A B C D E F G

1 Tool Kit Chapter 9

2
3 The Cost of Capital
4
5 9-1 The Weighted Average Cost of Capital
6
7 The cost of capital is the weighted average cost of the debt, preferred stock, and common equity that the firm uses to
8 finance its assets, or its WACC.
9
10 Definitions
11 WACC = Weighted average cost of capital
12 = wd rd(1 – T) + wps rps + ws rs
13
14 rd = Cost of debt
15 rps = Cost of preferred stock
16 rs = Cost of stock (common equity)
17
18 wd = Percent of target capital structure financed with debt
19 wps = Percent of target capital structure financed with preferred stock
20 ws = Percent of target capital structure financed with stock (common equity)
21
22 T = Tax rate
23
24
25 9-2 Choosing Weights for the Weighted Average Cost of Capital
26
27 Figure 9-1
28 MicroDrive, Inc.: Selected Capital Structure Data
29 (Millions of Dollars, December 31, 2019)
30 Investor-Supplied Capital
31 Book Market
32 Percent Book Percent Market
33 Liabilities and Equity of Total Value of Total Value
34 Accounts payable $ 200 5.5%
35 Notes payable 150 4.2% $ 150 5.0% $ 150
36 Accruals 400 11.1%
37 Total C.L. $ 750 20.8%
38 Long-term debt 520 14.4% 520 17.3% 520
39 Total liabilities $1,270 35.2%
40 Preferred stock 100 2.8% 100 3.3% 100
41 Common stock 500 13.9%
42 Retained earnings 1,740 48.2%
43 Total common equity $2,240 62.0% $2,240 74.4% $1,860
44 Total $3,610 100.0% $3,010 100.0% $2,630
45
46 Other Data (Millions, except per share data):
 A B C D E F G
47 Number of common shares outstanding = 60 Coupon rate on long-term debt =
48 Price per share of common stock = $31.00 Interest rate on short-term debt =
49 Number of preferred shares outstanding = 1
50 Price per share of preferred stock = $100.00
51 Coupon rate on preferred stock = 7.00%
52 Flotation cost for issuing preferred stock = 2.10%
53
54
55 Notes:
56
1. The market value of the notes payable is equal to the book value. Some of the long-term bonds sell at a discount and some sell at a premiu
57 but their aggregate market value is approximately equal to their aggregate book value.
58
59 2. The common stock price is $31 per share. There are 60 million shares outstanding, for a total market value of equity of $31(60) = $1,860
60 million.
61 3. The preferred stock price is $100 per share. There are 1 million shares outstanding, for a total market value of preferred of $100(1) = $10
62 million.
63
64
65 9-3 The Cost of Debt
66
67
The relevant cost of debt is the after-tax cost of new debt, taking account of the tax deductibility of interest. The after-tax
68 cost is calculated by multiplying the interest rate (or the before-tax cost of debt) times one minus the tax rate.
69
70
71
72
73 9-3a After-Tax Cost of Short-Term Debt: rstd (1 − T)
74
75 MicroDrive has a 25% tax rate and notes payable with an 8% interest rate:
76
77 Tax rate = 25%
78 rstd
= 8%
79
80 After-tax cost of short-term debt: r std (1 - T) = 6.0%
81
82 9-3b After-Tax Cost of Long-Term Debt: rd (1 − T)
83
84 MicroDrive can issue new bonds at 10%, so this is the pre-tax cost of debt.
85
86
87 Return required by investors in long-term debt = 10%
88
89 Tax rate = 25%
90 After-tax cost of long-term debt: r d
(1 - T) = 7.5%
91
92
93 After-tax Cost of Debt for an Outstanding Bond Trading at Par
94
95 The yield should be equal to the coupon rate on a par bond. Verify this by calculating the yield.
 A B C D E F G
96
97 Number of years to maturity 15
98 Number of payments per year 2
99 Annual coupon rate 10%
100 Par value $1,000
101 Issue price = Par = PV = $1,000
102
103 N= 30
104 PMT = $50
105 FV = $1,000
106
107 I/YR = rd = 5.0%
108
109 Annualized rd = 10.0%
110
111 Tax rate = 25%
112 After-tax cost of long-term debt: r d
(1 - T) = 7.5%
113
114
115 Cost of Debt for an Outstanding Bond not Trading at Par: Hypothetical Example
116
117 Use the RATE function to find the yield on the bonds with the following information:
118
119 Number of years to maturity 15
120 Number of payments per year 2
121 Annual coupon rate 9%
122 Par value $1,000
123 Current price = PV = $923.14
124
125 N= 30
126 PMT = $45
127 FV = $1,000
128
129 I/YR = rd = 5.0%
130
131 Annualized rd = 10.0%
132
133 Tax rate = 25%
134 After-tax cost of long-term debt: r d
(1 - T) = 7.5%
135
136
137 9-3c Yield to Maturity versus Expected Rate of Return
138
139 Use the RATE function to find the yield on the bonds with the following information:
140
141 Number of years to default 14
142 Recovery percentage at default 70%
143 Number of payments per year 2
144 Annual coupon rate 10%
145 Par value $1,000
 A B C D E F G
146 Current price = PV = $1,000
147
148 N= 28
149 PMT = $50
150 FV = $700
151
152 I/YR = rd = 4.44%
153
154 Annualized rd = 8.88%
155
156
157 9-3d Flotation Costs and the Cost of Debt
158
159 For illustrative purposes, suppose a bond is issued with 10-years until maturity, a $1,000 par value, an 8% annual
160 coupon rate, and will make semiannual payments. The issue price is equal to par and the bond will initially sell at its par
161 value. The tax rate is 25% and the flotation percentage cost is 2.8%.
162
163 Input Data:
164 Years to maturity = 10
165 Number of payments per year = 2
166 Maturity payment= M = Par = $1,000
167 Issue price = $1,000
168 Annual coupon rate = 8.0%
169 Flotation percentage cost (F) = 2.8%
170 Tax rate = 25%
171
172
173 The Constant Yield Method
174
175 The net issue price per bond to the issuer is the issue price minus the flotation cost. The first step in the constant yield
176 method is to calculate the issuer's pre-tax yield to maturity based upon the net issue price. Then multiply the pre-tax
177 yield by 1 – T. The result is the after-tax cost of debt.
178
179 Net issue price per bond = $972.00
180
181 N= 20
182 PMT = $40.00
183 PV = -$972.00
184 FV = $1,000.00
185
186 Issuer's pre-tax YTM = 8.420%
187
188 Tax rate = 25%
189
190 After-tax cost of long-term debt: rd (1 - T) = 6.315%
191
192
193 After-Tax Cost of Debt for a Par Bond: Flotation Costs ≥ De Minimis
194
195 The after-tax cost of debt depends upon flotation costs, but it also depends upon whether or not the flotation cost per
196 bond is greater than de minimis, which is defined as:
 A B C D E F G
197
198 de minimis = 0.0025(M)(Par) = $25.00
199
200 If the flotation cost per bond is greater than de minimis, then the constant yield method should be used. That is true for
201 this example, as shown below.
202
203 Flotation costs per bond = $28.00 ≥ $25.00 = de minimis
204
205 After-Tax Cost of Debt for a Par Bond: Flotation Costs < De Minimis
206
207 Now consider a bond exactly like the bond in the previous example except that it has a 28 year maturity instead of a 10
208 year maturity.
209
210 Input Data:
211 Years to maturity = 28
212 Number of payments per year = 2
213 Maturity payment= M = Par = $1,000
214 Issue price = $1,000
215 Annual coupon rate = 8.0%
216 Flotation percentage cost (F) = 2.8%
217 Tax rate = 25%
218
219
220 If the flotation cost per bond is greater than than de minimis, then the flotation cost must be allocated equally over each
payment period as a noncash expense that reduces the issuer's taxes in each payment period. The after-tax cost of debt is
221 equal to the yield to maturity, base upon after-tax cash interest payments. Otherwise, the constant yield method should
222 be used.
223
224
225 de minimis = 0.0025(M)(Par) = $70.00
226 Flotation costs per bond = $28.00
227
228
229 The net discount is < de minimis, so use the allocation method.
230
231 The first step is to allocate flotation costs in equal portions to each payment period. The allocated flotation costs are a
232 noncash expense but they may be deducted for tax purposes. This creates a tax shield each period in the amount of
233 T(allocated flotation cost). The second step is to calculate the after-tax coupon payments. Use these after-tax values to
calculate the yield to maturity, which is the after-tax cost of debt.
234
235
236
237 Number of coupon payments = N = 56
238 Allocated flotation cost/period = Allocated cost/N = $0.50
239 Tax savings from allocated cost = T(allocated cost) = $0.125
240 After-tax coupon payment = Pre-tax coupon (1 − T) = $30.00
241 Net after-tax payment including tax savings = PMT= $29.875
242 Net issue price per bond = Issue price − flotation costs = PV = -$972.00
243 Payment of face value at maturity = FV= $1,000.0
244
245 Semiannual yield to maturity = Rate = 3.0933%
246
247 Annual yield to maturity = After-tax cost of debt = 6.1867%
248
 A B C D E F G
249
250 Suppose the analyst incorrectly ignored the allocation of flotation expenses and instead used the constant yield method.
251 How much difference is there between this incorrect approach and the correct approach?
252
253 After-tax cost of long-term debt: constant yield method =
254
255 N= 56
256 PMT = $40.00
257 PV = -$972.00
258 FV = $1,000.00
259
260 Semiannual yield to maturity = Rate = 4.128995%
261 Annual yield to maturity = 8.25799%
262 After-tax cost of debt = annual YTM(1-T) = 6.1935% Keep in mind that this is the incorrect approach.
263
264 After-tax cost of long-term debt: allocation method = 6.1867%
265 −After-tax cost of long-term debt: constant yield method = 6.1935%
266
267 Error = -0.0068%
268
269 Most analysts would consider this to be too small a difference and would therefore use the easier constant yield method.
270
271
272 9-3e The After-Tax Cost of Debt: Flotation Costs, Premium Bonds, and Discount Bonds
273
274 The appropriate tax treatment depends upon whether the bond has a total net premium or total net discount.
275
276 Total net premium if: Issue price – flotation costs > Par
277 Total net discount if: Issue price – flotation costs < Par
278
279 If the bond has a total net premium, use the constant yield method. If the bond has a total net discount, use the same
280 approach as applied above for a bond with flotations costs.
281
282
283
284 9-4 Cost of Preferred Stock, rps
285
286
The cost of preferred stock is simply the preferred dividend divided by the price the company will receive if it issues new
287 preferred stock. No tax adjustment is necessary, as preferred dividends are not tax deductible.
288
289
290
What is the cost of preferred stock for a company that pays a preferred dividend of $7 per share if the company could sell
291 new preferred with a par value of $100 and a flotation cost of 2.1%?
292
293
294 Pref. coupon 7.0%
295 Par value $100.00
296 Pref. Dividend $7.00
297 Flotation % 2.1%
298 Net preferred issue price $97.90
299
300 rps = DivPref ÷ Net Pref. Price
 A B C D E F G
301 rps = $7.00 ÷ $97.90 = 7.150%
302
303
 A B C D E F G
304 9-5 Cost of Common Stock: The Market Risk Premium, RPM
305
306
Before addressing the required return of an individual stock, what is the required return for the stock market? What is
307 the Market Risk Premium (RP ), which is excess return investor require to induce them to invest in the stock market
M
308 rather than a long-term T-bond?
309
310
311
There are 3 methods to estimate the market risk premium. (1) Use historical market data as an estimate for the current
312 risk premium. (2) Ask experts. (3) Estimate a forward looking risk premium, found as the differential between expected
313 returns on the S&P 500 over some forecasted future period and the current long-term bond rate.
314
315
316
317 9-5a Historical Risk Premiums
318
319
Many analysts use data provided by Ibbotson Associates, which has collected data from 1926. Ibbotson publishes
320 information annually that enables use of different periods and thus different historical risk premiums. Ibbotson
321 recommends using the longest set of data, but others disagree, arguing that events that occurred back in the period of say
322 1926 to 1966 are less relevant than events that occurred during the last 50 or so years.
323
324
325
326 Ibbotson Historical Risk Premium: 1926-Current Date
327 Average
328 Arithmetic Geometric
329 Stock market return (return on large stocks) 12.00% 10.00%
330 Risk-free rate:
331 20-year T-bond yield at beginning of year 6.00% 5.60%
332
333 Historical risk premium:
334 RM minus T-bond yield = 6.00% 4.40%
335
336 Our Historical Risk Premium: 1968-Current Date
337
338 Data
339
10-Year T-bond (Treasury 10-year
340 S&P 500
constant maturity)

341

342
Reported
Total Return, Return on yield on last
343 Year Index Level rM Capital Gains Dividends day of year
344
345
346 2017 2,673.61 21.83% 19.41% 1.85% 2.33%
347 2016 2238.93 11.96% 9.54% 2.42% 2.45%
348 2015 2043.94 1.38% -0.73% 2.11% 2.27%
349 2014 2058.90 13.69% 11.39% 2.30% 2.17%
 A B C D E F G
350 2013 1848.36 32.39% 29.60% 2.79% 3.04%
351 2012 1426.19 16.00% 13.41% 2.59% 1.78%
352 2011 1257.60 2.11% 0.00% 2.11% 1.89%
353 2010 1257.64 15.06% 12.78% 2.28% 3.30%
354 2009 1115.1 26.46% 23.45% 3.01% 3.85%
355 2008 903.25 -37.00% -38.49% 1.49% 2.25%
356 2007 1468.36 5.49% 3.53% 1.96% 4.04%
357 2006 1418.3 15.79% 13.62% 2.17% 4.71%
358 2005 1248.29 4.91% 3.00% 1.91% 4.39%
359 2004 1211.92 10.88% 8.99% 1.89% 4.24%
360 2003 1111.92 28.70% 26.38% 2.32% 4.27%
361 2002 879.82 -22.10% -23.37% 1.27% 3.83%
362 2001 1148.08 -11.88% -13.04% 1.16% 5.07%
363 2000 1320.28 -9.11% -10.14% 1.03% 5.12%
364 1999 1469.25 21.04% 19.53% 1.51% 6.45%
365 1998 1229.23 28.58% 26.67% 1.91% 4.65%
366 1997 970.43 33.36% 31.01% 2.35% 5.75%
367 1996 740.74 23.07% 20.26% 2.81% 6.43%
368 1995 615.93 37.43% 34.11% 3.32% 5.58%
369 1994 459.27 1.31% -1.54% 2.85% 7.84%
370 1993 466.45 9.99% 7.06% 2.93% 5.83%
371 1992 435.71 7.67% 4.46% 3.21% 6.70%
372 1991 417.09 30.55% 26.31% 4.24% 6.71%
373 1990 330.22 -3.17% -6.56% 3.39% 8.08%
374 1989 353.4 31.49% 27.25% 4.24% 7.93%
375 1988 277.72 16.81% 12.40% 4.41% 9.14%
376 1987 247.08 5.23% 2.03% 3.20% 8.83%
377 1986 242.17 18.47% 14.62% 3.85% 7.23%
378 1985 211.28 32.16% 26.33% 5.83% 9.00%
379 1984 167.24 6.27% 1.40% 4.87% 11.55%
380 1983 164.93 22.51% 17.27% 5.24% 11.82%
381 1982 140.64 21.41% 14.76% 6.65% 10.36%
382 1981 122.55 -4.91% -9.73% 4.82% 13.98%
383 1980 135.76 32.42% 25.77% 6.65% 12.43%
384 1979 107.94 18.44% 12.31% 6.13% 10.33%
385 1978 96.11 6.56% 1.06% 5.50% 9.15%
386 1977 95.1 -7.18% -11.50% 4.32% 7.78%
387 1976 107.46 23.84% 19.15% 4.69% 6.81%
388 1975 90.19 37.20% 31.55% 5.65% 7.76%
389 1974 68.56 -26.47% -29.72% 3.25% 7.40%
390 1973 97.55 -14.66% -17.37% 2.71% 6.90%
391 1972 118.05 18.98% 15.63% 3.35% 6.41%
392 1971 102.09 14.31% 10.79% 3.52% 5.89%
393 1970 92.15 3.10% 0.10% 3.00% 6.50%
394 1969 92.06 -8.36% -11.36% 3.00% 7.88%
395 1968 103.86 10.66% 7.66% 3.00% 6.16%
396 1967 96.47 5.70%
397
398 Arithmetic average 11.49% 8.22% 3.26% 6.33%
399 Geometric average 10.10% 6.87% 3.25% 6.29%
400
401 Our Historical Risk Premium Based on Data
402
 A B C D E F G
403
404 Average
405 Arithmetic
406 Stock market return (S&P 500) 11.49%
407 Risk-free rate:
408 10-year Treasury contestant maturity yield at beginning of year 6.39%
409
410 Historical risk premium:
411 RM minus T-bond yield = 5.10%
412
413
414 Expert Opinions for Estimates of the Risk Premium
415
416 Surveys of experts (CFO's, analysts, professors) are another way to estimate the risk premium.
417
418
419 Forward-Looking Risk Premiums
420
421
422 Historical risk premiums look at past data and assume that investors think the best estimate of the current risk premium
is the historical differential between earned returns on stocks and bonds. Forward-looking risk premiums assume that
423 investors expect equities to earn a rate that is equal to the expected dividend yield plus the expected capital gains
424 (growth) rate and the current yield on Treasury securities.
425
426
427
If we make these two assumptions, we can use the constant dividend growth model to estimate the expected return on
428 the market: (1) growth is expected to be constant, (2) the firm pays out all available funds as dividends (i.e., there are no
stock repurchases or purchases of short-term securities).
429
430
431 rM = (D1/P0) + g
432
433
To use this model, we need estimates of the expected dividend yield and the expected growth rate in the stock price
434 (recall that in a constant growth model, the expected growth in stock price is also the expected growth in dividends).
435
436
437
438 Simplified Illustration of Estimating a Forward-Looking Risk Premium
439
440 Estimating the Year-1 Dividend Yield (See source at right)
441
442 D1/P0 = 2.00% Get from S&P see source at right
443
444 Estimating the Long-Term Growth Rate
445
446 Since 1988, the average dividend growth for the S&P 500 has been about:
447
448 g= 4.99% See estimate at right
449
 A B C D E F G
450 Estimated Forward-Looking Expected Market Return
451
452 rM = (D1/P0) + g

453 rM = 6.99%
454
455
456 Estimated Forward-Looking Premium
457 Yield on 10-year T-bond on
458 rRF = 2.97% 5/4/2018
459
460 RPM = rM – rRF = 4.02% Assumes constant growth and no stock repurchases.
461
462
463 9-6 Using the CAPM to Estimate the Cost of Common Stock, rs
464
465 rs = risk-free rate + (Market risk premium) (Beta)
466 = rRF + (RPM) bi (Recall that: RPM is the expected return on the market minus the risk-free rate.)
467
468 The Risk-Free Rate
469
470 The risk-free rate is often proxied by the yield on a long-term Treasury bond. When we wrote this, the rate on a 10-year T-bond was:
471
472
473 Date of data: 5/4/2018
474 Yield on 10-year T-bond = r RF
= 2.97%
475
476
477 The Market Risk Premium
478
479 The market risk premium is the return in excess of the risk-free rate that is required to induce investors to invest in the stock
480 market.
481
482 Assumed market risk premium = RPM = 6.00%
483
484
485 Estimating Beta
486
487 Beta can be estimated from historical stock returns using the following formula, where ρ im is the correlation between Stock i and the
488 market, σi is the standard deviation of Stock i, and σ M is the standard deviation of the market.
489
490 Beta for Stock i = bi = riM(si/sM)
491
492
The same estimate for beta can be obtained as the estimated slope coefficient in a regression, with the company’s stock returns on
493 the y-axis and market returns on the x-axis. Beta can also be obtained from many Web sources.
494
495
496
497 MicroDrive's beta:
498 bi = 1.33
 A B C D E F G
499
500
501 An Illustration of the CAPM Approach: MicroDrive’s Cost of Equity, r s
502
503
504 Risk-free rate 5.02%
505 Market risk premium 6.0%
506 Beta 1.33
507
508 rs = rRF + (RPM) (bi)
509 r s
= 5.02% + 6.0% 1.33
510 rs = 5.02% + 8.0%
511 rs = 13.00%
512
513
514
515 9-7 Dividend-Yield-Plus-Growth-Rate, or Discounted Cash Flow (DCF), Approach
516
517
518 The simplest DCF model assumes that growth is expected to remain constant, and in this case: rs = D1/P0 + g.
519
520
521 Estimating Inputs for the DCF Approach
522
523
524 The next expected dividend is easy to estimate, and the stock price can be determined readily. However, it
is not easy to determine the marginal investor's expected future growth rate. Three approaches are
525 commonly used: (1) historical growth rates, (2) retention growth model, and (3) analysts' forecasts.
526
527
528 1. Historical Growth Rates
529
530 Historical growth estimates are usually not good estimates of expected future growth except for a few very
531 stable and mature companies.
532
533
534 2. Retention Growth Model
535
536 Another method for finding the growth is utilizing the sustainable growth rate, found by multiplying the
537 expected future return on equity (ROE) times the expected future retention ratio (i.e., the percentage of net
538 income that is not paid out as dividends). This is:
539
540 g = (Retention rate) (ROE) = (1 – Payout rate) (ROE)
541
542 Suppose a firm's expected ROE is 14.5% and it pays out 63% of its earnings. What is the firm's sustainable
543 growth rate?
544
545 Payout rate = 63%
546 ROE = 14.50%
547
548 g = (1 – Payout rate) x (ROE)
549 g= 37% x 14.50%
 A B C D E F G
550 g= 5.4%
551
 A B C D E F G
552 3. Analysts' Forecasts
553
554
555 A third method for estimating the growth rate is to use analysts' forecasts. Value Line provides estimated dividends.
IBES, Zack's, and many brokerage firms provide estimates of growth rates, which can be used as proxies for dividend
556 growth. These often have a forecast for the next five years and then a long-term forecast for the period after five years,
557 which requires the use of a nonconstant multi-stage growth model, as described in the Web Extension.
558
559
560
561 An Illustration of the DCF Approach
562
563 Suppose a firm's stock trades at $32 and its next dividend is expected to be $1.82. If the expected growth
564 rate is 5.5%, what is the firm's cost of equity?
565
566 P0 = $32.00
567 D1 = $1.82
568 g= 5.4%
569
570 rs = D1 ÷ P0 + g
571 r s
= $1.82 ÷ $32.00 + 5.4%
572 rs = 11.1%
573
574
575 9-8 The Weighted Average Cost of Capital (WACC)
576
577
The weighted average cost of capital (WACC) is calculated using the firm's target capital structure together with its after-
578 tax cost of long-term debt, after-tax cost of short-term debt, cost of preferred stock, and cost of common equity.
579
580
581 WACC = Weighted average cost of capital
582 = wd rd(1 – T) + wstd(1 – T)rstd + wps rps + ws rs
583
584 A firm's target capital structure consists of the following capital structure. Using the relevant costs calculated previously,
585 what is the firm's weighted average cost of capital?
586
587 T= 25%
588 w d
= 20% rd = 10.0%
589 wstd = 4% rstd = 8.0%
590 w ps
= 2% r ps
= 7.15%
591 ws = 74% rs = 13.0%
592
593 Sources of Capital
Long-term Short-term Preferred Common
594 Debt Debt Stock Stock
595
596 Pre-tax cost of capital source, r i: 10.00% 8.00% 7.15% 13.00%
597 After-tax cost of debt, (1-T)(ri): 7.50% 6.00%
598
599 Cost of capital component for WACC: 7.50% 6.00% 7.15% 13.00%
 A B C D E F G
600 Target capital structure weight, w i: 20.00% 4.00% 2.00% 74.00%
601
602 Weighted component cost: 1.5000% 0.2400% 0.1430% 9.6200%
603
604
605 WACC = 11.50%
606
607
608 9-9 Adjusting the Cost of Equity for Flotation Costs
609
610 A company's stock sells for $32 and its next dividend is expected to be $1.82, with constant growth of 5.5%.
611 What is the cost of equity using the DCF model?
612
613 P0 = $32.00
614 D 1
= $1.82
615 g= 5.4%
616
617 rs = D1 ÷ P0 + g
618 r s
= $1.82 ÷ $32.00 + 5.4%
619 r s
= 11.1%
620
621 If the firm in the preceding question incurred a flotation cost of 12.5% for issuing new stock, how much
622 higher is its cost of equity from having to issue new common stock?
623
624 Flotation percentage cost (F) = 12.5%
625 Stock price = $32.00
626
627 Net proceeds after flotation costs = (Stock Price) (1 – F)
628 Net proceeds after flotation costs = $32.00 88%
629 Net proceeds after flotation costs = $28.00
630
631 Net proceeds after flotation costs = $28.00
632 D1 = $1.82
633 g= 5.40%
634
635 rs = D1 ÷ Net Proceeds + g
636 r s
= $1.82 ÷ $28.00 + 5.4%
637 rs = 6.5% + 5.4%
638 r s
= 11.9%
639
640 Notice that this cost of stock is quite different than the cost of stock without flotation costs.
641
642
To find the cost of perpetual preferred stock, simply use the procedure above with g = 0. If the preferred stock has a
643 fixed maturity, then use the same procedure as for debt, except that the preferred dividend is not tax deductible.
644
645
646
 A B C D E F G
647 9-10 Privately Owned Firms and Small Businesses
648
649
A privately held firm often estimates its own beta as the average beta of publicly traded companies in the same industry.
650
651
652 Own-Bond-Yield-Plus-Judgmental-Risk-Premium Approach
653
654
655 This approach consists of adding a judgmental risk premium to the yield on the firm's own long-term debt. It is logical
that a firm with risky, low-rated debt would also have risky, high-cost equity. Historically, we have observed that the risk
656 premium for equity is in the range of 3 to 5 percentage points. In addition to applications to privately held firms, this
657 method is used primarily in utility rate case hearings.
658
659
660 Example:
661
662 Judgmental over-own-bond-yield risk premium = 4.0%
663 Bond yield or rd = 10.0%
664
Extra
665 rs =
Premium
+ rd

666 rs = 4.0% + 10.0%

667 r s
= 14.0%
668
669
670 9-11 Managerial Issues and the Cost of Capital
671
672
There is a relationship between the cost of capital and risk--the higher a project's risk, the higher its cost of
673 capital. When adjusting for risk, firms usually begin by estimating a divisional cost of capital, and then
adjusting this estimate for the risk of individual projects.
674
675
676
Consider a company with a single division, steel production. The risk-free rate of interest is 5%, and the
677 market risk premium is 6%. If the firm has a beta of 1.1, what is the firm's cost of equity?
678
679
680 Risk-free rate 5%
681 Market risk premium 6.0%
682 Steel Beta 1.1 rSteel = 11.6%
683
684
Suppose the firm undertakes a new operation (a barge project). The average beta of companies that only
685 have barge operations (I.e., pure-play companies) is 1.5. What is the cost of equity for the new division?
686
687
688 Risk-free rate 5%
689 Market risk premium 6.0%
690 Barge Beta 1.5 rBarge = 14.0%
691
692 Now suppose the firm undertakes a new low-risk operation (a distribution center). The average beta of
companies that only have distribution centers (I.e., pure-play companies) is 0.5. What is the cost of equity
for the new division?
 A the firm undertakes
Now suppose B C
a new low-risk D (a distribution
operation E center). The F average beta Gof
693 companies that only have distribution centers (I.e., pure-play companies) is 0.5. What is the cost of equity
for the new division?
694
695
696 Risk-free rate 5%
697 Market risk premium 6.0% rCenter = 8.0%
698 Distribution Beta 0.5
699
700
701 After adding the two new divisions, the Steel division will make up 70% of the company's value, the Barge
division will make up 20%, and the Distribution division will make up 10%. What is the new beta for the
702 entire company? (Hint: the beta of the firm is a weighted average of the divisional betas.) What rate of
703 return will equity holders require the firm as a whole to provide?
704
705
706 Beta of Steel Division 1.1
707 % of the firm 70%
708
709 Beta of Barge Division 1.5
710 % of the firm 20%
711
712 Beta of Distribution Division 0.5
713 % of the firm 10% New corp. beta = 1.12
714
715 Risk-free rate 5%
716 Market risk premium 6.0%
717 Beta 1.12 New rs = 11.72%
 H I J K L M N
1 11/20/2018
2
3
4
5
6
common equity that the7firm uses to
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
Investor-Supplied Capital
31Market
Target
32 Percent Capital
33 of Total Structure
34
35 5.7% wstd = 4%
36
37
38 19.8% wd = 20%
39
40 3.8% wps = 2%
41
42
43 70.7% ws = 74%
44 100.0% 100%
45
46
 H I J K L M N
47 rate on long-term debt = 10.00%
Coupon
48 rate on short-term debt = 8.00%
Interest
49 Risk-free rate = 5.02%
50 Beta = 1.33
51 Market risk premium = 6.00%
52 Tax rate = 25%
53
54
55
56
long-term bonds sell at a discount and some sell at a premium,
k value. 57
58
59
nding, for a total market value of equity of $31(60) = $1,860
60
61value of preferred of $100(1) = $100
nding, for a total market
62
63
64
65
66
67
ax deductibility of interest. The after-tax
68rate.
times one minus the tax
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
91
92
93
94
95
 H I J K L M N
96
97
98
99
100
101
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133
134
135
136
137
138
139
140
141
142
143
144
145
 H I J K L M N
146
147
148
149
150
151
152
153
154
155
156
157
158
a $1,000 par value, an159
8% annual
160 sell at its par
and the bond will initially
161
162
163
164
165
166
167
168
169
170
171
172
173
174
175
ost. The first step in the constant yield
176the pre-tax
ssue price. Then multiply
177
178
179
180
181
182
183
184
185
186
187
188
189
190
191
192
193
194
195 cost per
whether or not the flotation
196
 H I J K L M N
197
198
199
method should be used. 200That is true for
201
202
203
204
205
206
has a 28 year maturity207instead of a 10
208
209
210
211
212
213
214
215
216
217
218
219
cost must be allocated220
equally over each
ment period. The after-tax cost of debt is
221
wise, the constant yield method should
222
223
224
225
226
227
228
229
230
231 costs are a
od. The allocated flotation
232
hield each period in the amount of
233 values to
ayments. Use these after-tax
234
235
236
237
238
239
240
241
242
243
244
245
246
247
248
 H I J K L M N
249
250yield method.
instead used the constant
pproach? 251
252
253
254
255
256
257
258
259
260
261
262
eep in mind that this is the incorrect approach.
263
264
265
266
267
268
269 yield method.
re use the easier constant
270
271
272
273
274
remium or total net discount.
275
276
277
278
as a total net discount,279
use the same
280
281
282
283
284
285
286
the company will receive if it issues new
tax deductible. 287
288
289
290
of $7 per share if the company could sell
291
292
293
294
295
296
297
298
299
300
 H I J K L M N
301
302
303
 H I J K L M N
304
305
306
d return for the stock market? What is
ce them to invest in the307
stock market
308
309
310
311
rket data as an estimate for the current
312
nd as the differential between expected
-term bond rate. 313
314
315
316
317
318
319
ta from 1926. Ibbotson publishes
320
torical risk premiums. Ibbotson
321
ts that occurred back in the period of say
years. 322
323
324
325
326
327
328
329
330
331 Note: Ibbotson actually uses the bond's return due to income as a proxy for the yield.
332
333
334
335
336
337
338
339
10-Year T-bond (Treasury 10-year
340
constant maturity)
For calculation of geometric mean: wealth relative
Premium

341
Actual
342 Yield on Return
First Day of During rM − rM − Actual
Year, Year, Required return of 10-
343 Required rRF Actual rRF rRF year bond Total Return, rM Capital Gains
344
345
346 2.45% 3.536% 19.38% 18.29% 1.22 1.19
347 2.27% 0.664% 9.69% 11.30% 1.12 1.10
348 2.17% 1.274% -0.79% 0.11% 1.01 0.99
349 3.04% 11.211% 10.65% 2.48% 1.14 1.11
 H I J K L M N
350 1.78% -8.9% 30.61% 41.28% 1.32 1.30
351 1.89% 2.885% 14.11% 13.11% 1.16 1.13
352 3.30% 16.901% -1.19% -14.79% 1.02 1.00
353 3.85% 8.934% 11.21% 6.13% 1.15 1.13
354 2.25% -11.085% 24.21% 37.55% 1.26 1.23
355 4.04% 21.628% -41.04% -58.63% 0.63 0.62
356 4.71% 10.938% 0.78% -5.45% 1.05 1.04
357 4.39% 1.554% 11.40% 14.24% 1.16 1.14
358 4.24% 2.900% 0.67% 2.01% 1.05 1.03
359 4.27% 4.540% 6.61% 6.34% 1.11 1.09
360 3.83% -0.047% 24.87% 28.75% 1.29 1.26
361 5.07% 16.918% -27.17% -39.02% 0.78 0.77
362 5.12% 5.571% -17.00% -17.45% 0.88 0.87
363 6.45% 19.203% -15.56% -28.31% 0.91 0.90
364 4.65% -10.240% 16.39% 31.28% 1.21 1.20
365 5.75% 16.185% 22.83% 12.39% 1.29 1.27
366 6.43% 12.750% 26.93% 20.61% 1.33 1.31
367 5.58% -1.771% 17.49% 24.84% 1.23 1.20
368 7.84% 30.486% 29.59% 6.94% 1.37 1.34
369 5.83% -10.655% -4.52% 11.97% 1.01 0.98
370 6.70% 14.859% 3.29% -4.87% 1.10 1.07
371 6.71% 6.800% 0.96% 0.87% 1.08 1.04
372 8.08% 21.229% 22.47% 9.32% 1.31 1.26
373 7.93% 6.589% -11.10% -9.76% 0.97 0.93
374 9.14% 20.659% 22.35% 10.83% 1.31 1.27
375 8.83% 6.079% 7.98% 10.73% 1.17 1.12
376 7.23% -6.152% -2.00% 11.38% 1.05 1.02
377 9.00% 26.304% 9.47% -7.83% 1.18 1.15
378 11.55% 37.359% 20.61% -5.20% 1.32 1.26
379 11.82% 14.280% -5.55% -8.01% 1.06 1.01
380 10.36% -1.951% 12.15% 24.46% 1.23 1.17
381 13.98% 52.399% 7.43% -30.99% 1.21 1.15
382 12.43% -0.605% -17.34% -4.30% 0.95 0.90
383 10.33% -6.890% 22.09% 39.31% 1.32 1.26
384 9.15% -0.918% 9.29% 19.36% 1.18 1.12
385 7.78% -3.802% -1.22% 10.36% 1.07 1.01
386 6.81% -1.536% -13.99% -5.64% 0.93 0.88
387 7.76% 16.699% 16.08% 7.14% 1.24 1.19
388 7.40% 4.214% 29.80% 32.99% 1.37 1.32
389 6.90% 2.503% -33.37% -28.97% 0.74 0.70
390 6.41% 2.100% -21.07% -16.76% 0.85 0.83
391 5.89% 1.323% 13.09% 17.66% 1.19 1.16
392 6.50% 12.151% 7.81% 2.16% 1.14 1.11
393 7.88% 21.133% -4.78% -18.04% 1.03 1.00
394 6.16% -8.137% -14.52% -0.22% 0.92 0.89
395 5.70% 1.649% 4.96% 9.01% 1.11 1.08
396
397
398 6.39% 7.67% 5.10% 3.82%
399 6.36% 6.98% 3.64% 1.54%
400
401
402
 H I J K L M N
403
404
Average
405 Geometric
406 10.10%
407
408 6.36%
409
410
411 3.64%
412
413
414
415
risk premium.
416
417
418
419
420
421
est estimate of the current
422 risk premium
rd-looking risk premiums assume that
423 gains
ld plus the expected capital
424
425
426
427
del to estimate the expected return on
ble funds as dividends428
(i.e., there are no

429
430
431
432
433
ected growth rate in the stock price
o the expected growth434
in dividends).
435
436
437
438
439
440
441
442 For current estimates from Standard & Poor’s, go to www.standardandpoors.com and select S&P Dow Jones Indices. Then sele
500 under Indices. Then under Additional Info, select Index Earnings and download the spreadsheet. The forward-looking div
443 yield is the one labeled Dividend yield (current indicated rate) around 90 lines down. Note that S&P reorganizes their site freq
444 and this spreadsheet may not be in the same location when you look! If you can't find it, search on Earnings Estimates, or EPSE
in the S&P 500 Index section.
445
446
447
448 Growth rate in dividends using the Excel function =LOGEST.
449 4.99%
 H I J K L M N
450
451
452
453
We would like estimates of the function: dividend = a*e^(r*year). r will be the estimated growth rate of dividends, which is wh
454 want. The Excel function =logest almost does this. It estimates a regression of the form: y = b*m^x, or in our case, dividends =
455 b*m^year. A little algebra shows that r = ln(m), which is the growth estimate. r can be estimated directly, see below, with the li
456 regression ln(y) = c + r*year. The easiest way to do this directly is to use the =slope function.
457
458
459 Growth rate in dividends using the Excel function =SLOPE and ln(dividends) as y.
460 4.86%
461
462
463
464
465
n the market minus the466risk-free rate.)
467
468
469
hen we wrote this, the 470
rate on a 10-year T-bond was:
471
472
473
474
475
476
477
478
479
ired to induce investors to invest in the stock
480
481
482
483
484
485
486
487 between Stock i and the
where ρ im is the correlation
f the market. 488
489
490
491
492
a regression, with the company’s stock returns on
y Web sources. 493
494
495
496
497
498
 H I J K L M N
499
500
501
502
503
504
505
506
507
508
509
510
511
512
513
514
DCF), Approach 515
516
517
518
519
520
521
522
523
524
525
526
527
528
529
530
531
532
533
534
535
536
537
538
539
540
541
542
543
544
545
546
547
548
549
 H I J K L M N
552
553
554
555dividends.
e Line provides estimated
h can be used as proxies for dividend
forecast for the period556
after five years,
in the Web Extension.557
558
559
560
561
562
563
564
565
566
567
568
569
570
571
572
573
574
575
576
577
capital structure together with its after-
ck, and cost of common 578
equity.
579
580
581
582
583
584 previously,
the relevant costs calculated
585
586
587
588
589
590
591
592
593
594
595
596
597
598
599
 H I J K L M N
600 100% = Sum
601
602 11.50% = Sum
603
604
605
606
607
608
609
610
611
612
613
614
615
616
617
618
619
620
621
622
623
624
625
626
627
628
629
630
631
632
633
634
635
636
637
638
639
tion costs. 640
641
642
th g = 0. If the preferred stock has a
643
d dividend is not tax deductible.
644
645
646
 H I J K L M N
647
648
649
traded companies in the same industry.
650
651
652
653
654
irm's own long-term debt.
655 It is logical
storically, we have observed that the risk
plications to privately 656
held firms, this
657
658
659
660
661
662
663
664
665
666
667
668
669
670
671
672
673
674
675
676
677
678
679
680
681
682
683
684
685
686
687
688
689
690
691
692
 O P Q R S T
304
305
306
307
308
309
310
311
312
313
314
315
316
317
318
319
320
321
322
323
324
325
326
327
328
329
330
331
332
333
334
335
336
337
338
339
340 wealth relative
ulation of geometric mean:

341
Yield on
342 Reported First Day
yield on of Year, Actual Return rM − Actual
343 last day Required During Year, return of 10-
Return on Dividends of year rRF Actual rRF rM − Required rRF year bond
344
345
346 1.02 1.02 1.02 1.04 1.19 1.18
347 1.02 1.02 1.02 1.01 1.10 1.11
348 1.02 1.02 1.02 1.01 0.99 1.00
349 1.02 1.02 1.03 1.11 1.11 1.02
 O P Q R S T
350 1.03 1.03 1.02 0.91 1.31 1.41
351 1.03 1.02 1.02 1.03 1.14 1.13
352 1.02 1.02 1.03 1.17 0.99 0.85
353 1.02 1.03 1.04 1.09 1.11 1.06
354 1.03 1.04 1.02 0.89 1.24 1.38
355 1.01 1.02 1.04 1.22 0.59 0.41
356 1.02 1.04 1.05 1.11 1.01 0.95
357 1.02 1.05 1.04 1.02 1.11 1.14
358 1.02 1.04 1.04 1.03 1.01 1.02
359 1.02 1.04 1.04 1.05 1.07 1.06
360 1.02 1.04 1.04 1.00 1.25 1.29
361 1.01 1.04 1.05 1.17 0.73 0.61
362 1.01 1.05 1.05 1.06 0.83 0.83
363 1.01 1.05 1.06 1.19 0.84 0.72
364 1.02 1.06 1.05 0.90 1.16 1.31
365 1.02 1.05 1.06 1.16 1.23 1.12
366 1.02 1.06 1.06 1.13 1.27 1.21
367 1.03 1.06 1.06 0.98 1.17 1.25
368 1.03 1.06 1.08 1.30 1.30 1.07
369 1.03 1.08 1.06 0.89 0.95 1.12
370 1.03 1.06 1.07 1.15 1.03 0.95
371 1.03 1.07 1.07 1.07 1.01 1.01
372 1.04 1.07 1.08 1.21 1.22 1.09
373 1.03 1.08 1.08 1.07 0.89 0.90
374 1.04 1.08 1.09 1.21 1.22 1.11
375 1.04 1.09 1.09 1.06 1.08 1.11
376 1.03 1.09 1.07 0.94 0.98 1.11
377 1.04 1.07 1.09 1.26 1.09 0.92
378 1.06 1.09 1.12 1.37 1.21 0.95
379 1.05 1.12 1.12 1.14 0.94 0.92
380 1.05 1.12 1.10 0.98 1.12 1.24
381 1.07 1.10 1.14 1.52 1.07 0.69
382 1.05 1.14 1.12 0.99 0.83 0.96
383 1.07 1.12 1.10 0.93 1.22 1.39
384 1.06 1.10 1.09 0.99 1.09 1.19
385 1.05 1.09 1.08 0.96 0.99 1.10
386 1.04 1.08 1.07 0.98 0.86 0.94
387 1.05 1.07 1.08 1.17 1.16 1.07
388 1.06 1.08 1.07 1.04 1.30 1.33
389 1.03 1.07 1.07 1.03 0.67 0.71
390 1.03 1.07 1.06 1.02 0.79 0.83
391 1.03 1.06 1.06 1.01 1.13 1.18
392 1.04 1.06 1.07 1.12 1.08 1.02
393 1.03 1.07 1.08 1.21 0.95 0.82
394 1.03 1.08 1.06 0.92 0.85 1.00
395 1.03 1.06 1.06 1.02 1.05 1.09
396 1.057
397
398
399
400
401
402
 O P Q R S T
403
404
405
406
407
408
409
410
411
412
413
414
415
416
417
418
419
420
421
422
423
424
425
426
427
428
429
430
431
432
433
434
435
436
437
438 This data comes from the S&P estimates Excel file referenced in the Web chapter tab.
439
440
441
andpoors.com and select 442S&P Dow Jones Indices. Then select SP Date as a year
gs and download the spreadsheet. The forward-looking dividend Date Annual DPS
nd 90 lines down. Note 443
that S&P reorganizes their site frequently 12/31/1988 89.06 $9.75
444 on Earnings Estimates, or EPSEST while
k! If you can't find it, search 12/31/1989 90.06 $11.06
445 12/31/1990 91.06 $12.09
446 12/31/1991 92.06 $12.20
447 12/31/1992 93.07 $12.39
448 12/31/1993 94.07 $12.58
449 12/31/1994 95.07 $13.17
 O P Q R S T
450 12/31/1995 96.07 $13.79
451 12/31/1996 97.07 $14.90
452 12/31/1997 98.07 $15.50
453 12/31/1998 99.07 $16.20
will be the estimated growth rate of dividends, which is what we
ression of the form: y 454
12/31/1999 100.07 $16.69
= b*m^x, or in our case, dividends =
455 directly, see below, with the linear
estimate. r can be estimated 12/31/2000 101.07 $16.27
456
o use the =slope function. 12/31/2001 102.07 $15.74
457 12/31/2002 103.07 $16.07
458 12/31/2003 104.07 $17.39
459 12/31/2004 105.07 $19.44
460 12/31/2005 106.07 $22.22
461 12/31/2006 107.07 $24.88
462 12/31/2007 108.07 $27.73
463 12/31/2008 109.08 $28.39
464 12/31/2009 110.08 $22.41
465 12/31/2010 111.08 $22.73
466 12/31/2011 112.08 $26.43
467 12/31/2012 113.08 $31.25
468 12/31/2013 114.08 $34.99
469 12/31/2014 115.08 $39.44
470 12/31/2015 116.08 $43.39
471 12/30/2016 117.08 $45.70
472 12/29/2017 118.08 $48.93
473
474
475
476
477
478
479
480
481
482
483
484
485
486
487
488
489
490
491
492
493
494
495
496
497
498
 U V W
403
404
405
406
407
408
409
410
411
412
413
414
415
416
417
418
419
420
421
422
423
424
425
426
427
428
429
430
431
432
433
434
435
436
437
he S&P estimates Excel438
file referenced in the Web chapter tab.
439
440
441
442 LN(Dividends)
443 2.2773
444 2.4029
445 2.4920
446 2.5017
447 2.5165
448 2.5319
449 2.5779
 U V W
450 2.6238
451 2.7013
452 2.7406
453 2.7847
454 2.8149
455 2.7894
456 2.7562
457 2.7772
458 2.8556
459 2.9674
460 3.1008
461 3.2142
462 3.3226
463 3.3459
464 3.1093
465 3.1236
466 3.2743
467 3.4420
468 3.5551
469 3.6749
470 3.7702
471 3.8221
472 3.8904
473
474
475
476
477
478
479
480
481
482
483
484
485
486
487
488
489
490
491
492
493
494
495
496
497
498
SECTION 9-3
SOLUTIONS TO SELF-TEST

A company has outstanding long-term bonds with a face value of $1,000, a 10% coupon rate, 25 years remaining
until maturity, and a current market value of $1,214.82. If it pays interest semiannually, what is the nominal annual
required rate of return on debt? If the company’s tax rate is 25%, what is the after-tax cost of debt?

Number of years to maturity 25

Number of payments per year 2
Annual coupon rate 10%
Face value $1,000
Tax rate 25%

N= 50
PV = ($1,214.82)
PMT = $50
FV = $1,000

I/YR = rd = 4.000%

Annualized rd = 8.000%

A-T rd = 6.000%
SECTION 9-4
SOLUTIONS TO SELF-TEST

A company’s preferred stock currently trades at $50 per share and it pays a $3 annual dividend. Flotation
costs are equal to 3% of the gross proceeds. If the company issues preferred stock, what is the cost of that
stock?

Preferred stock price $50

Dividend per share $3
Flotation percentage 3%

rps 6.19%
SECTION 9-6
SOLUTIONS TO SELF-TEST

A company’s beta is 1.4, the yield on a 10-year T-bond is 5%, and the market risk premium is 5.5%. What is r s?

Beta 1.40
10-year T-bond yield 4.0%
Market risk premium 4.5%

rs 10.30%
SECTION 9-7
SOLUTIONS TO SELF-TEST

A company’s estimated growth rate in dividends is 6%. Its current stock price is $40, and its expected annual dividend is
$2. Using the DCF approach, what is r s?

Growth 6.0%
Stock price $40.00
Expected dividend $2.00

rs 11.00%
SECTION 9-8
SOLUTIONS TO SELF-TEST

A firm has the following data: Target capital structure of 25% debt, 10% preferred stock, and 65% common equity; tax
rate = 25%; rd = 7%; rps = 7.5%; and rs = 11.5%. Assume the firm will not isssue new stock. What is this firm’s WACC?

wd 25%
wps 10%
ws 65%
Tax rate 25%
rd 7.0%
rps 7.5%
rs 11.5%
WACC 9.54%
SECTION 9-9
SOLUTIONS TO SELF-TEST

A firm has common stock with D1 = $3.00; P0 = $30; g = 5%; and F = 4%. If the firm must issue new stock, what is its cost of external equity, r e?

D1 $3.00
P0 $30.00
g 5.0%
F 4.0%
re 15.42%
st of external equity, r e?
SECTION 9-10
SOLUTIONS TO SELF-TEST

A company’s bond yield is 7%. If the appropriate over-own-bond-yield risk premium is 3.5%, what is r s, based upon the
bond--yield-plus-judgmental-risk-premium approach?

Bond yield 7.0%

Bond risk premium 3.5%

rs 10.50%
 A B C D E F G
1 11/20/2018
2
3 Web Extension 9A: The Required Return Assuming Nonconstant Dividends and Stock
4 Repurchases
5
6 As we explained in the chapter, two assumptions underlie the constant dividend growth model:
7 (1) firms do not repurchase any stock, and (2) growth in dividends will be constant. We now
explain how to estimate the required return when those assumptions are violated.
8
9
10 Estimating the Long-Term Growth Rate
11
12 The long-term constant growth rate should be approximately equal to the long-term growth rate
13 in sales revenue, which depends on prices and units sold. Prices will be determined by inflation
in the long-term, and units sold will depend on sustainable population growth.
14
15
16 The forward estimated inflation rate is the difference between yields on a regular 10-year
17 Treasury bond and an inflation protected 10-year Treasury bond, called a TIPS.
18
19 Yield on 10-year Treasury bond: 2.87% 2/28/2018
20 Yield on 10-year TIPS: 0.75%
21 Forward estimate of inflation: 2.12%
22
23 The Fed provides inflation data going back to 1947. The web site is: https://fred.stlouisfed.org/series/CPIAUCSL
24
25 Historical inflation rate: 3.47%
26
27 Range in expected long-term inflation:
28
29 Forward estimate of inflation to Historical inflation rate
30 2.12% to 3.47%
31
32 We estimate expected inflation as the average of the inflation premium from the TIPS and the
33 historical average:
34
35 Our estimate of expected inflation: 2.79%
36
37
38 Estimates of long-term population growth range from:
39
40 Low estimate of population growth High estimate of population growth
41 1.00% 2.50%
42
43 Average of estimated population growth: 1.75%
44
45
46 Estimates of long-term sales growth rate (inflation plus population growth rate):
47
48 Low range High range
49 3.12% 5.97%
50
 A B C D E F G
51 Average of range as an estimate of long-term sales growth, g: 4.54%
52
53
54 The Impact of Stock Repurchases on the Estimated Price
55
56 When there are repurchases, the growth rate in dividends per share changes.
57
58 - (r - gL )  r1  gL 
59 gDPS 
60 (r - gL )  1  gL 
61
62 The constant growth model is:
63
64
65 D 1  g DPS 
P̂0  0
66  r - g DPS 
67
68
69 This can be rearranged to give this formula:
70
71
 1  D 1  g L 
72 P̂0    0
73     r - gL 
74
75 The two formulas are equivalent, as shown in the following example.
76
77 g= 5.0%
78 α= 80.0%
79 rs = 12.0%
80 D0 = $2.00
81
82 - (r - gL )  r1  gL 
83 gDPS 
(r - gL )  1  gL 
= 6.329%
84
85
86
87
88
89
90 D 0 1  g DPS 
91 P̂0 
92
 rs - g DPS  = $37.50

93
94 Alternatively:
95
96
97  1  D 1  g L 
P̂0    0
98
99

   r - gL  = $37.50

100
101
 A B C D E F G
102 Estimating the Required Return
103
104 In the textbook, we assumed constant growth and no repurchases. We now consider cases with
105 repurchases and a period of nonconstant growth, beginning with the case of repurchases but
constant growth.
106
107
108 Repurchases and Constant Growth
109
110 If there are repurchase but still constant growth, then we can invert the constant growth formula
111 to solve for r.
112
113
D 1  g L 
114 r 0  gL
115
116
 P0
117
118
119 Repurchases and a Period of Nonconstant Growth
120
121 It is often the case that a period of nonconstant growth is expected before growth becomes
122 constant. The valuation model for this situation is:
123
124
125  D t (1  g L ) 
126  D D2 Dt 
  r  g  
127 P ̂_0  1 1      L 
128 = 
  1  r   1  r  2
 1  r  t

 1  r  t
129
130
131
132
133 Estimating the Required Market Return when there are Repurchases and a Period of Nonconstant Growth
134
135
136 In recent years, companies in the S&P 500 aggregately have distributed even more cash to
137 shareholders in the form of stock repurchases than in the form of dividends. Recently, only about
40% of distributions are in the form of dividends.
138
139
140 Percent of total distribution in the form of cash dividends = α = 41.0%
141
142 The next step is to estimate the total S&P dividend payouts for the next 2 years. S&P provides
143 historical data for earnings per share, and dividends per share. They also provide data for
144 estimated earnings per share for the next 2 years. We can use the historical data to estimate a
relationship between EPS and DPS, and then use that model and the estiamted EPS to estimate
145 DPS.
146
147
148 We obtained data from the Standard and Poor's Web site:
149 http://www.standardandpoors.com/home/en/us
150
151
For current estimates from Standard & Poor’s, go to www.standardandpoors.com and select S&P
152 Dow Jones Indices. Then select SP 500 under Indices. Then under Additional Info, select Index
153 Earnings and download the spreadsheet. This downloaded an Excel file with quarterly data for
the S&P 500. We summed up the quarterly data to get annual data. We also summed up the
quarterly forecasted EPS to get the next 2 years annual forecast of EPS. The data is shown below.
Note that S&P reorganizes their site frequently and this spreadsheet may not be in the same
location when you look! If you can't find it, search on Earnings Estimates, or EPSEST while in the
S&P 500 Index section.
 For current estimates from Standard & Poor’s, go to www.standardandpoors.com and select S&P
Dow Jones Indices. Then select SP 500 under Indices. Then under Additional Info, select Index
EarningsAand download B the spreadsheet.C This downloaded
D an ExcelEfile with quarterly
F G for
data
154 the S&P 500. We summed up the quarterly data to get annual data. We also summed up the
155 quarterly forecasted EPS to get the next 2 years annual forecast of EPS. The data is shown below.
Note that S&P reorganizes their site frequently and this spreadsheet may not be in the same
156 location when you look! If you can't find it, search on Earnings Estimates, or EPSEST while in the
157 S&P 500 Index section.
158
159
160
161 Annualized Data

162 Annual
Date Year Month S&P Price Annual EPS DPS Data for Regression Model
163 12/31/88 1988 12 277.72 $23.75 $9.75 Annual DPS
164 12/31/89 1989 12 353.40 $22.87 $11.06 $11.06
165 12/31/90 1990 12 330.22 $21.34 $12.09 $12.09
166 12/31/91 1991 12 417.09 $15.97 $12.20 $12.20
167 12/31/92 1992 12 435.71 $19.09 $12.39 $12.39
168 12/31/93 1993 12 466.45 $21.89 $12.58 $12.58
169 12/31/94 1994 12 459.27 $30.60 $13.17 $13.17
170 12/31/95 1995 12 615.93 $33.96 $13.79 $13.79
171 12/31/96 1996 12 740.74 $38.73 $14.90 $14.90
172 12/31/97 1997 12 970.43 $39.72 $15.50 $15.50
173 12/31/98 1998 12 1229.23 $37.71 $16.20 $16.20
174 12/31/99 1999 12 1469.25 $48.17 $16.69 $16.69
175 12/31/00 2000 12 1320.28 $50.00 $16.27 $16.27
176 12/31/01 2001 12 1148.08 $24.69 $15.74 $15.74
177 12/31/02 2002 12 879.82 $27.59 $16.07 $16.07
178 12/31/03 2003 12 1111.92 $48.74 $17.39 $17.39
179 12/31/04 2004 12 1211.92 $58.55 $19.44 $19.44
180 12/31/05 2005 12 1248.29 $69.83 $22.22 $22.22
181 12/31/06 2006 12 1418.30 $81.51 $24.88 $24.88
182 12/31/07 2007 12 1468.36 $66.18 $27.73 $27.73
183 12/31/08 2008 12 903.25 $14.88 $28.39 $28.39
184 12/31/09 2009 12 1115.10 $50.97 $22.41 $22.41
185 12/31/10 2010 12 1257.64 $77.35 $22.73 $22.73
186 12/31/11 2011 12 1257.60 $86.95 $26.43 $26.43
187 12/31/12 2012 12 1426.19 $86.51 $31.25 $31.25
188 12/31/13 2013 12 1848.36 $100.20 $34.99 $34.99
189 12/31/14 2014 12 2058.90 $102.31 $39.44 $39.44
190 12/31/15 2015 12 2043.94 $86.53 $43.39 $43.39
191 12/30/16 2016 12 2238.83 $99.26 $45.70 $45.70
192 12/30/17 2017 12 2,673.61 $124.87 $48.93 $48.93
193
194 Forecast 2018 12 $156.19 see estimate below
195 2019 12 $173.11 see estimate below
196
197 We estimated the following model: Coefficients using the LINEST function
198 d
199 Dt = a + b Dt-1 + c EPSt + d (Change in EPS) -0.1035743
200
201
202
For more detailed regression results, go to the Data tab and select "Data Analysis". Scroll down and choose "Regression". A dialog
203 box will open. Choose your Y variable range and your X variables range. Choose a cel for the "Output Range". The results from
204 such a regression follow. Notice that the Adjusted R Square is very high, showing that themodel does a good job of predicting the
dividend.
 For more detailed regression results, go to the Data tab and select "Data Analysis". Scroll down and choose "Regression". A dialog
box will open. Choose your Y variable range and your X variables range. Choose a cel for the "Output Range". The results from
A
such a regression follow.BNotice that theCAdjusted R Square
D E showing
is very high, F that themodel
G does a good job of predicting the
205 dividend.
206
207 SUMMARY OUTPUT
208
209 Regression Statistics
210 Multiple R 0.9906493668
211 R Square 0.981386168
212 Adjusted R Square 0.9791525082
213 Standard Error 1.5738684709
214 Observations 29
215
216 ANOVA
217 df SS MS F Significance F
218 Regression 3 3264.983738 1088.327913 439.3624094 1E-21
219 Residual 25 61.926549096 2.477061964
220 Total 28 3326.9102871
221
222 Coefficients Standard Error t Stat P-value Lower 95% Upper 95%
223 Intercept -1.6381897209 0.7546274762 -2.17085883 0.039641079 -3.1924 -0.0840053406
224 X Variable 1 0.8719453647 0.0670558492 13.00327079 1.260584E-12 0.73384 1.0100494712
225 X Variable 2 0.1187705888 0.0210638636 5.638594657 7.214533E-06 0.07539 0.1621524279
226 X Variable 3 -0.10357429 0.0222264369 -4.65995924 8.995467E-05 -0.1494 -0.0577980863
227
228
229
Estimat
Estimated ed
230 coefficient coeffici
Predicted Estimated for lagged ent for
Year dividend, D intercept, a dividend, b Lagged D EPS, c Forecast EPS
231 2018 $53.52 -1.638 0.872 $45.70 0.119 $156.19
232 2019 $63.83 -1.638 0.872 $53.52 0.119 $173.11
233
234
235 Create a time line showing the predicted dividends for each year until growth in payouts
236 becomes constant. To do this, obtain estimates of the next 2 year's projected dividends for the
237 market and the long-term growth rate in CASH FLOWS after year 2.
238
239
Find the horizon value on the time line assuming constant growth and an initial assumption for
240 the required return on the market. Find the present value of the annual payouts and the present
241 value of the horizon value; this is the estimate of the value of the market index. If the difference
between the actual current value of the market index and the estimated value is not zero, adjust
242 the input for the required market return until the difference is zero.
243
244
245 Figure 9A-1:
246 Estimating the Forward-Looking Market Risk Premium
247
248 INPUTS:
249 Projected Year 1 dividend for S&P 500 = $53.52
250 Projected Year 2 dividend for S&P 500 = $63.83
251 Projected portion of distributions as dividends, α = 41.0%
252 Projected long-term constant growth rate in cash flow, g L = 4.54%
 A B C D E F G
253 Actual price level of S&P 500 = $2,673.61
254
255 Key Input/Output: Estimate of rM

256 Key Input and Output: Estimate of r M = 9.79% Use Goal Seek to set
the blue cell to zero by
changing the orange
257 Price level of S&P 500: Actual - Estimated = $0.00 cell.
258
259 Time Line:
260 Year 0 1 2
261 Estimated dividend = $53.52 $63.83
262 Estimated P at Year 2 = [(D2/ α) (1+gL) ] / (rM − gL) = $3,100.32
263 Estimated price level of S&P 500 = (PV of dividends and P 2) = $2,673.61
264
265
266 Estimate of the market risk premium based on this estimate of r M.
267
268 Estimate of rM. Risk free rate
269 9.79% 2.87%
270
271 Estimate of the market risk premium 6.92%
 H I J K L M
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
https://fred.stlouisfed.org/series/CPIAUCSL
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
 H I J K L M
102
103
104
105
106
107
108
109
110
111
112
113
114
115
116
117
118
119
120
121
122
123
124
125
126
127
128
129
130
131
132
133 Growth
nd a Period of Nonconstant
134
135
136
137
138
139
140
141
142
143
144
145
146
147
148
149
150
151
152
153
 H I J K L M
154
155
156
157
158
159
160
161
162
Data for Regression Model
163 Lagged DPS Annual EPS Change in EPS 0
164 $9.75 $22.87 -$0.88
165 $11.06 $21.34 -$1.53
166 $12.09 $15.97 -$5.37
167 $12.20 $19.09 $3.12
168 $12.39 $21.89 $2.80
169 $12.58 $30.60 $8.71
170 $13.17 $33.96 $3.36
171 $13.79 $38.73 $4.77
172 $14.90 $39.72 $0.99
173 $15.50 $37.71 -$2.01
174 $16.20 $48.17 $10.46
175 $16.69 $50.00 $1.83
176 $16.27 $24.69 -$25.31
177 $15.74 $27.59 $2.90
178 $16.07 $48.74 $21.15
179 $17.39 $58.55 $9.81
180 $19.44 $69.83 $11.28
181 $22.22 $81.51 $11.68
182 $24.88 $66.18 -$15.33
183 $27.73 $14.88 -$51.30
184 $28.39 $50.97 $36.09
185 $22.41 $77.35 $26.38
186 $22.73 $86.95 $9.60
187 $26.43 $86.51 -$0.44
188 $31.25 $100.20 $13.69
189 $31.25 $102.31 $2.11
190 $34.99 $86.53 -$15.78
191 $39.44 $99.26 $12.73
192 $43.39 $124.87 $25.61
193
194
195
196
197using the LINEST function
Coefficients
198 c b a
199 0.1187706 0.8719454 -1.6381897
200
201
202
ta Analysis". Scroll down and choose "Regression". A dialog
203
e. Choose a cel for the "Output Range". The results from
204does a good job of predicting the
h, showing that themodel
 H I J K L M
205
206
207
208
209
210
211
212
213
214
215
216
217
218
219
220
221
222 Lower 95.0% Upper 95.0%
223 -3.192374101177 -0.0840053406
224 0.7338412581016 1.0100494712
225 0.0753887496036 0.1621524279
226 -0.149350493676 -0.0577980863
227
228
229

230 Estimated
coefficient for Forecast
change in EPS, d change in EPS
231 -0.104 $31.32
232 -0.104 $16.92
233
234
235
236
237
238
239
240
241
242
243
244
245
246
247
248
249
250
251
252