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PART SIX Cost of Capital and Long-Term Financial Policy

According to this screen, Eastman has 77 million shares of stock outstanding. The book value per share is \$20.92, but the stock actually sells for \$41.56. Total equity is therefore about \$1.611 billion on a book value basis, but it is closer to \$3.200 billion on a market value basis.

To estimate Eastman's cost of equity, we will assume a market risk premium of 9.1 percent, similar to what we calculated in Chapter 12. Eastman's beta on Yahoo! is 0.63. If you think back to our discussion of beta, this estimate for Eastman Chemical seems low, at least potentially. To check it, we went to money.cnn.com and www.msnbc.com. The beta estimates we found were 0.66 and 0.60, respectively. The estimate on Yahoo! is right in the middle, so we will use it. According to the bond section of finance.yahoo.com, T-bills were paying about 3.3 percent at the time. Using the CAPM to estimate the cost of equity, we find:

Eastman has only paid dividends for about three years, so estimating the future growth rate for the dividend discount model is problematic. However, under the research link at finance.yahoo.com, we found that analysts estimate that the growth in earning per share for the company will be 7.0 percent for the next five years. For now, we will use this growth rate in the dividend discount model to estimate the cost of equity; the link between earnings growth and dividends is discussed in a later chapter. The estimated cost of equity using the dividend discount model is:

Notice that the estimates for the cost of equity are quite different. Remember that each method of estimating the cost of equity relies on different assumptions, so this result is no surprise. There are two simple solutions to this problem. First, we could ignore one of the estimates. In this case, it would probably be the CAPM estimate because it looks like a relatively low return for shareholders to require based on our previous discussion of historical returns. Second, we could average the two estimates. Averaging the two estimates for the cost of equity gives us a cost of equity of 10.28 percent. This seems like a reasonable number, so we will use it in calculating the cost of capital in this example.

Eastman's Cost of Debt Eastman has four long-term bond issues that account for essentially all of its long-term debt. To calculate the cost of debt, we will have to combine these four issues. What we will do is compute a weighted average. We went to www.bondsonline.com and entered "Eastman Ch" to find quotes on the bonds.6 We should note here that finding the yield to maturity for all company's outstanding bond issues on a single day at Bondsonline.com is unusual. If you remember our previous discussion on bonds, the bond market is not as liquid as the stock market, and on many days individual bond issues may not trade. To find the book value of the bonds, we went to www.sec.gov and found the 10Q report dated June 31, 2001, and filed with the SEC on August 8, 2001. The basic information is as follows:

6You might be wondering why the yield on the 7.625 percent issue maturing in 2024 is so much lower than that on the other two long-term issues. The reason is that this issue has a put feature (discussed in Chapter 7) that the other two issues do not. Such features are desirable from the buyer's standpoint, so this issue has a higher price and, thus, a lower yield.

Ross et al.: Fundamentals VI. Cost of Capital and 15. Cost of Capital of Corporate Finance, Sixth Long-Term Financial Edition, Alternate Edition Policy

 Coupon Rate Maturity Book Value (face value, in millions) Price (% of par) Yield to Maturity 6.375%
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