Video 30 (Topic 6.4): The Cost of Common Stock 7/4/2018 12:41 AM Video 30 (Topic 6.4): The Cost of Common Stock FIN 614: Financial Management Larry Schrenk, Instructor © 2007 Microsoft Corporation. All rights reserved. Microsoft, Windows, Windows Vista and other product names are or may be registered trademarks and/or trademarks in the U.S. and/or other countries. The information herein is for informational purposes only and represents the current view of Microsoft Corporation as of the date of this presentation. Because Microsoft must respond to changing market conditions, it should not be interpreted to be a commitment on the part of Microsoft, and Microsoft cannot guarantee the accuracy of any information provided after the date of this presentation. MICROSOFT MAKES NO WARRANTIES, EXPRESS, IMPLIED OR STATUTORY, AS TO THE INFORMATION IN THIS PRESENTATION.

Topics What is the Cost of Common Stock? Calculating the Cost of Common Stock Using the Capital Asset Pricing Model (CAPM) Using the Discounted Dividend Model (DDM)

Cost of Common Stock Cost to the Firm to Secure Common Stock Financing Required Rate of Return to Common Stock Holders

Valuing the Cost of Common Stock: CAPM The Capital Asset Pricing Model (CAPM) estimates the cost of common stock CAPM is the expected return given a certain level of exposure to market risk

Valuing the Cost of Common Stock: CAPM–Example Your firm has a beta of 1.2, while the risk premium on the market is 8% and the risk free rate is 3%. What is the return on common equity? 3% + 1.2 x 8% = 12.6% NOTE: 8% is the risk premium on the market, not the return on the market, so the risk free rate has already been subtracted.

Valuing the Cost of Common Stock: DDM The Discounted Dividend Model (DDM) can estimate the cost of common stock Find the discount rate that makes the present value of dividends equal to the market price.

Valuing the Cost of Common Stock: DDM If the dividend is constant or constantly growing, solve the equation for r. Constant Dividend: Growing Dividend:

Valuing the Cost of Common Stock: DDM–Example What is the expected return on a stock if it is expected to pay a dividend of $4.00 per year forever, and it is now selling for $57.00?

Valuing the Cost of Common Stock: DDM–Mixed Model If the dividend has a more complex pattern, similar to what we saw in the mixed model, use the Internal Rate of Return (IRR). We will cover Internal Rate of Return (IRR) later in the course.

Alternatives Many of the broad range of asset pricing models can be used to find the expected return on a stock: Fama-French Model Free Cash Flow Model Etc.

Video 30 (Topic 6.4): The Cost of Common Stock 7/4/2018 12:41 AM Video 30 (Topic 6.4): The Cost of Common Stock FIN 614: Financial Management Larry Schrenk, Instructor © 2007 Microsoft Corporation. All rights reserved. Microsoft, Windows, Windows Vista and other product names are or may be registered trademarks and/or trademarks in the U.S. and/or other countries. The information herein is for informational purposes only and represents the current view of Microsoft Corporation as of the date of this presentation. Because Microsoft must respond to changing market conditions, it should not be interpreted to be a commitment on the part of Microsoft, and Microsoft cannot guarantee the accuracy of any information provided after the date of this presentation. MICROSOFT MAKES NO WARRANTIES, EXPRESS, IMPLIED OR STATUTORY, AS TO THE INFORMATION IN THIS PRESENTATION.