Cost of Capital

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Cost of Capital
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Components of Capital
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Summarized Balance SheetDecember 31, 1998 -
Millions
Note Current Liabilities includes a total of
346 million of permanent short-term debt.
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Summarized Balance SheetDecember 31, 1994 -
Millions
Note Current Liabilities includes a total of 8
million of permanent short-term debt.
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Cost of Capital Overview
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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

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Cost of Debt
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Hersheys Cost of Debt
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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

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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

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Cost of Preferred Stock
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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

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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

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Gordon Dividend Growth Model
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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.
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Cost of Hersheys EquityDividend Growth Model
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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

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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
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CAPMThree Different Stocks
Beta 2
Beta 2
Beta 1
Beta 1
Stock C
Beta .5
Beta .5
C
Stock B
B
Stock A
A
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CAPM Application
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CAPM RealityHershey Foods vs. Market
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Market Risk Premium
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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

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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

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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

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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

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Hersheys Cost of CapitalHistorical Book Basis
Weights
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Hersheys Cost of CapitalMarket Basis Weights
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Weighted Average Cost of Capital

• Weighting Basis
• Book Basis
• Market Basis
• Time Focus
• Historical
• Current
• Projected
• Related Topics
• Capital Structure
• Hurdle Rates