102.40.
You notice that it's a $12 million issue. If its market price right now is $102.40 on the 100,
then its market value is $12,288,000. It calculates all of that automatically for you.
And if you don't remember, do not touch anything that is peach or blue.
Why don't you want to touch that? Because you'll die. Or something like that.
Just put the stupid numbers in. And it will calculate, look at this, the cost of the debt, there it is.
The cost of the equity, well, it has 22 million shares, and each one of them is $34 a share.
So that's that $752. The preferred stock, you have 120,000 shares of it, and its market price right now is $63 a share.
There's that one. And then the weighted average cost of capital, it calculates each of these,
that particular component's market value divided by the total market value.
And it will just calculate all the market weights, they'll add up to 100%, and then it will take each of these,
the cost of debt, the weight of debt, times the after-tax cost of debt, the weight of equity,
times the after-tax cost of equity, plus the weight of preferred stock, times the cost of preferred stock,
and then the weight of equity, times the cost of common equity.
And that will give you your weighted average cost of capital. This is the market weighted average cost of capital.
Now over here, you could put in target weights. You want to make sure they add up to 100%.
In other words, the company wants to make its capital structure, in my case there, 25% debt, 5% preferred, and 70% equity.
And you can recalculate. As you see in this example, it's at the victim of the market right now.
The market prices are driving its whack. That means that the company is in a position where it's going to be hard to,
but it is going to have to wrestle down its weight, it's going to push up its weight of debt.
Notice right now, the weight of debt is only about 1.6%.
This is saying that we have to up the weight of debt in the capital structure.
And at the same time, their 97% equity, they have to reduce their reliance on expensive equity down to 70% from where it is now.
They also have to up this cheapo preferred stock. See how cheap preferred stock is?
And notice the preferred is actually a little cheaper than the after-tax cost of debt.
But if they can accomplish that, they can bring down their weighted average cost of capital.
That, ladies and gentlemen, is how you do this. Don't try to do it, well you can try to do it on your own,
but if you play with these numbers a little bit, it's actually just pulling the numbers out of the different places in the narrative up there
and putting them in the right place. Just don't touch anything that is in that orangish peach color or the blue,
and you'll look like a hero finding weighted average cost of capital.
But if you do it on your own, plan to have some snacks with you and plan to have a pillow near you so that you can take naps through the night as you do it.
And I encourage you on the next quiz, not this one you're going to take tonight, but on the next one and on the final exam,
this is one of your templates you definitely want to have up and ready to go, because this will save your bacon on this one.
That's all I have for you, I thank you.