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Finance: How do you assess the cost of equity? 11 Views

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The cost of equity is essentially how much the total returns, i.e. capital appreciation plus any dividends, are needed to keep shareholders from selling their stock. The old school way of calculating the cost of equity was to divide the stock price into the annual dividend per share. Of course, a majority of stocks presently do not pay dividends. Some companies calculate the cost of equity by factoring in a stock’s beta, or volatility and risk premium (added return needed to justify when compared to low risk investments) and adding it to its risk-free rate (the compared low risk investment cost).

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00:00
finance a la shmoop how do you assess the cost of equity
00:07
all right so people remember that's equity that's your stock that's the [Man driving a car]
00:11
ownership of the company trying to figure out how you assess the cost of it
00:15
when you do stuff with it okay so your specific motors your like [Specific motors store]
00:19
General Motors but your products way less vague with your stock at $20 a

00:25
share and fifty million shares outstanding Wall Street is telling you
00:29
when they're paying 20 bucks a share for your stock that specific motors is worth
00:32
a cool billion dollars got it 20 times 50 there you want to buy your dreaded
00:38
hated competitor Alfalfa Romeo for two hundred million dollars yep [Plane carrying Alfalfa Romeo banner]
00:43
the one started by the little rascal that one so you've gotten your board to
00:47
agree to let you make this transaction and you've gotten Alfalfa Romeo to agree [Specific Motors and Alfalfa Romeo board in a meeting]
00:53
to it as well the only question now is how you pay for this transaction that is
00:58
how you pay the two hundred million dollars is it in cash or is it in stock
01:03
all right well you could borrow the money and if you do the rate of interest
01:06
you'll pay is seven percent with terms already set so that you have to pay back
01:10
one tenth of the loan each year for ten years until it's all paid off got it so
01:16
two hundred million dollars that is 20 million a year and you can handle the
01:19
interest it would be 14 million bucks interest in year one but you would also
01:23
owe 20 million in principle pay downs at 34 million in year one and well frankly [Interest payments for year 1]
01:28
that's where you get nervous that's a lot of cash out of your pocket here...
01:32
If things don't go perfectly smoothly in your profit margins of the combined
01:36
company specific romeo' are less than you'd plan well then you could risk
01:41
putting the company in financial peril even bankruptcy because you know that if [Car driving by and stock value stamped with bankruptcy]
01:46
you don't pay back debt according to the deals terms, well then at least in theory
01:50
the debt holders could knock on your door one day and take ownership of your [Chains engulf Specific Motors]
01:54
company yeah company suicide, career suicide, the
01:58
financial end of the world as you know it so you look at paying the 200 mil in
02:02
equity instead of debt and you're wondering how to assess that cost got it
02:08
so you have a billion dollars you're going to give a fifth of that or 200
02:11
million dollars to the shareholders of Alfalfa Romeo in return for their excellent
02:16
cars all right well on your own this year you'll have three hundred million [Revenues for Specific Motors]
02:19
dollars in revenues to specific motors to deliver 40 million dollars in
02:23
earnings you trade at 25 times that 40 million of earnings billion dollars
02:29
remember you have 50 million shares outstanding trading at 20 bucks a share
02:33
do the math on both sides and you'll get a billion dollars either way see we do
02:37
it here for you at no extra charge at shmoop you can see it right there on the [Man points to Shmoop calculations]
02:40
screen....
02:42
well your business doesn't have a lot of research and development not big capital
02:46
expenditures so most if not all of your earnings is cash earnings that is of the
02:52
40 million dollars in earnings this year well close to a hundred percent of it is
02:56
cash we'll just call it that for this problem all right well if all you were
03:00
was a dividend producing machine well then this year you would be showing a [Machine producing dividends]
03:05
"free cash flow yield" of four percent or 40 million dollars in
03:12
cash generated by the billion-dollar market cap company that you have going
03:17
on there got it that's 40 million over the billion dollar valuation it's like a
03:21
4% cash yield for investors meaning if you paid $20 for a share of [20 dollars transfers to a share of stock]
03:25
stock you got about 80 cents in cash production from it so that's 80 cents
03:29
over 20 bucks the combo gets you a 4% cash yield so yeah that's how you assess
03:35
the cost of equity, you're paying for things in all stock with about 4% kind
03:41
of yield money so if you're paying a fifth of the company to buy Alfalfa
03:46
Romeo well you're gonna dilute that cash yield down and then you just have to do [Maths book opens]
03:50
the math whether Alfalfa Romeo generates enough cash to make the difference to
03:55
you does that make sense Otay! [Man waves]
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