Chapter 15

Required
Required Returns
Returns
and
and the
the Cost
Cost of
of
Capital
Capital
15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Overall Cost of
Capital of the Firm
Cost of Capital is the required 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).

15.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Cost of Debt

Cost of Debt is the required rate

of return on investment of the
lenders of a company.
n Ij + Pj
P0 = S (1 + k )j
j=1 d

ki = kd ( 1 – T )
15.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination of
the Cost of Debt
Assume that 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

15.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination of
the Cost of Debt
(1 + kd)10 = $1,000 / $385.54
= 2.5938
(1 + kd) = (2.5938) (1/10) =
1.1
kd = 0.1 or 10%

ki = 10% ( 1 – .40 )
ki = 6%
15.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Cost of Preferred Stock

Cost of Preferred Stock is the

required rate of return on
investment of the preferred
shareholders of the company.

kP = D P / P 0

15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination of the
Cost of Preferred Stock
Assume that (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%

15.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Cost of Equity
Approaches
 Dividend Discount Model
 Capital-Asset Pricing Model
 Before-Tax
Cost of Debt plus
Risk Premium

15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Dividend Discount Model

The cost of equity 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)¥

15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Constant Growth Model

The constant dividend growth

assumption reduces the model to:

ke = ( D1 / P0 ) + g

Assumes that dividends will grow

at the constant rate “g” forever.
15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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) + 0.08
ke = 0.05 + 0.08 = 0.13 or 13%
15.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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)bj
15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 11.4%
ke = Rf + (Rm – Rf)bj
= 4% + (11.4% – 4%)1.25
ke = 4% + 9.25% = 13.25%
15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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*

* Risk premium is not the same as CAPM risk

premium
15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination of the
Cost of Equity (kd + R.P.)
Assume that Basket Wonders (BW)
typically adds a 2.75% premium to the
before-tax cost of debt.
ke = kd + Risk Premium
= 10% + 2.75%
ke = 12.75%

15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Weighted Average Cost
of Capital (WACC)
n
Cost of Capital = S
kx(Wx)
x=1

15.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Limitations of the WACC

1.Weighting System
 Marginal Capital Costs
 Capital Raised in Different
Proportions than WACC

15.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Limitations of the WACC

2. Flotation Costs are the costs

associated with issuing securities
such as underwriting, legal, listing,
and printing fees.

15.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determining Project-Specific
Required Rate of Return

1. Calculate the required return

for Project k (all-equity financed).
Rk = Rf + (Rm – Rf)bk
2. Adjust for capital structure of the
firm (financing weights).
Weighted Average Required Return = [ki]
[% of Debt] + [Rk][% of Equity]
15.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.