BIAYA MODAL PART 2 - FARFIN CLASS

Summary

This educational video explains various methods for calculating the cost of equity capital, including discounted cash flow, bond yield, and the capital asset pricing model (CAPM). The presenter provides step-by-step examples, demonstrating how to calculate the cost of equity using real-world data. The video also covers the weighted average cost of capital (WACC), showing how to combine different cost components to determine a company’s overall capital cost. The content is tailored for those looking to grasp key concepts in corporate finance and capital budgeting, offering both theory and practical application.

Takeaways

• 😀 The video explains the three primary methods for calculating the cost of equity: Discounted Cash Flow (DCF), Bond Yield, and Capital Asset Pricing Model (CAPM).
• 😀 DCF calculates cost of equity using dividends, stock price, and growth rate with the formula: K_e = D1 / P + G.
• 😀 An example using DCF shows that if the first-year dividend is 200, the stock price is 1000, and the growth rate is 8%, the cost of equity is 28%.
• 😀 Bond Yield method compares the return on stocks to risk-free instruments like bonds, adding a risk premium. The formula is K_e = Bond Yield + Risk Premium.
• 😀 A sample calculation with the Bond Yield method results in a cost of equity of 29% when using a bond coupon of 2000, bond price of 9000, and a risk premium of 7%.
• 😀 The CAPM method calculates the cost of equity by considering the risk-free rate, the stock’s beta, and the market return using the formula: K_e = R_f + β(R_m - R_f).
• 😀 In the CAPM example, using a beta of 0.686, a risk-free rate of 15%, and a market return of 25%, the cost of equity is approximately 22%.
• 😀 There is no single 'best' method for determining the cost of equity, but CAPM is the most popular and widely used approach.
• 😀 The Weighted Average Cost of Capital (WACC) calculates the average rate of return a company must pay to finance its operations, using debt, preferred stock, and equity.
• 😀 The WACC formula is WACC = (W_D × K_D) + (W_PS × K_PS) + (W_S × K_S), where the terms represent the proportions and costs of each capital component.
• 😀 In a WACC example, for a company with 30% debt, 20% preferred stock, and 50% common stock, and respective costs of 12.6%, 10%, and 25%, the WACC is 20.78%.

Q & A

What are the three methods used to calculate the cost of equity?

The three methods to calculate the cost of equity are: 1) Discounted Cash Flow (DCF), 2) Bond Yield, and 3) Capital Asset Pricing Model (CAPM).

How does the Discounted Cash Flow (DCF) method work to calculate the cost of equity?

The DCF method calculates the cost of equity using the formula: K = D1 / P + G, where D1 is the dividend in the first year, P is the price of the stock, and G is the growth rate of the dividends.

What is the significance of the formula used in the Discounted Cash Flow method?

The formula K = D1 / P + G allows us to calculate the cost of equity by considering the dividends paid, the current stock price, and the expected growth rate of the dividends.

What does the Bond Yield method suggest about the relationship between stocks and bonds?

The Bond Yield method suggests that stocks are riskier than bonds because stocks may not always pay dividends, while bonds typically offer fixed interest. Therefore, the required return for stocks should be higher than for bonds.

How is the cost of equity calculated using the Bond Yield method?

The cost of equity using the Bond Yield method is calculated by adding the bond yield to the risk premium. The formula is: K = Bond Yield + Risk Premium, where the risk premium is the difference between the returns on stocks and bonds.

What is the Capital Asset Pricing Model (CAPM) and how is it used to calculate the cost of equity?

CAPM is a model that calculates the cost of equity using the formula: K = RF + β(RM - RF), where RF is the risk-free rate, β is the beta (systematic risk), and RM is the market return.

What role does beta play in the CAPM formula?

Beta in the CAPM formula represents the systematic risk of a stock, showing how much the stock’s returns are expected to move in relation to the overall market returns.

What is the risk-free rate (RF) used in the CAPM model?

The risk-free rate (RF) in the CAPM model is typically the return on low-risk investments such as government bonds, which serve as a benchmark for comparing the returns of riskier investments like stocks.

Why is the Capital Asset Pricing Model (CAPM) considered the most popular method for calculating the cost of equity?

CAPM is considered the most popular method because it incorporates systematic risk (beta) and the market's return, offering a more comprehensive and market-driven approach to estimating the cost of equity.

How do you calculate the Weighted Average Cost of Capital (WACC)?

WACC is calculated using the formula: WACC = (WD * KD) + (WP * KP) + (WS * KS), where WD, WP, and WS are the weights of debt, preferred stock, and common equity, respectively, and KD, KP, and KS are the costs of each type of capital.

What is the significance of calculating the WACC for a company?

Calculating WACC is significant because it provides a weighted average of a company's cost of financing, considering debt, preferred stock, and equity. It helps in evaluating investment projects and determining the company's overall cost of capital.