Risk, Return,

and Cost of Capital

 Market Indexes
 Several market indexes measure the
investment performance of the overall
market.
 Market Indexes
 The Dow Jones Industrial Average (also
called Dow 30 or simply Dow) is an equal
share index of thirty industrial stocks in the
US.
 It is an index of important but few firms,
independently of how many shares each
company has outstanding.
Market Indexes
 Market Indexes
 The Standard and Poor’s Composite
Index (also called S&P 500 or S&P) is a
market value weighted index of 500 firms
in the US, covering about 70 percent of
the value of stocks traded.
 Compared to the Dow, the S&P 500 is a
broader index and is adjusted for the
relative market value of each company.
Market Indexes
 Market Indexes
 FTSE 100 Index (London), Nikkei Index
(Tokyo), Hang Seng Index (Hong Kong),
Korea Composite Stock Price Index
(South Korea), and Philippine Stock
Exchange Index (Philippines) are just a
few other market performance indices.
 Portfolios
 A portfolio is a group of assets held by an
investor.
 Portfolios
 There are many equivalent ways of
describing a portfolio.
 The most convenient approach is to list
the percentage of the total portfolio’s value
that is invested in each portfolio asset.
 We call these percentages the portfolio
weights.
 Portfolios
 For example, if we have $50 in one asset
and $150 in another, our total portfolio is
worth $200.
 The percentage of our portfolio in the first
asset is $50 / $200 = 0.25.
 The percentage of our portfolio in the
second asset is $150 / $200 = 0.75.
 Portfolios
 Our portfolio weights are thus 0.25 and
0.75.
 Notice that the weights have to add up to
1.00 because all of our money is invested
somewhere.
 Exercises
 You buy 100 shares of Tidepool Co. for
$40 each and 200 shares of Madfish, Inc.,
for $15 each. What are the weights in your
portfolio?
 Exercises
 You buy 100 shares of Tidepool Co. for
$40 each and 200 shares of Madfish, Inc.,
for $15 each. What are the weights in your
portfolio?
 Total: 100 x $40 + 200 x $15 = $7,000
 Tidepool: $4,000 / $7,000 = 0.5714
 Madfish: $3,000 / $7,000 = 0.4286
 Portfolios
 The expected return of a portfolio is the
weighted average of the expected returns
of the respective assets in the portfolio:
 E(Rp) = ∑xjrj = (x1 x r1) + (x2 x r2) + (x3 x r3)
+ … + (xn x rn)
 Portfolios
 The expected return of a portfolio is the
weighted average of the expected returns
of the respective assets in the portfolio:
 E(Rp) = ∑xjrj = (x1 x r1) + (x2 x r2) + (x3 x r3)
+ … + (xn x rn)
 where: n is the number of assets in the
portfolio
 Portfolios
 The expected return of a portfolio is the
weighted average of the expected returns
of the respective assets in the portfolio:
 E(Rp) = ∑xjrj = (x1 x r1) + (x2 x r2) + (x3 x r3)
+ … + (xn x rn)
 where: x1, x2, x3, and xn are the portfolio
weights
 Portfolios
 The expected return of a portfolio is the
weighted average of the expected returns
of the respective assets in the portfolio:
 E(Rp) = ∑xjrj = (x1 x r1) + (x2 x r2) + (x3 x r3)
+ … + (xn x rn)
 where: r1, r2, r3, and rn are the expected
returns on assets 1 through n
 Portfolios
 For example, you own a portfolio that is 20
percent invested in Stock X, 45 percent in
Stock Y, and 35 percent in Stock Z. The
expected returns on these three stocks are
10 percent, 14 percent, and 16 percent,
respectively. What is the expected return
on the portfolio?
 Portfolios
 E(Rp) = (xX x rX) + (xY x rY) + (xZ x rZ)
 E(Rp) = (0.20 x 0.10) + (0.45 x 0.14) +
(0.35 x 0.16) = 13.90%
 Exercises
 You own a portfolio that has $2,300
invested in Stock A and $3,400 invested in
Stock B. If the expected returns on these
stocks are 11 percent and 16 percent,
respectively, what is the expected return
on the portfolio?
 Exercises
 You own a portfolio that has $2,300
invested in Stock A and $3,400 invested in
Stock B. If the expected returns on these
stocks are 11 percent and 16 percent,
respectively, what is the expected return
on the portfolio? 13.98% or = $2,300 /
($2,300 + $3,400) x 11% + $3,400 /
($2,300 + $3,400) x 16%
 Exercises
 You have $10,000 to invest in a stock
portfolio. Your choices are Stock X with an
expected return of 15 percent and Stock Y
with an expected return of 10 percent. If
your goal is to create a portfolio with an
expected return of 12.2 percent, how
much money will you invest in Stock X? In
Stock Y?
 Exercises
 15%X +10%(10,000 – X) = 12.2%(10,000)
 15%X + 1,000 – 10% = 1,220
 5%X = 220
 X = 220/5%
 X = 4,400
 Y = 10,000 – 4,400 = 5,600
 Risk Defined
and Measured
 Risk is the potential variability in future
cash flows.
 The wider the range of possible events
that can occur, the greater the risk.
 We can quantify the risk of an investment
by computing the variance in the possible
investment returns and its square root, the
standard deviation.
 Diversification
and Portfolio Risk
 Diversification is the process of
combining assets to reduce risk.
 Diversification
and Portfolio Risk
 Studies of common stocks listed on the
New York Stock Exchange demonstrate
that the standard deviation of a portfolio
decreases as the number of securities in
the portfolio increases.
 However, spreading an investment across
a number of assets will eliminate some,
but not all, of the risk.
 Diversification
and Portfolio Risk
 There are two kinds of risks with respect to
diversification: systematic risk and
unsystematic risk.
 Diversification
and Portfolio Risk
 Systematic risk (also called market risk
or nondiversifiable risk) is a risk that
affects a large number of assets, although
at varying degrees.
 Changes in gross domestic product,
interest rates, and inflation are examples
of systematic risk.
 Diversification
and Portfolio Risk
 Unsystematic risk (also called unique
risk, non-systemic risk, asset-specific
risk, firm-specific risk or diversifiable
risk) is a risk that affects a small number
of assets (or one).
 Strikes, accidents, and corporate
takeovers are examples of unsystematic
risk.
 Diversification
and Portfolio Risk
 When securities are combined into
portfolios, their unsystematic risks tend to
cancel out, leaving only the variability that
affects all securities to some degree.
 Large portfolios have little or no
unsystematic risk.
 Systematic Risk
and Beta
 The systematic risk of an asset is
measured by its beta coefficient (β), which
measures the amount of systematic risk
for a particular asset relative to the amount
of systematic risk for the average asset.
 Systematic Risk
and Beta
 To help clarify the idea of systematic risk,
let’s examine the relationship between the
common stock returns of eBay and the
returns of the S&P 500 Index.
Systematic Risk
and Beta
 Systematic Risk
and Beta
 Each of the 12 dots in the figure below
represents the returns of eBay and the
S&P 500 Index for a particular month.
 For instance, the returns for November
2014 for eBay and the S&P 500 Index
were 4.53 percent and 2.48 percent,
respectively.
Systematic Risk
and Beta
 Systematic Risk
and Beta
 We have drawn a line of “best fit,” which
we call the characteristic line.
 The slope of the characteristic line
measures the average relationship
between a stock’s returns and those of the
S&P 500 Index.
 This slope of 0.782 is the beta of eBay.
Systematic Risk
and Beta
 Systematic Risk
and Beta
 A beta of 1 implies the asset has the same
systematic risk as the overall market.
 A beta of less than 1 implies the asset has
less systematic risk than the overall
market while a beta of more than 1 implies
the asset has more systematic risk than
the overall market.
 Systematic Risk
and Beta
 The least risky investment are Treasury
bills.
 Since the return on Treasury bills is fixed,
it is unaffected by what happens to the
market.
 In other words, Treasury bills have a beta
of 0.
 Systematic Risk
and Beta
 We also considered a much riskier
investment, the market portfolio of
common stocks.
 This has average market risk: its beta is
1.0.
 Systematic Risk
and Beta
Company Name Beta Company Name Beta
Apple Inc. 1.22 McDonald’s 0.50
Coca-Cola 0.45 Microsoft Corporation 1.23
Home Depot 1.03 Pfizer 0.65
IBM 1.36 Nike 0.85
Johnson & Johnson 0.70 Walt Disney 0.97
 Capital Asset
Pricing Model
 An investor’s required rate of return can
be defined as the minimum rate of return
necessary to attract an investor to
purchase or hold a security.
 We can separate the return into its basic
components.
 Capital Asset
Pricing Model
 Investor’s required rate of return = Risk-
free rate of return + Risk premium on
stock
 The risk-free rate of return is the
required rate of return, or discount rate, for
riskless investments.
 Typically, our measure for the risk-free rate
of return is the Treasury bill rate.
 Capital Asset
Pricing Model
 Investor’s required rate of return = Risk-
free rate of return + Risk premium on
stock
 The risk premium on the stock is the
additional return we must expect to
receive for assuming risk.
 Capital Asset
Pricing Model
 For example, assume you are considering
the purchase of a stock that you believe
will provide a 10 percent return over the
next year. If the expected risk-free rate of
return, such as the rate of return for 90-
day Treasury bills, is 2 percent, then the
risk premium you are demanding to
assume the additional risk is 8 percent.
 Capital Asset
Pricing Model
 The finance profession has had difficulty in
developing a practical approach to
measure an investor’s required rate of
return; however, financial managers often
use a method called the capital asset
pricing model (CAPM).
 Capital Asset
Pricing Model
 This model is an equation that equates the
expected rate of return on a stock to the
risk-free rate plus a risk premium for the
stock’s systematic risk.
 Capital Asset
Pricing Model
 Rearranging this equation to solve for the
risk premium, we have:
 Risk premium on stock = Investor’s
required rate of return (r) – Risk-free rate
of return (rf)
 Capital Asset
Pricing Model
 In a competitive market, the expected risk
premium varies in direct proportion to
beta.
 Capital Asset
Pricing Model
 The expected risk premium on an
investment with a beta of 0.5 is, therefore,
half the expected risk premium on the
market (the difference between the
expected return on a market portfolio and
the risk-free rate)
 Capital Asset
Pricing Model
 The expected risk premium on an
investment with a beta of 2 is twice the
expected risk premium on the market.
 Capital Asset
Pricing Model
 We can write this relationship as follows:
 Risk premium on stock = Beta (β) x
Expected risk premium on market
 Risk premium on stock = Beta (β) x
[Expected return on a market portfolio (rm)
– Risk-free rate of return (rf)]
 r – rf = β(rm – rf)
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 where: r is the investor’s required rate of
return
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 where: rf is the risk-free rate of return
(based on the Treasury bills)
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 where: β is the beta coefficient (the
systematic risk of an asset)
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 where: rm is the expected return on a
market portfolio
 Capital Asset
Pricing Model
 Rearranging terms, the equation for the
CAPM can be written as:
 r = rf + β(rm – rf)
 where: (rm – rf) is the expected risk
premium on the market
 Capital Asset
Pricing Model
 Suppose that the interest rate on Treasury
bills is about 2% and the expected return
on S&P is 9%. Using the information from
Table 1 (the beta of Apple Inc. is 1.22), our
estimate of the expected return from Apple
Inc. is:
 r(Apple Inc.) = 2% + 1.22(9% – 2%) =
10.54%
 Exercises
 A stock has a beta of 1.25, the expected
return on the market is 14 percent, and the
risk-free rate is 5.2 percent. What must the
expected return on this stock be?
 Exercises
 A stock has a beta of 1.25, the expected
return on the market is 14 percent, and the
risk-free rate is 5.2 percent. What must the
expected return on this stock be?
 16.2% or =5.2%+1.25*(14%-5.2%)
 Exercises
 A stock has an expected return of 13
percent, the risk-free rate is 4.5 percent,
and the market risk premium is 7 percent.
What must the beta of this stock be?
 Exercises
 A stock has an expected return of 13
percent, the risk-free rate is 4.5 percent,
and the market risk premium is 7 percent.
What must the beta of this stock be?
 13% = 4.5% + β(7%)
 Β = 1.21
 Exercises
 A stock has an expected return of 10
percent, its beta is 0.70, and the risk-free
rate is 5.5 percent. What must the
expected return on the market be?
 Exercises
 A stock has an expected return of 10
percent, its beta is 0.70, and the risk-free
rate is 5.5 percent. What must the
expected return on the market be?
 10% = 5.5% + 0.70(rm – 5.5%)
 rm = 11.93%
 Exercises
 A stock has an expected return of 15
percent, its beta is 1.45, and the expected
return on the market is 12 percent. What
must the risk-free rate be?
 Exercises
 A stock has an expected return of 15
percent, its beta is 1.45, and the expected
return on the market is 12 percent. What
must the risk-free rate be?
 15% = rf + 1.45(12% – rf)
 rf = 5.33%
 Cost of Capital
 The capital structure, or the market value
mix of debt and equity securities, features
the sources of financing as a portfolio of
financing funding a portfolio of assets.
 For example, a firm that has $40 billion in
debt and $10 billion in equity is said to be
80% debt-financed and 20% equity-
financed.
 Cost of Capital
 The cost of capital is the expected return
on a portfolio of all the firm’s existing
securities.
 It is the opportunity cost of capital for
investment in the firm’s assets, and
therefore the appropriate discount rate for
the firm’s average-risk projects.
 Cost of Capital
 However, the cost of capital is not the
correct discount rate if the new projects
are more or less risky than the firm’s
existing business.
 The cost of capital is a weighted average
of returns demanded by debt and equity
investors.
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: L is the market value of
outstanding debt
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: E is the market value of
outstanding equity
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: A is the total market value or
assets of a firm
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: rdebts is the required return on a
firm’s debt (the yield to maturity)
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: requity is the required return on a
firm’s equity (estimated using the CAPM or
DDM)
 Cost of Capital
 The formula to compute the cost of capital
is as follows:
 rassets = L/A x rdebt + E/A x requity
 where: rassets is the required return on all of
a firm’s assets (estimated using the CAPM
or DDM)
 Cost of Capital
 For example, a firm has issued long-term
bonds with a present value of $25 million
and a yield of 8%. It currently has 12
million shares outstanding, trading at $20
each, offering an expected return of 14%.
The book value per share is $15. What is
the firm’s cost of capital?
 Cost of Capital
 The market value of its debt is
$25,000,000 and the market value of its
equity is 12,000,000 shares x $20 =
$240,000,000.
 Therefore, total market value is
$265,000,000.
 rasset = $25/$265 x 8% + $240/$265 x 14%
= 13.43%
 Exercises
 Calculate the cost of capital of a company
for which the key figures are as follows:
Equity Debt
Book value $10 million $1 million
Market value $12 million $1 million
Expected return 15% 10%
 Exercises
 Calculate the cost of capital of a company
for which the key figures are as follows:
Equity Debt
Book value $10 million $1 million
Market value $12 million $1 million
Expected return 15% 10%
 $12/$13 x 15% + $1/$13 x 10% = 14.62%
 Cost of Capital
 Taxes. For proper valuation we must value
the firm’s after-tax cash flows.
 Most companies are financed by both
equity and debt and the interest payments
on debt are deducted from income before
tax is calculated.
 Cost of Capital
 Therefore, the cost to the company is
reduced by the amount of their tax
savings.
 The weighted average cost of capital
provides a firm’s after-tax cost of capital.
The formula is as follows:
 rassets = L/A x rdebt x (1 – t) + E/A x requity
 where t is the firm’s tax rate.
 Cost of Capital
 For example, what is the WACC for a firm
with $30 million in outstanding debt with a
required return of 8%, 8 million in equity
shares outstanding trading at $15 each with a
required return of 12%, and a tax rate of
35%?
 rassets = $30/($30 + 8 x $15) x 8% x (1 – 35%)
+ (8 x $15)/($30 + 8 x $15) x 12% = 10.64%
 Cost of Capital
 A firm has 40 million shares outstanding
trading for $10 per share. In addition, it has
$100 million in outstanding debt. Suppose its
equity cost of capital is 15%, its debt cost of
capital is 8%, and the corporate tax rate is
40%. What is its weighted average cost of
capital?
 Cost of Capital
 A firm has 40 million shares outstanding
trading for $10 per share. In addition, it has
$100 million in outstanding debt. Suppose its
equity cost of capital is 15%, its debt cost of
capital is 8%, and the corporate tax rate is
40%. What is its weighted average cost of
capital?
 $400/$500 x 15% + $100/$500 x 8% x (1 –
0.40) = 12.96%
 Cost of Capital
 Preferred stock. If there are 3 (or more)
sources of financing, simply calculate the
weighted-average after-tax return of each
security type.
 If the firm issues preferred stock:
 rassets = D/V x (1 – t) rdebt + E/V x requity + P/V
x rpreferred
 Cost of Capital
 For example, consider a firm with $8
million in outstanding bonds, $15 million
worth of outstanding common stock, and
$5 million worth of outstanding preferred
stock. Assume required returns of 8%,
12%, and 10%, respectively, and a 35%
tax rate.
 Cost of Capital
 rassets = $8/($8 + $15 + $5) x 8% x (1 –
35%) + $15/($8 + $15 + $5) x 12% +
$5/($8 + $15 + $5) x 10% = 9.7%
 Exercises
 A firm has a target capital structure of 50%
common stock, 5% preferred stock, and
45% debt. Its cost of equity is 15%, the
cost of preferred stock is 6%, and the cost
of debt is 8%. The relevant tax rate is
35%. What is its WACC?
 Exercises
 A firm has a target capital structure of 50%
common stock, 5% preferred stock, and
45% debt. Its cost of equity is 15%, the
cost of preferred stock is 6%, and the cost
of debt is 8%. The relevant tax rate is
35%. What is its WACC?
 0.50 x 15% + 0.05 x 6% + 0.45 x 8% x (1 –
.35) = 10.14%
 Exercises
 A firm has the following capital structure. Its
corporate tax rate is 35%. What is its WACC?
Security Market Value r
Debt $20 million 6%
Preferred stock $10 million 8%
Common stock $50 million 12%
 Exercises
 A firm has the following capital structure. Its
corporate tax rate is 35%. What is its WACC?
Security Market Value r
Debt $20 million 6%
Preferred stock $10 million 8%
Common stock $50 million 12%
 $20/$80 x 6% x (1 – 0.35) + $10/$80 x 8% +
$50/$80 x 12.0% = 9.475%
 Exercises
 A firm has a target capital structure of 40%
debt and 60% equity. The yield to maturity on
the company’s outstanding bonds is 9%, and
the company’s tax rate is 40%. Its CFO has
calculated the company’s WACC as 9.96%.
What is the company’s cost of equity capital?
 Exercises
 A firm has a target capital structure of 40%
debt and 60% equity. The yield to maturity on
the company’s outstanding bonds is 9%, and
the company’s tax rate is 40%. Its CFO has
calculated the company’s WACC as 9.96%.
What is the company’s cost of equity capital?
 (9.96% – (0.4)(9%)(1 - 0.4))/0.6 = 13%
 Measuring
Capital Structure
 When estimating WACC, the market
values is used, not the book values.
 The cost of capital must be based on what
investors are actually willing to pay for the
company’s outstanding securities—that is,
based on the securities’ market values.
 Measuring
Capital Structure
 Bonds. The present value of all coupons
and principal, discounted at the current
yield to maturity is the market value of
debt.
 Measuring
Capital Structure
 For example, if a firm’s bonds pay a 5%
coupon and mature in 3 years, what is
their market value, assuming a 7% yield to
maturity? Assume the bond has a $1,000
par value.
 PV = 50/1.07 + 50/1.072 + 1,050/1.73 =
$947.51
 Measuring
Capital Structure
 Stocks. The market price per share
multiplied by the number of shares
outstanding is the market value of equity.
 Measuring
Capital Structure
 Debt-Equity Ratio. Debt-equity ratio is a
measure of the relationship between the
capital contributed by creditors and the
capital contributed by shareholders.
 Measuring
Capital Structure
 For example, if a firm is 80% debt-
financed and 20% equity-financed, then its
debt-equity ratio is 80%/20% or 4.
 In another example, if the firm has a debt-
equity ratio of 0.33, then it has a capital
structure of 0.33/(0.333+1) or 25% debt
and 1/(0.333+1) or 75% equity.
 Exercises
 A firm has a target debt-equity ratio of
0.80. Its cost of equity is 17%, and its cost
of debt is 10%. If the tax rate is 35%, what
is the company’s WACC?
 Exercises
 A firm has a target debt-equity ratio of
0.80. Its cost of equity is 17%, and its cost
of debt is 10%. If the tax rate is 35%, what
is the company’s WACC?
 0.80/1.80 x 10% x (1 – .35) + 1/1.80 x
17% = 12.33%
 Exercises
 A firm has a weighted average cost of capital
of 10.2%. The company’s cost of equity is
14%, and its cost of debt is 8.4%. The tax
rate is 35%. What is its target debt-equity
ratio?
 Exercises
 A firm has a weighted average cost of capital
of 10.2%. The company’s cost of equity is
14%, and its cost of debt is 8.4%. The tax
rate is 35%. What is its target debt-equity
ratio?
 10.2% = 8.4%(1 – 35%)D/A + 14%(1 – D/A)
 D/A = 0.4450; E/A = 1 – 0.4450
 D/E = 0.4450/(1 – 0.4450) = 0.8017
 Exercises
 A firm has a target debt-equity ratio of
0.70. Its WACC is 10.5%, and the tax rate
is 35%.
a. If Jungle’s cost of equity is 15 percent,
what is its pretax cost of debt?
 Exercises
 A firm has a target debt-equity ratio of
0.70. Its WACC is 10.5%, and the tax rate
is 35%.
a. If Jungle’s cost of equity is 15 percent,
what is its pretax cost of debt?
 10.5% = 0.7/1.7(1 – 35%)D + 1/1.7 x 15%
 D = 6.26%
 Exercises
 A firm has a target debt-equity ratio of
0.70. Its WACC is 10.5%, and the tax rate
is 35%.
b. If instead you know that the after-tax cost
of debt is 5.9 percent, what is the cost of
equity?
 Exercises
 A firm has a target debt-equity ratio of
0.70. Its WACC is 10.5%, and the tax rate
is 35%.
b. If instead you know that the after-tax cost
of debt is 5.9 percent, what is the cost of
equity?
 10.5% = 0.7/1.7(5.9%) + 1/1.7 x requity
 requity = 13.72%
 Calculating
Expected Returns
 To calculate the WACC, we must first
calculate the cost of capital adjusted for
taxes and flotation costs from each
security.
 Calculating
Expected Returns
 Bonds. The yield to maturity represents
an investor’s expected return on a firm’s
bonds (refer to Module 3).
 Calculating
Expected Returns
 In the previous example, a bond with a
$1,000 par value pays a 5% coupon and
matures in 3 years. If the market value of
the bond is $947.51, its yield to maturity or
pre-tax cost of debt is 7%. If the tax rate is
34 percent, then the after-tax cost of debt
is 7% x (1 – 34%) = 4.62%.
 Calculating
Expected Returns
 Common stock (in the form of retained
earnings). The expected return on a firm’s
common stock is estimated using the
capital asset pricing model (refer to the
discussion on CAPM of this module) or the
dividend discount model (refer to Module
3).
 Calculating
Expected Returns
 For example, a firm’s beta is 1.5, Treasury
bills currently yield 4%, and the long-run
market risk premium is 8%. What is the
firm’s cost of equity?
 requity = 4% + 1.5(8%) = 16%
 Calculating
Expected Returns
 For example, a firm’s shares are trading
for $45 per share. The firm just paid $2
dividend per share. What is its expected
return on equity assuming a 9% constant
growth rate?
 requity = $2(1.09)/$45 + 9% = 13.84%
 Exercises
 A stock in a firm has a beta of 1.25. The market
risk premium is 7%, and Treasury bills are
currently yielding 5%. Its most recent dividend
was $2.10 per share, and dividends are
expected to grow at a 5 percent annual rate
indefinitely. The stock sells for $34 per share.
a. What is the company’s cost of equity capital
using DDM?
 Exercises
 A stock in a firm has a beta of 1.25. The market
risk premium is 7%, and Treasury bills are
currently yielding 5%. Its most recent dividend
was $2.10 per share, and dividends are
expected to grow at a 5 percent annual rate
indefinitely. The stock sells for $34 per share.
a. What is the company’s cost of equity capital
using DDM?
 $2.10(1.05)/$34 + 0.05 = 11.49%
 Exercises
 A stock in a firm has a beta of 1.25. The market
risk premium is 7%, and Treasury bills are
currently yielding 5%. Its most recent dividend
was $2.10 per share, and dividends are
expected to grow at a 5 percent annual rate
indefinitely. The stock sells for $34 per share.
b. What is the company’s cost of equity capital
using CAPM?
 Exercises
 A stock in a firm has a beta of 1.25. The market
risk premium is 7%, and Treasury bills are
currently yielding 5%. Its most recent dividend
was $2.10 per share, and dividends are
expected to grow at a 5 percent annual rate
indefinitely. The stock sells for $34 per share.
b. What is the company’s cost of equity capital
using CAPM?
 5% + 1.25(7%) = 13.75%
 Exercises
 The common stock of a firm has a beta of
0.90. The Treasury bill rate is 4%, and the
market risk premium is estimated at 8%.
Its capital structure is 30% debt, paying a
5% interest rate, and 70% equity. It also
pays tax at 40%.
a. What is its cost of equity capital?
 Exercises
 The common stock of a firm has a beta of
0.90. The Treasury bill rate is 4%, and the
market risk premium is estimated at 8%.
Its capital structure is 30% debt, paying a
5% interest rate, and 70% equity. It also
pays tax at 40%.
a. What is its cost of equity capital?
 4% + (0.90 x 8%) = 11.2%
 Exercises
 The common stock of a firm has a beta of
0.90. The Treasury bill rate is 4%, and the
market risk premium is estimated at 8%.
Its capital structure is 30% debt, paying a
5% interest rate, and 70% equity. It also
pays tax at 40%.
b. What is its WACC?
 Exercises
 The common stock of a firm has a beta of
0.90. The Treasury bill rate is 4%, and the
market risk premium is estimated at 8%.
Its capital structure is 30% debt, paying a
5% interest rate, and 70% equity. It also
pays tax at 40%.
b. What is its WACC? 0.30 x 5% x (1 – 0.40)
+ 0.70 x 11.2% = 8.74%
 Calculating
Expected Returns
 Preferred stocks. The expected return on
a firm’s preferred stock that pays a fixed
annual dividend is estimated using a
simple perpetuity (refer to Module 3).
 Calculating
Expected Returns
 For example, if a share of preferred stock
sells for $40 and it pays a dividend of $3
per share, what is the expected return on
that share of stock?
 rpreferred = $3/$40 = 7.5%
 Calculating
Expected Returns
 Flotation costs. Flotation costs are the
transaction costs incurred when a firm
raises funds by issuing a particular type of
security.
 If a new type of security has a selling cost,
the proceeds to the firm are equal to the
selling price in the market minus the
flotation cost.
 Calculating
Expected Returns
 If firms must pay flotation costs when they sell
bonds, the net proceeds per bond received by
the firm are less than the market price of the
bond.
 Note that the adjustment for flotation costs
simply involves replacing the market price of the
bond with the net proceeds per bond received
by the firm after paying these costs.
 Calculating
Expected Returns
 For example, after talking with the firm’s investment
banker, a firm’s chief financial officer has determined that
a 20-year maturity bond with a $1,000 face value and 8
percent coupon can be sold to investors for net proceeds
of $908.32. Since it is issuing new bonds, it will incur
$58.32 per bond in flotation costs. If its tax rate is 34
percent, the after-tax cost of debt financing to the firm is:
 rdebt =RATE(20,1000*8%,-(908.32-58.32),1000,0) x (1 –
34%) = 6.42%
 Calculating
Expected Returns
 A bond that has $1,000 par value and a
contract or coupon interest rate of 11 percent.
A new issue would have a flotation cost of 5
percent of the $1,125 market value. The
bonds mature in 10 years. The firm’s
marginal tax rate is 34 percent. What is the
cost of debt?
 Calculating
Expected Returns
 A bond that has $1,000 par value and a
contract or coupon interest rate of 11 percent.
A new issue would have a flotation cost of 5
percent of the $1,125 market value. The
bonds mature in 10 years. The firm’s
marginal tax rate is 34 percent. What is the
cost of debt?
 6.53% or =rate(10,1000*11%,-1125*(1-
5%),1000,0)*(1-34%)
 Calculating
Expected Returns
 If a company were to issue new common
stock, the cost of a new common stock
issue under the CAPM model would be
computed using equation as follows:
 requity = Investor’s required rate of return /
(1 - (F / P0))
 = (rf + β(rm – rf)) / (1 - (F / P0))
 Calculating
Expected Returns
 For example, a firm currently sells its
common shares for $22.00 per share. If the
investor’s required rate of return on these
shares was 18 percent, and the firm incurred
transaction costs totaling $2.00 per share,
what was its cost of capital after adjusting for
the effects of the transaction costs?
 requity = 18% / (1 – $2/$22) = 19.80%
 Calculating
Expected Returns
 If a company were to issue new common
stock, the cost of a new common stock
issue under the DDM model would be
computed using equation as follows:
 requity = D1 / (P0 – F) + g
 = D0 (1 + g) / (P0 – F) + g
 = D0 (1 + g) / P0 / (1 - (F / P0)) + g
 Calculating
Expected Returns
 For example, common shareholders anticipate receiving
a $2.20 per share dividend next year, based on the fact
that they received $2 last year and expect dividends to
grow 10 percent next year. Furthermore, analysts predict
that dividends will continue to grow at a rate of 10
percent into the foreseeable future. If the company were
to issue new common stock for $50.00 a share, the firm
would incur a $7.50 per share cost to sell the new
shares. The cost of a new common stock issue is:
 requity = $2.20 / ($50.00 – $7.50) + 10% = 15.18%
 Exercises
 A firm is issuing new common stock at a
market price of $27. Dividends last year were
$1.45 and are expected to grow at an annual
rate of 6 percent forever. Flotation costs will
be 6 percent of market price. What is its cost
of new common stock?
 Exercises
 A firm is issuing new common stock at a
market price of $27. Dividends last year were
$1.45 and are expected to grow at an annual
rate of 6 percent forever. Flotation costs will
be 6 percent of market price. What is its cost
of new common stock?
 12.06% or =1.45*(1+6%)/(27*(1-6%))+6%
 Calculating
Expected Returns
 If a company were to issue new preferred
stock, the cost of a new preferred stock
issue would be computed using equation
as follows:
 rpreferred = D1 / (P0 – F)
 Calculating
Expected Returns
 For example, the annual preferred
dividend of a company is $10.50, the
preferred stock price is $100, and the
flotation, or selling cost, is $4. The cost of
preferred stock is:
 rpreferred = $10.50 / ($100 – $4) = 10.94%
 Exercises
 A preferred stock paying a 9 percent
dividend on a $150 par value. If a new
issue is offered, flotation costs will be 12
percent of the current price of $175. What
is its cost of new preferred stock?
 Exercises
 A preferred stock paying a 9 percent
dividend on a $150 par value. If a new
issue is offered, flotation costs will be 12
percent of the current price of $175. What
is its cost of new preferred stock?
 8.77% =9%*150/(175*(1-12%))
End of Module 4