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• Cost of Equity
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Economics of new nuclear power plants - Capital costs
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Some analysts argue (for example Steve Thomas, Professor
of Energy Studies at the University of Greenwich in the UK,
quoted in the book The Doomsday Machine (2012 book)|The
Doomsday Machine by Martin Cohen and Andrew McKillop ])
that what is often not appreciated in debates about the
economics of nuclear power is that the cost of equity, that is
companies using their own money to pay for new plants, is
generally higher than the cost of debt.The Doomsday
Machine, Cohen and McKillop (Palgrave 2012) page 199
Another advantage of borrowing may be that once large loans
have been arranged at low interest rates - perhaps with
government support - the money can then be lent out at
higher rates of return.
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Corporate finance - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT) is
also typically higher than the cost of debt - which
is, additionally, a deductible expense – and so
equity financing may result in an increased hurdle
rate which may offset any reduction in cash flow
risk.See:[
http://www.lawyersclubindia.com/articles/OptimalBalance-of-Financial-Instruments-Long-TermManagement-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant Choudhary,
LL.M
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Capital asset pricing model
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CAPM “suggests that an investor’s cost of equity
capital is determined by beta.”
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Business valuation - Modified Capital Asset Pricing Model
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The Cost of Equity (Ke) is computed by using the
Modified Capital Asset Pricing Model (Mod. CAPM)
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Business valuation - Build-Up Method
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Total Cost of Equity (TCOE) = risk-free rate + total
beta*equity risk premium
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Business valuation - Build-Up Method
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While it is possible to isolate the companyspecific risk premium as shown above,
many appraisers just key in on the total
cost of equity (TCOE) provided by the
following equation: TCOE = risk-free rate +
Total beta*equity risk premium.
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Modigliani-Miller theorem - Proposition II
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* r_E is the required rate of
return on equity, or cost of
equity.
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Modigliani-Miller theorem - Proposition II
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* r_0 is the company cost of equity capital
with no leverage (unlevered cost of equity,
or return on assets with D/E = 0).
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Modigliani-Miller theorem - Proposition II
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The same relationship as earlier described
stating that the cost of equity rises with
leverage, because the risk to equity rises,
still holds
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Working capital management - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT) is
also typically higher than the cost of debt - which
is, additionally, a deductible expense – and so
equity financing may result in an increased hurdle
rate which may offset any reduction in cash flow
risk.See:[http://www.lawyersclubindia.com/articles/
Optimal-Balance-of-Financial-Instruments-LongTerm-Management-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant Choudhary,
LL.M
1
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Time value of money - Calculations
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The rate of return in the calculations can
be either the variable solved for, or a
predefined variable that measures a
discount rate, interest, inflation, rate of
return, cost of equity, cost of debt or any
number of other analogous concepts. The
choice of the appropriate rate is critical to
the exercise, and the use of an incorrect
discount rate will make the results
meaningless.
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Capital structure - Capital structure in a perfect market
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Their second 'proposition' stated that the
cost of equity for a leveraged firm is equal
to the cost of equity for an unleveraged
firm, plus an added premium for financial
risk
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Working capital management - Capitalization structure
The cost of equity (see Capital asset pricing
model|CAPM and arbitrage pricing theory|APT) is
also typically higher than the cost of debt - which
is, additionally, a deductible expense – and so
equity financing may result in an increased hurdle
rate which may offset any reduction in cash flow
risk.See:[http://www.lawyersclubindia.com/articles/
Optimal-Balance-of-Financial-Instruments-LongTerm-Management-Market-Volatility-ProposedChanges-3765.asp Optimal Balance of Financial
Instruments: Long-Term Management, Market
Volatility Proposed Changes], Nishant Choudhary,
LL.M
1
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Residual income valuation
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'Residual income valuation' (RIV; also,
residual income model and residual
income method, RIM) is an approach to
equity valuation that formally accounts for
the cost of equity capital
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Residual income valuation - Concept
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This rate of return is the cost of equity,
and a formal equity cost must be
subtracted from net income
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Residual income valuation - Calculation of residual income
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The cost of equity is typically calculated
using the Capital Asset Pricing
Model|CAPM, although other approaches
such as arbitrage pricing theory|APT are
also used. The currency charge to be
subtracted is then simply
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Residual income valuation - Calculation of residual income
:Equity Charge =
Equity Capital x Cost of
Equity,
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Residual income valuation - Valuation formula
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Using the residual income approach, the
company valuation|value of a company's
stock can be calculated as the sum of its
book value and the present value of its
expected future residual income,
discounted at the cost of equity, r, resulting
in the general formula:
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Residual income valuation - Comparison with other valuation methods
As can be seen, the residual income
valuation formula is similar to the dividend
discount model (DDM) (and to other
discounted cash flow (DCF) valuation
models), substituting future residual
earnings for dividend (or free cash)
payments (and the cost of equity for the
weighted average cost of capital).
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Adjusted present value
Technically, an APV valuation model looks
similar to a standard Discounted cash
flow|DCF model. However, instead of
weighted average cost of capital|WACC, cash
flows would be discounted at the unlevered
cost of equity, and tax shields at either the
cost of debt (Myers) or following later
academics also with the unlevered cost of
equity.http://www.iese.edu/research/pdfs/DI0488-E.pdf
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Cost of capital - Summary
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A company's securities typically include
both debt and equity, one must therefore
calculate both the cost of debt and the
cost of equity to determine a company's
cost of capital
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Cost of capital - Summary
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The cost of equity is therefore inferred by
comparing the investment to other
investments (comparable) with similar risk
profiles to determine the market cost of
equity
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Cost of capital - Summary
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Once cost of debt and cost of equity have
been determined, their blend, the
weighted-average cost of capital (WACC),
can be calculated. This WACC can then
be used as a Annual effective discount
rate|discount rate for a project's projected
cash flows.
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Cost of capital - Cost of debt
Since in most cases debt expense is a
deductible expense, the cost of debt is
computed as an after tax cost to make it
comparable with the cost of equity
(earnings are After Taxes|after-tax as well)
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Cost of capital - Cost of equity
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Cost of equity = Risk free
rate of return + Premium
expected for risk
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Cost of capital - Cost of equity
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Cost of equity = Risk free rate of return +
Beta x (market rate of return- risk free rate
of return)
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Dividend discount model
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The variables are: P is the current stock
price. g is the constant growth rate in
perpetuity expected for the dividends. r is
the constant cost of equity capital for that
company. D_1 is the value of the next
year's dividends.
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Dividend discount model - Derivation of equation
: P = \frac
\times(1+g)(1+r)D_0(1+g)IncomeCapital
GainTotal ReturnDividend
YieldGrowthCost Of EquityDPDPDr -gD_0
\left( 1+g \right)^t\left( 1+r\right)^tP_N\left(
1 +r\right)^ND_0 \left( 1 + g \right)\left( 1+g
\right)^N\left( 1 + r \right)^ND_0 \left( 1 + g
\right)^N \left( 1 + g_\infty \right)\left( 1 + r
\right)^N \left( r - g_\infty \right)rP_0 + g.
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Uwe Reinhardt - Research
Reinhardt's previous work on hospitals
examined the tax advantage|tax and cost
of capital|cost of equity capital advantages
of non-profit hospital|not-for-profit
hospitals over for-profit hospitals.
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Tax benefits of debt
For example, some critics have argued
that the cost of equity should also be
deductible; which could reduce the Internal
Revenue Code's influence on capitalstructure decisions, potentially reducing
the economic instability attributable to
excessive debt financing.
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Growth and yield modelling
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'Growth and yield model is a branch of the
subject financial management. this method
is also known as gordon constant growth
model. in this method the cost of equity
share capital by determining the sum of
yield percentage and growth percentage..
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Cost of debt - Cost of debt
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Since in most cases debt expense is a
deductible expense, the cost of debt is
computed as an after tax cost to make it
comparable with the cost of equity
(earnings are after-tax as well)
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