**Components of Capital**MBA 402**Summarized Balance SheetDecember 31, 1998 - $ Millions**Note: Current Liabilities includes a total of $346 million of permanent short-term debt. MBA 402**Summarized Balance SheetDecember 31, 1994 - $ Millions**Note: Current Liabilities includes a total of $8 million of permanent short-term debt. MBA 402**Cost of Capital Overview**MBA 402**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**Cost of Debt**MBA 402**Hershey’s Cost of Debt**MBA 402**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**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**Cost of Preferred Stock**MBA 402**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**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**Gordon Dividend Growth Model**MBA 402**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**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**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**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**CAPM: Application**MBA 402**Market Risk Premium**MBA 402**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**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**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**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**Hershey’s Cost of CapitalHistorical Book Basis Weights**MBA 402**Weighted Average Cost of Capital**• Weighting Basis • Book Basis • Market Basis • Time Focus • Historical • Current • Projected • Related Topics • Capital Structure • Hurdle Rates MBA 402