In your weekly meeting Sue asks you to prepare some numbers for the investor conference call right after the board meeting. You know one question potential investors will have is how much return they can expect from investing in your common stock. So you need to calculate the cost of your stock in relation to the price and expected return.
Scenario Steps to Completion
1. The company's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, the average market return is expected to be 6% for the next several years, your stock is of average volatility for the market, and inflation is expected to be 3% which is equal to the return on government bonds then what is the firm's cost of capital for common stock and expected return for investors?
Concept Check: Capital is acquired in the marketplace. For many of us it is in the form of loans; publicly traded companies have access to debt in the form of bonds and equity in the form of stocks. In any instance we are being judged as to how much of a risk is the capital at for not being recovered. Risks include (but are not limited to); inflation or the erosion of the value of my money; opportunity costs in the form of interest free government securities, compensation for the chance of not being paid back (default risk), compensation for the length of time the capital is at risk (maturity) and compensation for the ability to be able to turn the investment of capital into cash by trading it or converting the obligation (liquidity risk).
Cost of Capital = Inflation Premium + Compensation for risk free rate of return + Specific Risk Premium compensations (Default risk, Liquidity Risk, Maturity Risk, Opportunity Risk,etc)
Helpful Hint: We need to look at this from the market perspective of what is a fair rate of return for the investment compared to alternatives available. This is where we look at market returns versus individual returns and use the Capital Asset Pricing Model (CAPM).
re = (Inflation + risk free rate) + beta (market return - risk free rate)
This equation considers similar views of return as above but also factors in the required market return (rm) as well as the inflation adjusted risk free rate (rf) and a measure of the individual stock risk beta (b).
So, when asking for a loan we need to think in terms of the lender and we need to communicate to them why their capital is at the lowest point of risk and that the return is adequate to cover that risk as well as be desirable compared to alternative investments.