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Cost of Capital Oct 2nd

What is the cost of preferred shares?


o Should we use past coupons or current market yields?
o Why does this cost seem lower than the cost of debt?
o How do we incorporate issuing costs?
o Why not issue preferred shares instead of debt all of the time?
o How do we adjust these instruments to an after-tax basis?
What is the cost of equity (Ke)?
o Should we use the dividend yield?
o Or the ratio of the earnings per share to the stock price?
o Or the historical return on equity?
o How should the beta of the stock employed to compute the cost of equity?
o How accurate is the estimate of beta?
o R2 = Variation explained by / Total variance
o Can data on other similar companies be used to enhance the confidence in
the beta?
o Should the Treasury bill rate of the long-term Government of Canada rate
be used in calculation of the risk-free rate?
o What should be used as the risk premium for the market? (Arithmetic /
geometric???)
o What if this value has varied depending on the time period chosen?
o Why compute Ke via several alternatives?
Geometric vs Arithmetic Average
o This is a contentious issue
o There are theoretical reasons for using the arithmetic mean as the correct
measure of Rm
o However, the long-run geometric average also represents the investor
expectations
Earning-Price Ratio
Equals the capitalization of rake (Ke or r) only when marginal NPV of projects is
Zero.
What is the cost of retained earnings?
o Is it free? No. Opportunity cost!
o Is it the same as the cost of a new issue of equity?
What is the cost of depreciation generated funds?
o Are they free?
How are all of these individual costs accumulated to obtain an overall COC?
o Should book value or market value weights be used?
o What do we use for market weights if the securities are not widely traded
such as the privately placed debt instruments or the bank loans?
Cost of Marginal Source of Funds vs Marginal Cost of Capital

o Use of the cost of marginal sources of capital for hurdle rates resulted in
sub-optimal result.
How should the derived number for the cost of capital can be used?
o NPV approach or IRR approach?
o There can be multiple IRR. NPV is always the best approach. NPV dollar
value, IRR is percentage value.
o Adjustment for risk?
Summary
o The reason we calculate WACC is to determine the min acceptable rate of
return on future investment projects
o WACC allows us to separate the investment decision from the financing
decision
o WACC is determined through the use of both quantitative models an
implicit estimation of variables
o Estimation process requires scientific formulae as well as managerial
judgment.
Encana Corporation : Cost of Capital
Deferred taxes (Final Exam?)
o A DT liability represents tax payments that have appeared on the IS but
not yet been paid
o Sometimes firms can write off assts faster for tax purposes for
determining accounting income
o The reduction in tax goes to DT account with the logic that it will have to
be paid later
o In theory, equity should include share capital, R/E and DT
o We assume that DT is not a permanent component of EnCanas Equity.