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Alan Cring Productions in association with the Emergent Light Studio presents

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the Illinois State Collegiate Compendium, academic lectures in business and economics.

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This is business finance, FIL 341 for Autumn Semester 2024.

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Today, the weighted average cost of cap and this has to do with the component cost of capital.

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Now you did this in FIL 240.

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The version this time is very similar, but I dig in a little deeper and I do have an Excel spreadsheet

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to do the unholy thing of getting a weighted average cost of capital.

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I'm also, and I just thought about this, I'm trying to get finished fairly quickly.

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A nice little Excel template in finding the actual component cost of capital.

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It's pretty easy to put it together and if you don't have it, it's just some quick formula.

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So it's not a panic situation if I don't get it ready for you.

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By the way, I do have a quiz.

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It will open at 5 p.m. tonight and I can't remember when it closes.

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It closes tomorrow in the afternoon.

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And once we're getting close to when it opens, I'll send you the passcode for it.

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It's a pretty straightforward quiz.

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It's nothing major, but it'll catch us up to where we were last week in the course

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as far as giving you some forewarnings of what the final exam will be like.

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But look at the numbers real quick here.

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There was a big day tomorrow and then there's some degree of buyer's remorse.

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It's not too terrible right now, but it will get quite significant in the one to two year period

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because if we do close down the, not the boards, if we do assess tariffs on all our trading partners,

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they will reciprocate and this was what happened in 1929, exactly the same thing.

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When the Congress and the President at the time blamed the rest of the world for the problems

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that were building because of economic policies in the 1920s.

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So they shut down the imports with giant tariffs.

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The rest of the world retaliated and that act was called the Smoot-Hawley Act of 1929.

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And that was what buckled the markets, it snapped.

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And that was what caused the crash.

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They were building toward a downturn because there was so much underlying rot in the economic system of the 1920s.

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But past Smoot-Hawley, everyone retaliated against every, the United States, and we all went into the Great Depression.

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So if that happens, we're going to see an awful situation.

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And that will be, from my forecasting model, six to eight quarters.

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So that'd be about when you're out there getting a job.

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So brace yourselves, get ready to get ready for a real hard ride here over the next couple of years.

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And of course, Wall Street was all giddy, but at the same time, there are the analysts that I know, they say,

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this is going to be a fun ride here.

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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.

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And there is, I got a rumor last night, and I don't know how to take this one,

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but apparently there is some talk in Iran of using a nuclear option.

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And if that happens, well, the fun begins.

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But anyway, oil is on the way up.

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That'll probably push gas prices up a little bit, maybe over the next week, two weeks, unless it calms back down.

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Gold is having a really hard move upward.

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Now, the big thing with gold is there is, I mean, almost anyone I talk to, they say there is a threshold.

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There is a neckline we don't want to see with gold.

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That is $3,000 an ounce.

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Now, we're still $300 away from that, $294 away from that.

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However, keep an eye on the price of gold.

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That is considered to be the clarion of the four horsemen if it gets to $3,000 an ounce before maybe the spring.

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So we're on our way up, but anyway, bond yields have taken a real good tumble.

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They're down seven, actually eight basis points now, which is good news, and that is on buying of bonds.

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In other words, there is a movement of capital into bonds right now.

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Now, it's certainly not a flight to quality, I wouldn't say, because you don't see equity prices going down.

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There's buying of equities, but there is a sufficiently strong purchase of bonds to push up the price of bonds,

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which drives the yields down.

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So if you start to see the yields falling, that means the price of bonds rising,

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and concomitantly the prices of stock indices falling, that's the flight to quality.

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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.

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Now, moving over here to the Nikkei really didn't do anything today.

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It just popped at the beginning, and then it dropped, pop and drop, and then it just sort of floated along,

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growling and grumbling, and lost down a quarter of a percent, which isn't anything notable.

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Now, London, just in the last maybe 15, 20 minutes, has taken a nasty sour turn downward.

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Not sure why, I haven't talked to anyone for a while, so I don't know why, but it's taken a turn.

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It was just sort of floating and bouncing, and then something started to sell off.

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I don't know how bad the sell off is going to be, but it has turned downward,

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and it looks like in maybe 15 minutes you've lost a third of a percent.

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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.

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But this is what we do in our business, in finance we're always watching numbers.

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That's what we do in our job.

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And not just looking at the numbers, but interpreting them, and that's why networking is so important.

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I am hopeful that next semester I'll be able to get a couple of speakers,

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at least in front of the Illinois State students in finance, some of my former students,

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from recently and long ago, to give some insights from the perspective of finance professionals,

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which they are. They're in the big towers in Chicago and Manhattan.

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I'm trying to think of how I can coordinate a Zoom with all of them there, or at least a series,

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so you can hear them, hear how we talk, how we think.

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You're seeing it with me, but you'll definitely see it with them if I can get them in.

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But they're very excited about meeting you guys, and so we'll try to do that next semester at some point.

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Or if you want to, we can just drive up to Chicago, have some Chicago hot dogs,

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and go to the financial district, and on the way back stop at Joliet and get some White Castles.

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Or not.

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Okay, let me take you to this.

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Like I said, this is component cost of capital building up to the weighted average cost of capital.

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Now, the thing about weighted average cost of capital is that it is not, the arithmetic is pretty straightforward.

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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.

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Excel works hard so we don't have to.

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Now, this is not the one that I give to the 240 students.

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This is a little bit souped up with, you see, well, I'll get to that in a minute here.

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But the component cost of capital, and I also dig in a little deeper on the components themselves.

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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.

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And those fall into two broad categories.

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The debt, and I may be repeating myself here, but I'm going to get a running start.

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And the equity.

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Now, the debt is simply, well, I shouldn't say simply because the first thing you would think of, what's the debt?

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What's the cost of debt?

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Well, you'd say the coupon.

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Okay, can you be a little clearer on that?

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Well, the coupon on the last issue of debt that they've made, because if you've done your seniors, maybe at 5%,

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then your senior subordinates are going to have a higher coupon because there's a slightly higher risk default premium in them.

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And getting along the way here, eventually you say, okay, so the after-tax cost of debt,

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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.

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And I did this last time.

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I'm just getting a running start here.

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I think I did it last time.

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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?

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The answer is no.

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You would never use the coupon.

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What you would use is the yield to maturity, because that's what the market's current required rate of return is.

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In other words, if you went out there and just issued debt right now,

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the YTM of this, of the company's yield to maturity, is the signal of what the market expects the debt to pay.

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Okay, so, but it would be the yield to maturity on the last issue of debt, again,

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because, and also, that yield to maturity might itself be a little on the low side,

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because that's the yield the market expects on what it has already issued.

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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

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than the yield to maturity on its current highest rate debt.

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So, this is actually not the best, it's better than anything else you can get.

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It's the one we use.

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And when you see the weighted average cost of capital spreadsheet,

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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.

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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.

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This is one of the big reasons why debt is cheaper than equity, because we can, debt is tax deductible.

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The other reason debt is cheaper than equity is because it has the prior claim to the cash flows.

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Now, interestingly enough, and I think the book brings this up, I'm not sure,

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there are actually, in practical terms, there are a couple of other ways, besides getting the YTM, that you can get this.

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One is, if you've got a relationship with an investment bank, and you've got contacts there,

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you can call them and say, hey, we're not going to do it, but we need to know,

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what would you think, estimate, would be the coupon on debt if we were to issue new debt right now?

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And there are companies that actually do that, and they say, oh, where are you?

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Okay, probably I'm seeing maybe about 5.85% coupon.

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They know what they're talking about, so that might, some companies would use that as the R sub D,

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and it would be a pretty solid estimate.

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Another way to do it, which is kind of dodgy, but it's used, at least for back of the envelope calculations,

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is to, what is your debt rating with S&P, Moody's, or Fitch, right now?

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What's your, okay, we're AA.

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Well, what you would do is look at some very new AA issues, corporate issues that have just come out.

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Take their average.

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That's a pretty good estimate of what your current cost of debt is, if you're a AA,

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if your rating is AA on Standard & Poor's or Moody's or something like that, that's used.

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And actually, that one works, and there are even services that are free.

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You can see what is the current rate on AA debt or the yield to maturity,

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and you can just calculate them up and see what looks like the right one to use for you.

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Maybe you see AA debt, the average reported by one of these places, like several places.

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I think there's one called bank.com or something like that that issues current rates on all kinds of things.

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And you could pull that up and have a look at it, see what the current yield to maturity is on AA, on average.

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And that you could use for R sub D as well.

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So there are different avenues, and all of them are used to one extent or another out there in the real world.

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If you get into this part of finance, you'll find that there's a preferred one in your company to use.

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And it's certainly not always finding the yield to maturity on your current debt, on your most riskiest current debt.

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But anyway, that's the first one.

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Now that's debt.

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Now in terms of equity, and again I'm just repeating myself a little bit here too, there is preferred equity.

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Preferred equity is super simple, but there are two different parts to it.

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Now in FIL 240, I talk about just one part to it.

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There is a second part as well.

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But basically you start with how to price preferred stock.

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The price of preferred stock right now currently is going to be the dividend on the preferred,

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excuse me, divided by the price of the preferred, current price of the preferred.

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I'm sorry, the rate of return, the required rate of return on preferred.

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Sorry about that.

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The required rate of return on preferred.

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So in other words, well I won't do that, we already did that.

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But you can just cross multiply and you can say that the current price,

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the current required rate of return on preferred stock is going to be nothing but the dividend

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over the current price of the preferred stock.

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So in other words, if you have $80 par value preferred,

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let me say, let's say 2.00% preferred,

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and the current price is $60 on it,

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then the required rate of return to the preferred stock would be the dividend 2% times the par value

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divided by the current price of $60.

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So if you do that, that's what? Point.

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Okay, that's $1.60 divided by $60.

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Let me hit that real quick here for you.

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Oh, I have a calculator right there. Okay, good.

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Okay, so I take $1.60 divided by $60,

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and I get 2.67% on preferred stock.

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Now, interestingly enough, you can see preferred stocks required rate of return

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be lower than the after-tax cost of debt.

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That's almost a topsy-turvy because that is the safest.

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Well, preferred stock tends to be, not always, but quite frequently,

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preferred stock is actually cheaper than debt,

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and that's one of those mysteries,

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why do companies no longer use preferred stock as a means of raising capital?

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It's just the way it is.

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There are two schools of thought on this.

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One I've told you before is preferred stock is forever.

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You're stuck with a dividend.

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You get no choice.

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You pay the dividend, or two things could happen.

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One is, if you don't pay the preferred dividend, you can't pay a common dividend,

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and that's going to piss off your common shareholders.

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There's another thing that can happen, and I recall a couple of examples of this.

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A company had preferred stock.

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It didn't pay the dividend for like three, four, five years,

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and it didn't pay, of course, its common shareholders either,

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but the preferred shareholders, they started selling off their preferred

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and acquiring common stock, and they then got together with the other common stockholders,

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and they threw out the board of directors.

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Essentially, it was an owner's takeover of the corporation.

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So you don't want to honk off your preferred shareholders.

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So that's another reason why companies don't push out preferred stock anymore,

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because you have a dividend forever.

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It's a perpetuity, and if you don't pay it, well, they can't sue you or anything,

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but they could turn on you and get together with the common shareholders

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and kick the board of directors out.

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So those two things deter preferred stock as a means of raising capital these days.

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Now, I want to take you to another little aspect of this,

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and this is an odd thing.

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I have a written example here.

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Okay.

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It's called the exclusion.

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You see, a corporate buyer, now corporations are big investors in stocks that pay dividends,

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and they buy common stock.

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They buy preferred stock.

215
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Now, if you're a corporate investor, you get an exclusion on preferred of 50%.

216
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It's not taxed.

217
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So in other words, and the other part is taxed at the corporate tax rate.

218
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So in this case, the required preferred stock dividend after tax and exclusion

219
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is going to be the, before all of this, the R sub PS minus the R sub PS times 1 minus the exclusion

220
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times the tax rate.

221
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It's a tax shield like that, not to the company that's issuing the preferred,

222
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but to investors who invest in it.

223
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So, and by the way, the exclusion, we can put here that it is 50%,.50.

224
00:23:02,000 --> 00:23:07,000
Now, I wouldn't hold you to this on a quiz or an exam, but it is out there,

225
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and how much you should pay attention to it, you pay attention to it only if you are the investor,

226
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not the company itself, realistically.

227
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I don't think I've ever seen a company actually calculate this for its own purposes,

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but it might, you know, a corporation is considering, you know, we've got extra retained earnings,

229
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let's buy some stock of some companies.

230
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That is why they're going to consider that to be kind of an attractive thing,

231
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because then they can gobble up some of that preferred stock that's out there floating around.

232
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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.

233
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And again, I won't ask you about this part of it, but it is out there.

234
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It's something that if you get into the corporate, if you're a corporate, not an investment,

235
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but if you're corporate, this is something that you might want to keep an eye on.

236
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And that's kind of interesting too, because corporate holders of debt and equity,

237
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in other words, they invest in debt, they invest in equity,

238
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they are great because they've got all this capital, they can buy stock, buy your debt and all this.

239
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The downside is that they have teeth that a normal investor, an individual or something like that doesn't have,

240
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because they, if you don't pay that preferred dividend, well, wow, who cares?

241
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It's not required to pay a dividend, it's common, or to prefer.

242
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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.

243
00:25:04,000 --> 00:25:10,000
So it's a great thing on one side, yeah, we've got this whole investment community called corporations,

244
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flush with funds to buy our stock and all this, but the downside of it is,

245
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they're not exactly the most pleasant people to work with if you screw the pooch in your operations in your company,

246
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and you don't have earnings to pay your dividends.

247
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So anyway, I put that up there just as a side note.

248
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Now the next thing is that we go to equity.

249
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The other side of equity is we have, we distinguish between internally generated equity,

250
00:25:54,000 --> 00:26:02,000
that's your retained earnings, cost of, that's your existing common shareholders,

251
00:26:02,000 --> 00:26:06,000
and then you have your externally generated equity.

252
00:26:06,000 --> 00:26:21,000
That would be if you sell stock to new investors.

253
00:26:21,000 --> 00:26:29,000
Internally generated equity is that making money, bringing funds in the old fashioned way,

254
00:26:29,000 --> 00:26:32,000
you actually sell a product or a service.

255
00:26:32,000 --> 00:26:36,000
It is your retained earnings.

256
00:26:36,000 --> 00:26:44,000
As you build up, you've got your net income, and then into retained earnings that are already there,

257
00:26:44,000 --> 00:26:51,000
you add that net income minus your dividends.

258
00:26:51,000 --> 00:26:59,000
Think about it from the perspective of your owners, your shareholders.

259
00:26:59,000 --> 00:27:05,000
If you don't pay them a dividend, you put it into the retained earnings.

260
00:27:05,000 --> 00:27:08,000
Well, that is going to grow the corporation,

261
00:27:08,000 --> 00:27:16,000
but it also represents an opportunity cost to your owners, your shareholders.

262
00:27:16,000 --> 00:27:26,000
So every penny that you put back into the company is a penny that the owners don't have for their own purposes.

263
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What are their own purposes?

264
00:27:28,000 --> 00:27:30,000
They could invest in something else.

265
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They could invest those dividends somewhere else.

266
00:27:32,000 --> 00:27:37,000
Or they could just buy themselves a Grand Slam breakfast at Denny's.

267
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Whatever it is, they don't have it.

268
00:27:40,000 --> 00:27:44,000
That's why retained earnings are a cost.

269
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They are in fact an opportunity cost to your owners, to the shareholders.

270
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So there is an internal cost of capital, R sub S.

271
00:27:58,000 --> 00:28:04,000
And then there is another cost of capital for new shareholders.

272
00:28:04,000 --> 00:28:12,000
Now, they are going to be more expensive than your existing shareholders simply because you have to bring them in.

273
00:28:12,000 --> 00:28:18,000
You have to find that therein lies a direct cost and an opportunity cost.

274
00:28:18,000 --> 00:28:20,000
You go to an investment banker.

275
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You've got a stock that is running at, let's say, $40 a share.

276
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Investment bankers are going to say, yeah, we'll bring it in.

277
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We'll sell your new stock.

278
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But they are going to keep some of that.

279
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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.

280
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Because investment bankers are going to say, well, we've got our brokerage fees.

281
00:28:45,000 --> 00:28:47,000
We've got our to-do-this offering.

282
00:28:47,000 --> 00:28:51,000
We've got our accountants, our lawyers, our consultants.

283
00:28:51,000 --> 00:28:54,000
So they are going to whack you for some of that money.

284
00:28:54,000 --> 00:29:03,000
That's why the new shareholders, the cost of new equity is higher than the cost of existing equity.

285
00:29:03,000 --> 00:29:07,000
Now, what are we talking about in terms of how much more expensive?

286
00:29:07,000 --> 00:29:09,000
Sometimes it's not much.

287
00:29:09,000 --> 00:29:12,000
You might have existing shareholders cost you 12%.

288
00:29:12,000 --> 00:29:16,000
Your new shareholders cost you 12.87%.

289
00:29:16,000 --> 00:29:20,000
It could, however, be more dramatic than that.

290
00:29:20,000 --> 00:29:25,000
Especially, okay, a couple of situations where it could happen.

291
00:29:25,000 --> 00:29:36,000
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.

292
00:29:36,000 --> 00:29:38,000
They are going to bleed you.

293
00:29:38,000 --> 00:29:47,000
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?

294
00:29:47,000 --> 00:29:49,000
It's just madness.

295
00:29:49,000 --> 00:29:51,000
There's also another side to it too.

296
00:29:51,000 --> 00:29:53,000
Well, there's two other sides.

297
00:29:53,000 --> 00:30:05,000
One other side is that oftentimes getting the attention of one of those transnational ginormous I.B.'s is even just getting their attention.

298
00:30:05,000 --> 00:30:07,000
They are going to say, nah, like that.

299
00:30:07,000 --> 00:30:10,000
So you're going to end up with a regional, a regional I.B.

300
00:30:10,000 --> 00:30:12,000
Now, there's nothing wrong with them.

301
00:30:12,000 --> 00:30:15,000
They just are second tier.

302
00:30:15,000 --> 00:30:24,000
And so in that regard, a second tier is probably going to cost you more than a first tier would.

303
00:30:24,000 --> 00:30:28,000
Because a first tier has the infrastructure to do whatever it wants.

304
00:30:28,000 --> 00:30:30,000
It could do an IPO for God.

305
00:30:30,000 --> 00:30:35,000
A regional is not quite as powerful.

306
00:30:35,000 --> 00:30:45,000
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.

307
00:30:45,000 --> 00:30:49,000
It's kind of back and forth.

308
00:30:49,000 --> 00:30:52,000
Now there's another one.

309
00:30:52,000 --> 00:31:02,000
In my side, end of the business, finding any I.B. that would do an IPO for a small company was a joke.

310
00:31:02,000 --> 00:31:04,000
It was a laugh.

311
00:31:04,000 --> 00:31:06,000
Blah, no.

312
00:31:06,000 --> 00:31:10,000
And I mean, some of these were actually pretty reputable operations.

313
00:31:10,000 --> 00:31:13,000
But trying to do, these were private companies.

314
00:31:13,000 --> 00:31:14,000
They wanted to go public.

315
00:31:14,000 --> 00:31:20,000
And like hell, anyone was going to do an IPO for them.

316
00:31:20,000 --> 00:31:28,000
So what we had to do, there was, we did what was called a Western style offering.

317
00:31:28,000 --> 00:31:31,000
That was one.

318
00:31:31,000 --> 00:31:34,000
Another term for it is a best efforts.

319
00:31:34,000 --> 00:31:46,000
You find a low end I.B. and they'll say, okay, we will try to sell this issue.

320
00:31:46,000 --> 00:31:55,000
No guarantee, but you'll have our traders, our facilities will try to do it.

321
00:31:55,000 --> 00:31:58,000
That's called a Western style offering.

322
00:31:58,000 --> 00:32:05,000
As opposed to Eastern, which is the I.B., the real ones that do firm underwritings.

323
00:32:05,000 --> 00:32:15,000
So I did a couple of Western styles out of maybe about half a dozen, two subscribed, fully subscribed.

324
00:32:15,000 --> 00:32:17,000
The others fizzled out.

325
00:32:17,000 --> 00:32:24,000
But it was all I could do at that time or any time really.

326
00:32:24,000 --> 00:32:32,000
Okay, now there's another one that is really risky.

327
00:32:32,000 --> 00:32:36,000
It's called a self offering.

328
00:32:36,000 --> 00:32:46,000
Where the company people themselves try to sell the new issue.

329
00:32:46,000 --> 00:32:56,000
And some states over the years, since I got out of consulting, have banned self offerings.

330
00:32:56,000 --> 00:32:59,000
They've just banned them.

331
00:32:59,000 --> 00:33:13,000
And of those that I did that were self offerings, in two rather dramatic cases, it was they violated law when they did them.

332
00:33:13,000 --> 00:33:19,000
They sold them in an incorrect manner or something like that.

333
00:33:19,000 --> 00:33:26,000
And especially the state regulators were watching like a hawk to see if the company would make a mistake.

334
00:33:26,000 --> 00:33:32,000
And then nail them to the wall, seize all their stuff, and then put them out of business.

335
00:33:32,000 --> 00:33:37,000
In one case, I had a company that did a self offering.

336
00:33:37,000 --> 00:33:40,000
And it was an impressive technology.

337
00:33:40,000 --> 00:33:44,000
This was the 90s. And they had a machine.

338
00:33:44,000 --> 00:33:55,000
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.

339
00:33:55,000 --> 00:34:01,000
There was a computer, this contraption, and a printer.

340
00:34:01,000 --> 00:34:10,000
And they could have a judge remotely sign a warrant, a search warrant.

341
00:34:10,000 --> 00:34:21,000
And he'd sign it, and this pen would replicate his signature on a warrant that was printed out on this printer.

342
00:34:21,000 --> 00:34:29,000
Now I'm sure that can be done very easily, but at the time it was holy cow.

343
00:34:29,000 --> 00:34:37,000
And in fact, two states had authorized this as valid signature by a judge for a warrant.

344
00:34:37,000 --> 00:34:44,000
Well, that state they were in, I'll be damned if those guys were not the state regulator.

345
00:34:44,000 --> 00:34:47,000
There was one ambitious son of a bitch.

346
00:34:47,000 --> 00:34:53,000
And he casually said, could we talk for a while? I want to find out all about this. This is cool.

347
00:34:53,000 --> 00:34:56,000
And these guys had no idea what he was doing.

348
00:34:56,000 --> 00:35:09,000
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?

349
00:35:09,000 --> 00:35:15,000
And one of the guys said, well, we've got to eat. Yeah. That was enough.

350
00:35:15,000 --> 00:35:20,000
Operation was shut down. They were charged, convicted, and sent to prison.

351
00:35:20,000 --> 00:35:25,000
And the technology disappeared into the ether.

352
00:35:25,000 --> 00:35:28,000
Of course it didn't, but that was what it was.

353
00:35:28,000 --> 00:35:31,000
The regulator who pulled this off got a feather in his cap.

354
00:35:31,000 --> 00:35:35,000
Those guys were destroyed, ruined for life, and all that.

355
00:35:35,000 --> 00:35:38,000
So you don't want to do a self-offering. Don't do it.

356
00:35:38,000 --> 00:35:43,000
No matter how much, yeah, I'm going to sell some stock. I've got a company. Would you like to buy some stock?

357
00:35:43,000 --> 00:35:46,000
Don't. For God's sake.

358
00:35:46,000 --> 00:35:51,000
Anyway, internally generated equity.

359
00:35:51,000 --> 00:35:54,000
There are a couple of different ways that you can do it.

360
00:35:54,000 --> 00:35:56,000
One way is to use the dividend growth model.

361
00:35:56,000 --> 00:36:06,000
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.

362
00:36:06,000 --> 00:36:20,000
Well, you can cross-multiply that one and get the cost of internally generated equity retained earnings would be the dividend at period one,

363
00:36:20,000 --> 00:36:29,000
which is dividend now times one minus G, one plus G, over the price of the stock right now plus G.

364
00:36:29,000 --> 00:36:32,000
That's called the dividend growth model approach.

365
00:36:32,000 --> 00:36:37,000
It's the most common one.

366
00:36:37,000 --> 00:36:41,000
It's the most common one.

367
00:36:41,000 --> 00:36:48,000
And don't sweat it. If you have to do this, it's not hard. It's just arithmetic mostly.

368
00:36:48,000 --> 00:36:53,000
But it's also, if you're doing the weighted average cost of capital, I've got it baked in there.

369
00:36:53,000 --> 00:36:57,000
It'll calculate it for you along the way.

370
00:36:57,000 --> 00:37:03,000
Okay, now there are a couple of other ways here to do it.

371
00:37:03,000 --> 00:37:06,000
Let me erase this.

372
00:37:06,000 --> 00:37:14,000
So cost of retained earnings, I'll put it over here.

373
00:37:14,000 --> 00:37:29,000
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.

374
00:37:29,000 --> 00:37:35,000
And the dividend in period one is the dividend that has just been issued, grown one period.

375
00:37:35,000 --> 00:37:44,000
The only place that's really, this is best if the company is stable, it has a stable growth rate of its dividends.

376
00:37:44,000 --> 00:37:52,000
Every company tries to get there, but some companies aren't there yet, but there it is.

377
00:37:52,000 --> 00:37:55,000
Now I'm going to put a side note here.

378
00:37:55,000 --> 00:37:57,000
Growth rate.

379
00:37:57,000 --> 00:38:00,000
Two ways that you could look at growth rate.

380
00:38:00,000 --> 00:38:01,000
What's the growth rate?

381
00:38:01,000 --> 00:38:12,000
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.

382
00:38:12,000 --> 00:38:14,000
You can get a growth rate that way.

383
00:38:14,000 --> 00:38:24,000
There's another way.

384
00:38:24,000 --> 00:38:34,000
One minus the dividend ratio.

385
00:38:34,000 --> 00:38:41,000
In other words, this is the plow back ratio times your return on equity.

386
00:38:41,000 --> 00:38:53,000
That's a way that you can get the growth rate of dividends as well.

387
00:38:53,000 --> 00:38:55,000
You can calculate that way.

388
00:38:55,000 --> 00:39:01,000
I'm going to tell you right now, the book shows us, says, yeah, this is good.

389
00:39:01,000 --> 00:39:07,000
In practice, this gives you really wonky growth rates, really wonky.

390
00:39:07,000 --> 00:39:10,000
You get growth rates of 16, 18 percent.

391
00:39:10,000 --> 00:39:13,000
No, it can't be that high.

392
00:39:13,000 --> 00:39:18,000
It'd be better to just pull a growth rate out of your butt than to do that.

393
00:39:18,000 --> 00:39:25,000
But it's in the book and it's part of knowing the things that you should know to be a finance major.

394
00:39:25,000 --> 00:39:38,000
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.

395
00:39:38,000 --> 00:39:46,000
So, for example, if I had, let's say that the company, the dividend ratio of the company.

396
00:39:46,000 --> 00:39:53,000
In other words, dividend divided by dividend ration.

397
00:39:53,000 --> 00:40:04,000
In other words, the dividend amount divided by the net earnings, let's say that that comes out to be.60.

398
00:40:04,000 --> 00:40:11,000
In other words, 60 percent of income is given back to the shareholders.

399
00:40:11,000 --> 00:40:16,000
That means that 40 percent is retained by the company.

400
00:40:16,000 --> 00:40:26,000
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.

401
00:40:26,000 --> 00:40:33,000
So, the growth rate by this model, and you're going to see why I tell you that it gives wonky results.

402
00:40:33,000 --> 00:40:53,000
You do this one and you're going to get, okay, one minus.6 is.4 times.18.

403
00:40:53,000 --> 00:41:03,000
Seven point two percent growth rate. That's pretty darn high.

404
00:41:03,000 --> 00:41:10,000
So, yeah, it might be, a company might have a growth rate of dividends of seven point two percent.

405
00:41:10,000 --> 00:41:17,000
But I really have not ever seen a company have dividends grow at seven point two percent on a sustained basis.

406
00:41:17,000 --> 00:41:23,000
So, even though this is there, the book promotes it, says here's a great idea for defining growth rate.

407
00:41:23,000 --> 00:41:25,000
Don't do that.

408
00:41:25,000 --> 00:41:32,000
The best way to do it is just to look at the pattern of growth of dividends over a period of years.

409
00:41:32,000 --> 00:41:41,000
So, for example, suppose that I see a company, its dividends, it started out with a two dollar dividend.

410
00:41:41,000 --> 00:41:47,000
Then the next year it had a two dollar and three cent dividend.

411
00:41:47,000 --> 00:41:53,000
Then a year later it had a two dollar and seven cent dividend.

412
00:41:53,000 --> 00:42:01,000
Okay, so the growth rate here is two point oh three over two point oh oh minus one.

413
00:42:01,000 --> 00:42:09,000
The dividend here was two point zero seven over two point oh three minus one.

414
00:42:09,000 --> 00:42:13,000
You take the average of those two. Those are both growth rates.

415
00:42:13,000 --> 00:42:18,000
You take the average growth rate over the last three years or five years, whatever you want.

416
00:42:18,000 --> 00:42:22,000
That's a cleaner way to do it.

417
00:42:22,000 --> 00:42:38,000
And the results will be more real because it's actually based on the historic pattern of dividends in a case like that.

418
00:42:38,000 --> 00:42:55,000
Okay, now, moving on from that, the next way that you can get the cost of retained earnings is like this.

419
00:42:55,000 --> 00:42:58,000
There's the dividend growth model, that one.

420
00:42:58,000 --> 00:43:05,000
Then you could just use cap M.

421
00:43:05,000 --> 00:43:23,000
Remember, R sub S plus beta of the stock times the expected return to the market minus the risk free rate.

422
00:43:23,000 --> 00:43:30,000
In other words, this thing right in here, that's called the risk premium.

423
00:43:30,000 --> 00:43:35,000
That's a way you can do it too.

424
00:43:35,000 --> 00:43:39,000
Couple of things about this, a warning.

425
00:43:39,000 --> 00:43:43,000
Couple of warnings.

426
00:43:43,000 --> 00:43:45,000
First of all, the beta.

427
00:43:45,000 --> 00:43:48,000
Well, what happens if your company doesn't have a beta?

428
00:43:48,000 --> 00:43:55,000
Well, you get companies that are comparable to it, comps, and you take the average of their betas,

429
00:43:55,000 --> 00:44:04,000
public companies, and then you just take the average of their betas if you don't have a beta of your own.

430
00:44:04,000 --> 00:44:08,000
There's another thing about this application of the cap M.

431
00:44:08,000 --> 00:44:11,000
The R sub F.

432
00:44:11,000 --> 00:44:15,000
Now, you would hear me normally say use a one year T bill yield.

433
00:44:15,000 --> 00:44:17,000
We looked at that chart.

434
00:44:17,000 --> 00:44:28,000
As a matter of fact, let me pull that up right now.

435
00:44:28,000 --> 00:44:31,000
Pull up an instance of Firefox here.

436
00:44:31,000 --> 00:44:34,000
We're going to go to Google here.

437
00:44:34,000 --> 00:44:39,000
Really? I don't want to do that. Come on.

438
00:44:39,000 --> 00:44:52,000
Go to Google here and Google.com.

439
00:44:52,000 --> 00:45:03,000
Pull it up and you have your, now I usually just do a search, Treasury.

440
00:45:03,000 --> 00:45:14,000
Treasure Island yield curve, yield curve, and I go to the horse's mouth.

441
00:45:14,000 --> 00:45:15,000
Okay.

442
00:45:15,000 --> 00:45:24,000
Now, if we look here, what I would do is, oh no, whoa, that's definitely not what I want to see.

443
00:45:24,000 --> 00:45:26,000
Let's go the current month.

444
00:45:26,000 --> 00:45:28,000
Okay. Well, that's okay.

445
00:45:28,000 --> 00:45:33,000
Now, I would probably look at a one year T bill.

446
00:45:33,000 --> 00:45:39,000
What?

447
00:45:39,000 --> 00:45:43,000
Whoa, that can't be right.

448
00:45:43,000 --> 00:45:52,000
That cannot be right.

449
00:45:52,000 --> 00:45:59,000
Wait, let me see that. Those rates can't be right.

450
00:45:59,000 --> 00:46:06,000
Par value, Treasury bill, right.

451
00:46:06,000 --> 00:46:10,000
For the current month.

452
00:46:10,000 --> 00:46:12,000
What is it?

453
00:46:12,000 --> 00:46:19,000
It says for the current month. Let's try this.

454
00:46:19,000 --> 00:46:25,000
I saw that and I thought, no.

455
00:46:25,000 --> 00:46:29,000
Say that again.

456
00:46:29,000 --> 00:46:36,000
Oh, okay, apply. I always forget that.

457
00:46:36,000 --> 00:46:47,000
Now, I want to go back to the par value yield curve and apply.

458
00:46:47,000 --> 00:46:49,000
Yeah.

459
00:46:49,000 --> 00:46:51,000
I am sorry.

460
00:46:51,000 --> 00:46:56,000
I gave myself a heart attack there doing that.

461
00:46:56,000 --> 00:46:58,000
Now, let's go down here.

462
00:46:58,000 --> 00:47:00,000
You would look at the one year.

463
00:47:00,000 --> 00:47:02,000
That's how you use CAPM.

464
00:47:02,000 --> 00:47:13,000
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%.

465
00:47:13,000 --> 00:47:15,000
That's what you would use for R sub F.

466
00:47:15,000 --> 00:47:17,000
And then expect your return to the market.

467
00:47:17,000 --> 00:47:22,000
You just go with one of those services that gives a forecast for the next year for the market.

468
00:47:22,000 --> 00:47:41,000
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.

469
00:47:41,000 --> 00:47:44,000
The yield on the seven year.

470
00:47:44,000 --> 00:47:48,000
This guy here.

471
00:47:48,000 --> 00:47:53,000
And if possible, and some say, use the 10 or the 20.

472
00:47:53,000 --> 00:47:58,000
Now, I'll take the middle road here for seven years.

473
00:47:58,000 --> 00:47:59,000
Here's the logic.

474
00:47:59,000 --> 00:48:02,000
Stock is a long term thing.

475
00:48:02,000 --> 00:48:05,000
I mean, it's forever in a way.

476
00:48:05,000 --> 00:48:10,000
And you are using equity to invest.

477
00:48:10,000 --> 00:48:19,000
Now, let's say you've got a project. A project would surely have a life more than a year.

478
00:48:19,000 --> 00:48:23,000
Four, five, seven, ten, twenty years.

479
00:48:23,000 --> 00:48:31,000
It's certainly not going to be comparable to yields on a one year treasury.

480
00:48:31,000 --> 00:48:44,000
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.

481
00:48:44,000 --> 00:48:49,000
So that's the one that is I have heard from others.

482
00:48:49,000 --> 00:48:55,000
They saw me using a one year, some years back, and they said, you don't use that.

483
00:48:55,000 --> 00:48:57,000
You use a seven year.

484
00:48:57,000 --> 00:48:59,000
And I heard seven year repeatedly.

485
00:48:59,000 --> 00:49:02,000
So whatever you want to use, but it's certainly not going to be a one year.

486
00:49:02,000 --> 00:49:06,000
Now, in the normal use of CAPM, you use a one year.

487
00:49:06,000 --> 00:49:12,000
But in this, you're dealing with long term funds, but capital budgeting.

488
00:49:12,000 --> 00:49:18,000
So you would want to use a long term R sub F. Ouch, I almost heard something I care about.

489
00:49:18,000 --> 00:49:19,000
Okay.

490
00:49:19,000 --> 00:49:21,000
There's that.

491
00:49:21,000 --> 00:49:22,000
Okay.

492
00:49:22,000 --> 00:49:23,000
That's the CAPM.

493
00:49:23,000 --> 00:49:28,000
Now, there's one other one, and I can't even remember what the book uses for the term for it.

494
00:49:28,000 --> 00:49:37,000
But it's normally called bond yield plus equity premium, the EP.

495
00:49:37,000 --> 00:50:00,000
In other words, the equity premium is the, in general, is the cost of equity minus the cost of debt.

496
00:50:00,000 --> 00:50:21,000
So let's, in your industry, in your industry, let's say that the average cost of equity is 14% in your industry.

497
00:50:21,000 --> 00:50:28,000
And the average cost of debt in your industry is, let's say, 8%.

498
00:50:28,000 --> 00:50:39,000
Then the equity premium would be 14% less 8%, or 6%.

499
00:50:39,000 --> 00:50:56,000
Now, you take that and you say, okay, our cost of debt right now is 10%.

500
00:50:56,000 --> 00:51:12,000
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%.

501
00:51:12,000 --> 00:51:20,000
There's your little box right there.

502
00:51:20,000 --> 00:51:22,000
It's cost of debt plus an equity premium.

503
00:51:22,000 --> 00:51:31,000
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.

504
00:51:31,000 --> 00:51:35,000
And that should give you a decent shot.

505
00:51:35,000 --> 00:51:40,000
Now, which one do you use?

506
00:51:40,000 --> 00:51:43,000
You use all of them if you can.

507
00:51:43,000 --> 00:51:46,000
And then you take the average of them.

508
00:51:46,000 --> 00:51:50,000
Or you at least use two of them and take the average of the two.

509
00:51:50,000 --> 00:51:53,000
And that's very popular.

510
00:51:53,000 --> 00:52:01,000
This is not as exact a science as I might try to promote it as.

511
00:52:01,000 --> 00:52:12,000
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.

512
00:52:12,000 --> 00:52:17,000
I don't even show the more complex ones at the MBA level.

513
00:52:17,000 --> 00:52:25,000
These are the things that are used in the corporate anyway.

514
00:52:25,000 --> 00:52:27,000
Now, cost of new.

515
00:52:27,000 --> 00:52:31,000
The cost of new equity, we applied this one.

516
00:52:31,000 --> 00:52:51,000
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.

517
00:52:51,000 --> 00:52:54,000
That float is how much the brokers are going to take from you.

518
00:52:54,000 --> 00:52:58,000
It can be expressed as a dollar amount or percent.

519
00:52:58,000 --> 00:53:07,000
So in other words, I could say, okay, the current price of my stock is $40.

520
00:53:07,000 --> 00:53:18,000
The investment bankers have given me a float and you usually use a small F if it's a percentage of 6%.

521
00:53:18,000 --> 00:53:28,000
So in other words, you would take $40 times 1 minus 6% for it.

522
00:53:28,000 --> 00:53:32,000
That's about how you do it.

523
00:53:32,000 --> 00:53:41,000
Now, for my purposes in doing this with you, I would not ask you for new.

524
00:53:41,000 --> 00:53:53,000
Because we are driving toward the all famous weighted average cost of capital.

525
00:53:53,000 --> 00:54:00,000
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.

526
00:54:00,000 --> 00:54:04,000
And it's simply like this.

527
00:54:04,000 --> 00:54:15,000
The weighted average cost of capital is the weight of debt in your capital structure times the after-tax cost of debt

528
00:54:15,000 --> 00:54:28,000
plus the weight of equity in your capital structure times the cost of equity.

529
00:54:28,000 --> 00:54:36,000
Doesn't look too bad yet, but let me tell you, it is a tedious arithmetic exercise.

530
00:54:36,000 --> 00:54:46,000
So put expanding this for the different types of equity.

531
00:54:46,000 --> 00:54:56,000
The weight of equity is the weight of preferred in your capital structure times the cost of preferred stock

532
00:54:56,000 --> 00:55:07,000
plus the weight of existing retained earnings times the cost of those retained earnings

533
00:55:07,000 --> 00:55:29,000
plus the weight of new common stock times the cost of new common stock.

534
00:55:29,000 --> 00:55:39,000
Now, I'm not going to worry about this one. I won't test you on that one. It makes it really complicated.

535
00:55:39,000 --> 00:55:49,000
MBA level complicated. For our purposes here, we have enough fun to work with.

536
00:55:49,000 --> 00:56:00,000
The problem is this. These weights here, they have to be market weights, the current market weight of your debt,

537
00:56:00,000 --> 00:56:10,000
the current market weight of your preferred, the current market weight of your common stock.

538
00:56:10,000 --> 00:56:16,000
And that's where it can get hairy because you have to find their prices.

539
00:56:16,000 --> 00:56:23,000
And here's what we do.

540
00:56:23,000 --> 00:56:32,000
We go to Canvas, which I showed done anyway.

541
00:56:32,000 --> 00:56:50,000
We go to Canvas and you go into your files folder.

542
00:56:50,000 --> 00:56:59,000
Now, like I said, if you were my student for 240, oops, go to your spreadsheets.

543
00:56:59,000 --> 00:57:08,000
And then there was you had a version of this. This one is a little more sophisticated, a little more.

544
00:57:08,000 --> 00:57:15,000
And mainly this.

545
00:57:15,000 --> 00:57:22,000
Okay, leave student view. Let me get this out of the way. Edit.

546
00:57:22,000 --> 00:57:27,000
And let me take this down a few notches so you can see the whole thing.

547
00:57:27,000 --> 00:57:33,000
Now, I've got this is a template and you can follow through.

548
00:57:33,000 --> 00:57:43,000
And if you put the numbers from the narrative in the right places, it will spit out your whack.

549
00:57:43,000 --> 00:57:57,000
The difference between this one and the one in 240 is that in this one, a company could put target weights.

550
00:57:57,000 --> 00:58:04,000
In other words, it could define its capital structure, find its optimal capital structure,

551
00:58:04,000 --> 00:58:16,000
and then see what its existing whack is compared to what it wants as its target capital structure.

552
00:58:16,000 --> 00:58:20,000
So this panel you wouldn't have.

553
00:58:20,000 --> 00:58:23,000
Now, normally what we'll do is we'll just push it out.

554
00:58:23,000 --> 00:58:32,000
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.

555
00:58:32,000 --> 00:58:42,000
One after the other. So we've got SPK Corporation, 22 million shares, that common stock. That goes there.

556
00:58:42,000 --> 00:58:52,000
Well, its market price, currently priced at $34 a share. That goes there.

557
00:58:52,000 --> 00:59:02,000
Just pay the dividend, that's D0, of $1.80, that goes there. And it's expected to grow at 2% there.

558
00:59:02,000 --> 00:59:12,000
That's the D1 over the P0. And then you work your way along here and it's got some preferred stock.

559
00:59:12,000 --> 00:59:23,000
120,000 shares goes there. And it is 1.5% preferred, that's the dividend there.

560
00:59:23,000 --> 00:59:31,000
The current market price, which is how you calculate the dividends of $85 a share, goes there.

561
00:59:31,000 --> 00:59:39,000
I'm sorry, the par value goes there. And then the current market price of $63 goes there.

562
00:59:39,000 --> 00:59:49,000
And then we need to get the yield to maturity. So we can get the cost of debt, after-tax cost of debt.

563
00:59:49,000 --> 00:59:57,000
Well, that, we've got $12 million, that's the face value of the bonds.

564
00:59:57,000 --> 01:00:13,000
Now, right now, those 12 million are 4.25% coupon. They're due in 2031, so that's seven years to maturity, the term.

565
01:00:13,000 --> 01:00:21,000
And on the 100, they're $102.40.

566
01:00:21,000 --> 01:00:34,000
You notice that it's a $12 million issue. If its market price right now is $102.40 on the 100,

567
01:00:34,000 --> 01:00:44,000
then its market value is $12,288,000. It calculates all of that automatically for you.

568
01:00:44,000 --> 01:00:51,000
And if you don't remember, do not touch anything that is peach or blue.

569
01:00:51,000 --> 01:00:58,000
Why don't you want to touch that? Because you'll die. Or something like that.

570
01:00:58,000 --> 01:01:06,000
Just put the stupid numbers in. And it will calculate, look at this, the cost of the debt, there it is.

571
01:01:06,000 --> 01:01:15,000
The cost of the equity, well, it has 22 million shares, and each one of them is $34 a share.

572
01:01:15,000 --> 01:01:26,000
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.

573
01:01:26,000 --> 01:01:34,000
There's that one. And then the weighted average cost of capital, it calculates each of these,

574
01:01:34,000 --> 01:01:39,000
that particular component's market value divided by the total market value.

575
01:01:39,000 --> 01:01:47,000
And it will just calculate all the market weights, they'll add up to 100%, and then it will take each of these,

576
01:01:47,000 --> 01:01:55,000
the cost of debt, the weight of debt, times the after-tax cost of debt, the weight of equity,

577
01:01:55,000 --> 01:02:11,000
times the after-tax cost of equity, plus the weight of preferred stock, times the cost of preferred stock,

578
01:02:11,000 --> 01:02:16,000
and then the weight of equity, times the cost of common equity.

579
01:02:16,000 --> 01:02:24,000
And that will give you your weighted average cost of capital. This is the market weighted average cost of capital.

580
01:02:24,000 --> 01:02:31,000
Now over here, you could put in target weights. You want to make sure they add up to 100%.

581
01:02:31,000 --> 01:02:45,000
In other words, the company wants to make its capital structure, in my case there, 25% debt, 5% preferred, and 70% equity.

582
01:02:45,000 --> 01:02:54,000
And you can recalculate. As you see in this example, it's at the victim of the market right now.

583
01:02:54,000 --> 01:03:04,000
The market prices are driving its whack. That means that the company is in a position where it's going to be hard to,

584
01:03:04,000 --> 01:03:11,000
but it is going to have to wrestle down its weight, it's going to push up its weight of debt.

585
01:03:11,000 --> 01:03:16,000
Notice right now, the weight of debt is only about 1.6%.

586
01:03:16,000 --> 01:03:22,000
This is saying that we have to up the weight of debt in the capital structure.

587
01:03:22,000 --> 01:03:36,000
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.

588
01:03:36,000 --> 01:03:41,000
They also have to up this cheapo preferred stock. See how cheap preferred stock is?

589
01:03:41,000 --> 01:03:45,000
And notice the preferred is actually a little cheaper than the after-tax cost of debt.

590
01:03:45,000 --> 01:03:52,000
But if they can accomplish that, they can bring down their weighted average cost of capital.

591
01:03:52,000 --> 01:04:00,000
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,

592
01:04:00,000 --> 01:04:10,000
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

593
01:04:10,000 --> 01:04:17,000
and putting them in the right place. Just don't touch anything that is in that orangish peach color or the blue,

594
01:04:17,000 --> 01:04:22,000
and you'll look like a hero finding weighted average cost of capital.

595
01:04:22,000 --> 01:04:33,000
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.

596
01:04:33,000 --> 01:04:41,000
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,

597
01:04:41,000 --> 01:04:48,000
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.

598
01:04:48,000 --> 01:04:52,000
That's all I have for you, I thank you.