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Required Returns

and the Cost of

Capital

Pearson Education Limited 2004

Fundamentals of Financial Management, 12/e

Created by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

15-1

After studying Chapter 15,

you should be able to:

Explain how a firm creates value and identify the key sources of

value creation.

Define the overall cost of capital of the firm.

Calculate the costs of the individual components of a firms cost

of capital - cost of debt, cost of preferred stock, and cost of

equity.

Explain and use alternative models to determine the cost of

equity, including the dividend discount approach, the capital-

asset pricing model (CAPM) approach, and the before-tax cost of

debt plus risk premium approach.

Calculate the firms weighted average cost of capital (WACC) and

understand its rationale, use, and limitations.

Explain how the concept of Economic Value Added (EVA) is

related to value creation and the firms cost of capital.

Understand the capital-asset pricing model's role in computing

project-specific and group-specific required rates of return.

15-2

Required Returns and

the Cost of Capital

Creation of Value

Overall Cost of Capital of the Firm

Project-Specific Required Rates

Group-Specific Required Rates

Total Risk Evaluation

15-3

Key Sources of

Value Creation

Industry Attractiveness

phase of competitive e.g., patents,

product entry temporary

cycle monopoly

power,

oligopoly

pricing

Marketing Superior

and Perceived

Cost quality organizational

price capability

15-4

Competitive Advantage

Overall Cost of

Capital of the Firm

rate of return on the various

types of financing. The overall

cost of capital is a weighted

average of the individual

required rates of return (costs).

15-5

Market Value of

Long-Term Financing

Long-Term Debt $ 35M 35%

Preferred Stock $ 15M 15%

Common Stock Equity $ 50M 50%

$ 100M 100%

15-6

Cost of Debt

Cost of Debt is the required rate

of return on investment of the

lenders of a company.

n

Ij + Pj

P0 = (1 + kd)j

j =1

ki = kd ( 1 - T )

15-7

Determination of

the Cost of Debt

Assume that Basket Wonders (BW) has

$1,000 par value zero-coupon bonds

outstanding. BW bonds are currently

trading at $385.54 with 10 years to

maturity. BW tax bracket is 40%.

$0 + $1,000

$385.54 =

(1 + kd)10

15-8

Determination of

the Cost of Debt

(1 + kd)10 = $1,000 / $385.54

= 2.5938

(1 + kd) = (2.5938) (1/10)

= 1.1

kd = .1 or 10%

ki = 10% ( 1 - .40 )

ki = 6%

15-9

Cost of Preferred Stock

required rate of return on

investment of the preferred

shareholders of the company.

kP = D P / P 0

15-10

Determination of the

Cost of Preferred Stock

Assume that Basket Wonders (BW)

has preferred stock outstanding with

par value of $100, dividend per share

of $6.30, and a current market value of

$70 per share.

kP = $6.30 / $70

kP = 9%

15-11

Cost of Equity

Approaches

Dividend Discount Model

Capital-Asset Pricing

Model

Before-Tax Cost of Debt

plus Risk Premium

15-12

Dividend Discount Model

capital ke, is

the discount rate that equates the

present value of all expected

future dividends with the current

market price of the stock.

D1 D2 D

P0 = + +...+

(1+ke)1 (1+ke)2 (1+ke)

15-13

Constant Growth Model

assumption reduces the model to:

ke = ( D1 / P0 ) + g

at the constant rate g forever.

15-14

Determination of the

Cost of Equity Capital

Assume that Basket Wonders (BW) has

common stock outstanding with a current

market value of $64.80 per share, current

dividend of $3 per share, and a dividend

growth rate of 8% forever.

ke = ( D 1 / P0 ) + g

ke = ($3(1.08) / $64.80) + .08

Growth Phases Model

leads to the following formula

(assume 3 growth phases):

a D0(1+g1)t b Da(1+g2)t-a

P0 = (1+ke)t

(1+ke)t

+

t=1 t=a+1

Db(1+g3)t-b

t=b+1 (1+ke)t

15-16

Capital Asset

Pricing Model

The cost of equity capital, ke, is

equated to the required rate of

return in market equilibrium. The

risk-return relationship is described

by the Security Market Line (SML).

ke = Rj = Rf + (Rm - Rf) j

15-17

Determination of the

Cost of Equity (CAPM)

Assume that Basket Wonders (BW) has

a company beta of 1.25. Research by

Julie Miller suggests that the risk-free

rate is 4% and the expected return on

the market is 11.2%

ke = Rf + (Rm - Rf) j

= 4% + (11.2% - 4%)1.25

15-18 ke = 4% + 9% = 13%

Before-Tax Cost of Debt

Plus Risk Premium

The cost of equity capital, ke, is the

sum of the before-tax cost of debt

and a risk premium in expected

return for common stock over debt.

ke = kd + Risk Premium*

premium

15-19

Determination of the

Cost of Equity (kd + R.P.)

Assume that Basket Wonders (BW)

typically adds a 3% premium to the

before-tax cost of debt.

ke = kd + Risk Premium

= 10% + 3%

ke = 13%

15-20

Comparison of the

Cost of Equity Methods

Capital Asset Pricing Model 13%

Cost of Debt + Risk Premium 13%

Generally, the three methods

will not agree.

15-21

Weighted Average

Cost of Capital (WACC)

n

Cost of Capital = kx(Wx)

x=1

.50(13%)

WACC = .021 + .0135 + .065

= .0995 or 9.95%

15-22

Limitations of the WACC

1. Weighting System

Marginal Capital Costs

Capital Raised in Different

Proportions than WACC

15-23

Limitations of the WACC

associated with issuing securities

such as underwriting, legal, listing,

and printing fees.

b. Adjustment to Discount Rate

15-24

Economic Value Added

A measure of business performance.

It is another way of measuring that

firms are earning returns on their

invested capital that exceed their cost

of capital.

Specific measure developed by Stern

Stewart and Company in late 1980s.

15-25

Economic Value Added

Capital x Capital Employed]

Since a cost is charged for equity capital also, a

positive EVA generally indicates shareholder

value is being created.

Based on Economic NOT Accounting Profit.

NOPAT net operating profit after tax is a

companys potential after-tax profit if it was all-

equity-financed or unlevered.

15-26

Adjustment to

Initial Outlay (AIO)

Initial Cash Outlay (ICO).

n CFt

NPV = - ( ICO + FC )

t=1 (1 + k) t

15-27

Adjustment to

Discount Rate (ADR)

proceeds (price) of the security and

recalculate yield figures.

Impact: Increases the cost for any

capital component with flotation costs.

decreases the NPV.

15-28

Determining Project-Specific

Required Rates of Return

Initially assume all-equity financing.

Determine project beta.

Calculate the expected return.

Adjust for capital structure of firm.

Compare cost to IRR of project.

15-29

Difficulty in Determining

the Expected Return

Determining the SML:

Locate a proxy for the project (much

easier if asset is traded).

Plot the Characteristic Line

relationship between the market

portfolio and the proxy asset

excess returns.

Estimate beta and create the SML.

15-30

Project Acceptance

and/or Rejection

Accept

X SML

EXPECTED RATE

X X

OF RETURN

X X O

X X

O O

O O Reject O

Rf O

15-31

Determining Project-Specific

Required Rate of Return

for Project k (all-equity financed).

Rk = Rf + (Rm - Rf) k

2. Adjust for capital structure of the

firm (financing weights).

Weighted Average Required Return = [ki][%

of Debt] + [Rk][% of Equity]

15-32

Project-Specific Required

Rate of Return Example

being considered with an IRR of 19%.

Examination of firms in the networking

industry allows us to estimate an all-equity

beta of 1.5. Our firm is financed with 70%

Equity and 30% Debt at ki=6%.

The expected return on the market is 11.2%

and the risk-free rate is 4%.

15-33

Do You Accept the Project?

ke = Rf + (Rm - Rf) j

= 4% + (11.2% - 4%)1.5

ke = 4% + 10.8% = 14.8%

= 1.8% + 10.36% = 12.16%

IRR = 19% > WACC = 12.16%

15-34

Determining Group-Specific

Required Rates of Return

Use of CAPM in Project Selection:

Initially assume all-equity financing.

Determine group beta.

Calculate the expected return.

Adjust for capital structure of group.

Compare cost to IRR of group project.

15-35

Comparing Group-Specific

Required Rates of Return

Expected Rate of Return

Company Cost

of Capital

Group-Specific

Required Returns

15-36

Qualifications to Using

Group-Specific Rates

Amount of non-equity financing

relative to the proxy firm.

Adjust project beta if necessary.

Standard problems in the use of

CAPM. Potential insolvency is a

total-risk problem rather than

just systematic risk (CAPM).

15-37

Project Evaluation

Based on Total Risk

Approach (RADR)

The required return is increased

(decreased) relative to the firms

overall cost of capital for projects

or groups showing greater

(smaller) than average risk.

15-38

RADR and NPV

$000s Adjusting for risk correctly

15 may influence the ultimate

Net Present Value

Project decision.

10 RADR low

risk at 10%

(Accept!)

5 RADR high

risk at 15%

(Reject!)

0

-4

0 3 6 9 12 15

Discount Rate (%)

15-39

Project Evaluation

Based on Total Risk

Probability Distribution Approach

Acceptance of a single project

with a positive NPV depends on

the dispersion of NPVs and the

utility preferences of

management.

15-40

EXPECTED VALUE OF NPV Firm-Portfolio Approach

Indifference

C Curves

B

A

Curves show

HIGH

Risk Aversion

STANDARD DEVIATION

15-41

EXPECTED VALUE OF NPV Firm-Portfolio Approach

Indifference

C Curves

B

A

Curves show

MODERATE

Risk Aversion

STANDARD DEVIATION

15-42

EXPECTED VALUE OF NPV Firm-Portfolio Approach

C Indifference

Curves

B

A

Curves show

LOW

Risk Aversion

STANDARD DEVIATION

15-43

Adjusting Beta for

Financial Leverage

j = ju [ 1 + (B/S)(1-TC) ]

j: Beta of a levered firm.

ju: Beta of an unlevered firm

(an all-equity financed firm).

B/S: Debt-to-Equity ratio in

Market Value terms.

TC : The corporate tax rate.

15-44

Adjusted Present Value

sum of the discounted value of a

projects operating cash flows plus the

value of any tax-shield benefits of

interest associated with the projects

financing minus any flotation costs.

Unlevered Value of

APV = Project Value

+ Project Financing

15-45

NPV and APV Example

Assume Basket Wonders is considering a

new $425,000 automated basket weaving

machine that will save $100,000 per year

for the next 6 years. The required rate on

unlevered equity is 11%.

BW can borrow $180,000 at 7% with

$10,000 after-tax flotation costs. Principal

is repaid at $30,000 per year (+ interest).

15-46

The firm is in the 40% tax bracket.

Basket Wonders

NPV Solution

financed firm?

firm

NPV = $423,054 - $425,000

NPV = -$1,946

15-47

Basket Wonders

APV Solution

What is the APV?

APV

First, determine the interest expense.

Int Yr 1 ($180,000)(7%) = $12,600

Int Yr 2 ( 150,000)(7%) = 10,500

Int Yr 3 ( 120,000)(7%) = 8,400

Int Yr 4 ( 90,000)(7%) = 6,300

Int Yr 5 ( 60,000)(7%) = 4,200

Int Yr 6 ( 30,000)(7%) = 2,100

15-48

Basket Wonders

APV Solution

Second, calculate the tax-shield benefits.

TSB Yr 1 ($12,600)(40%) = $5,040

TSB Yr 2 ( 10,500)(40%) = 4,200

TSB Yr 3 ( 8,400)(40%) = 3,360

TSB Yr 4 ( 6,300)(40%) = 2,520

TSB Yr 5 ( 4,200)(40%) = 1,680

TSB Yr 6 ( 2,100)(40%) = 840

15-49

Basket Wonders

APV Solution

Third, find the PV of the tax-shield benefits.

TSB Yr 1 ($5,040)(.901) = $4,541

TSB Yr 2 ( 4,200)(.812) = 3,410

TSB Yr 3 ( 3,360)(.731) = 2,456

TSB Yr 4 ( 2,520)(.659) = 1,661

TSB Yr 5 ( 1,680)(.593) = 996

TSB Yr 6 ( 840)(.535) = 449 PV =

$13,513

15-50

Basket Wonders

NPV Solution

APV

APV = -$1,946 + $13,513 - $10,000

APV = $1,567

15-51

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