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Expense of Capital

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  1. Cost of Capital

  2. Components of Capital MBA 402

  3. Summarized Balance SheetDecember 31, 1998 - $ Millions Note: Current Liabilities includes a total of $346 million of permanent short-term debt. MBA 402

  4. Summarized Balance SheetDecember 31, 1994 - $ Millions Note: Current Liabilities includes a total of $8 million of permanent short-term debt. MBA 402

  5. Cost of Capital Overview MBA 402

  6. Cost of Capital Agenda • Cost of Individual Components • Cost of Debt • Cost of Preferred Stock • Cost of Equity • Weighting Approaches • Book vs. Market Weights • Current vs. Target • Weighted Average Cost of Capital • Capital Structure Theory • Hurdle Rates MBA 402

  7. Cost of Debt MBA 402

  8. Hershey’s Cost of Debt MBA 402

  9. Cost of Debt Issues • Book (or Historical) vs. Market Cost of Debt • Previous Example was Book or Historical Cost of Debt • Cost of Previously Issued Debt • In This Example: 4.05% • Market Cost • Current Cost of Similar Debt • As of July 1999 • Pre-Tax Cost of Similar Debt: 6.75% • After-Tax Market Cost of Debt: 4.13% MBA 402

  10. Preferred Stock • Special Form of Ownership That Has a Fixed Periodic Dividend Payment That Must Be Paid Before Any Payment of Common Stock Dividends • Hybrid Security • Characteristics of Debt, but • Considered Equity • Limited Participation in the Growth of the Firm • Dividends Are Not Tax Deductible • Unlike Tax Deductible Interest • Popular with Utility Companies MBA 402

  11. Cost of Preferred Stock MBA 402

  12. Preferred Stock Issues • What Price for the Preferred Shares • Par Value • Set “Value” When Issued • Related to Book (or Historical) Value • Related to Book (or Historical) Cost of Preferred Stock • Market Value • Current “Value” in the Market • Related to Market Value • Related to Market Cost of Preferred Stock MBA 402

  13. Cost of Equity • Cost of Equity Includes: • All Stockholder Equity Components • Common Stock • Paid in Excess • Retained Earnings • Miscellaneous • Shareholders’ Required Return • Three Techniques • Gordon Dividend Growth Model • Capital Asset Pricing Model • William Sharpe Won Part of a Nobel Prize • Arbitrage Pricing Theory MBA 402

  14. Gordon Dividend Growth Model MBA 402

  15. Interpretation of GordonDividend Growth Model Note: Dividends are assumed to grow at 10% annually. This is my assumption. Do NOT buy stock in Hershey based upon this illustrative growth rate. The stock price in July 1999 was $58. MBA 402

  16. Cost of Hershey’s Equity:Dividend Growth Model MBA 402

  17. Dividend Growth Model Issues • For Most Effective Use, Company Needs to Pay Dividend with Steady Stable Growth • Can Be Used for Zero Dividend Companies by Estimating First Dividend Payment • Difficulty in Defining Growth • Long-Term, Perpetual Growth Rate MBA 402

  18. Capital Asset Pricing Model (CAPM)Graphical Overview Stock Return = Risk-Free Rate + Beta (Excess Market Return) Excess Return = Capital Appreciation +Dividend Yield - Risk Free Rate MBA 402

  19. CAPMThree Different Stocks Beta = 2 Beta = 2 Beta = 1 Beta = 1 Stock C Beta = .5 Beta = .5 C Stock B B Stock A A MBA 402

  20. CAPM: Application MBA 402

  21. CAPM RealityHershey Foods vs. Market MBA 402

  22. Market Risk Premium MBA 402

  23. CAPM Issues • Conceptual Appeal • Determining Market Risk Premium • Conceptual Appeal • Portfolio Technique With Limited Statistical Properties for Single Company Application • Conceptual Appeal • CAPM Rejected Theoretically: • Alpha Term  0 • Other Things Explain Return • Conceptual Appeal • Lead to Arbitrage Pricing Theory MBA 402

  24. Arbitrage Pricing Theory • Multiple Regression Model • Factors May Include • Inflation • GNP Growth • Interest Rates • Difference Between Long and Short-Term Rates • Difference Between High Quality (AA) and Lower Quality (BB) Rates • Others • Focussed on Surprise in the Factors MBA 402

  25. Cost of Equity Issues • Three Techniques - With Limitations • Dividend Growth Model • Capital Asset Pricing Model • Arbitrage Pricing Theory • Systematic Estimation • Largest Cost Component • Not Tax Deductibility MBA 402

  26. Cost of Capital Components • Cost of Debt • Historical vs. Marginal • Cost of Preferred Stock • Par Value vs. Current Market Price • Cost of Equity • Dividend Growth • Capital Asset Pricing Model • Arbitrage Pricing Theory MBA 402

  27. Hershey’s Cost of CapitalHistorical Book Basis Weights MBA 402

  28. Hershey’s Cost of CapitalMarket Basis Weights MBA 402

  29. Weighted Average Cost of Capital • Weighting Basis • Book Basis • Market Basis • Time Focus • Historical • Current • Projected • Related Topics • Capital Structure • Hurdle Rates MBA 402