Required Returns

and the Cost of

Capital

15-1
 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
15-2
 Key Sources of
Value
Creation
Industry Attractiveness

Growth Barriers to Other --

phase of competitive e.g., patents,
product entry tempor
cycle ary
monopoly
power,
oligopoly
pricing
Marketing Superior
Perceived
Cost and organizational
quality
price capability

15-3
Competitive Advantage
 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).

15-4
 Cost of Capital
● Purpose to study Competitive Advantage
● Cost & its Classifications
● Explicit Cost
● Implicit Cost (Opportunity Cost)
● Absolute Cost
● Relative Cost
● Floatation cost
● Specific Cost
● Multiple Cost / WACC
15-5
 Source of Capital or
Financing
Debt Financing
●DebtCertificate (Interest / Discount or Premium)
●Loan (Interest / Processing or other

charges) Equity Financing

●Ordinary Shares Financing (Dividend/Disc. or Prem.)
●Retained Earning (Dividend/Disc. or Prem.)

Hybrid Financing
●Preferred Stock (Dividend / Disc. or Prem.)
●Convertibles

15-6
 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).

15-7
 Market Value of
Long-Term Financing
Type of Financing Mkt Val Weight
Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%

Common Stock Equity $ 50M50%

$ 100M

100%
15-8
 Cost of Debt
Cost of Debt is the rate of return demanded
by investors for their investment in Bonds /
Debentures / Long term Debts.

Int = Annual interest to be paid

t = Company’s effective tax rate
RV = Redemption value per Debenture
N = Number of years to maturity
SV = issue price per debenture minus floatation cost
15-9
Determination of the Cost of
Debt the cost of capital in the following cases:
Calculate
i) X Ltd. issues 12% Debentures of face value Rs. 100
each and realizes Rs. 95 per Debenture.
The Debentures are redeemable after 10 years at a
premium of 10%.
Note: Both companies are paying income tax at 50%.
Data:
Int = Annual interest to be paid i.e. Rs. 12
t = Company’s effective tax rate i.e. 50% or 0.50
RV = Redemption value per Debenture i.e. Rs. 110
N = Number of years to maturity = 10 years
SV = issue price per debenture minus floatation cost i.e. Rs. 95
15-10
 Determination of
the Cost of Debt
kd = [12 + (110 – 95) / 10] (1 – .5)
(110 + 95) / 2
[12 + (110 - 95) / 10] (1 - 0.5) = [12 + 1.5] x 0.5 = 6.75
(110 + 95) / 2 = 102.5
(kd) = 6.75 / 102.5 = 0.0659 or 6.59%

15-11
 Cost of Preferred Stock
Cost of Preferred Stock is the required rate of return on investment
of the preferred shareholders of the company.

kP = DP /
P0

15-12
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.
k = $6.30 / $70
P
kP = 9%
15-13
 Determination of the Cost of
Preferred Stock
A company raised preference share capital of Rs. 1,00,000 by the issue of 10%
preference share of Rs. 10 each. Find out the cost of preference share capital when
it is issued at (i) 10% premium, and (ii) 10% discount
Cost of 10% preference share capital
(i) When share issued at 10% premium
Kp = D / P0
= 1 / 11 = 9.09%
(ii) When share issued at 10% discount
Kp = D / P0
= 1 / 9 = 11.11%

15-14
 Cost of Equity Approaches
● Dividend Discount Model
● Capital-Asset
Pricing
Model
● Before-Tax Cost of Debt
plus Risk Premium 15-15
 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
D stock.
D D
P0 = 1 2 ∞
(1+ ke)1 + (1. + e)2 ∞ (1+k e)

15-16
 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.
15-17
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
ke = .05 + .08 = .13 or 13%
Growth Phases Model

15-18
 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)βj
15-19
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)βj
= 4% + (11.2% - 4%)1.25
k = 4% + 9% = 13% 15-20
 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
15-22
 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%
15-23
Comparison of the Cost of
Equity Methods
Constant Growth Model 13%
Capital Asset Pricing Model 13%
Cost of Debt + Risk Premium 13%

Generally, the three methods

will not agree.

15-24
Weighted Average cost of
capital

WACC = .35(6%) + .15(9%) +

.50(13%)
WACC = .021 + .0135 + .065
= .0995 or 9.95%
15-25
 Limitations of the WACC

1. Weighting System
● Marginal Capital Costs
● CapitalRaised in
Different
Proportions than
WACC
15-26
 Limitations of the WACC

2. Flotation Costs are the costs

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

a. Adjustment to Initial Outlay

b. Adjustment to Discount Rate
15-27
 Adjustment to
Discount Rate (ADR)
Subtract Flotation Costs from the
proceeds (price) of the security
and recalculate yield figures.
Impact: Increases the cost for any
capital component with flotation costs.

Result: Increases the WACC,

which
15-27
 Project-Specific
Required Rates of Return
Use of CAPM in Project Selection:
● 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 theproxy asset
excess returns.
● Estimate beta and create the 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

SYSTEMATIC RISK (Beta)

15-31
 Project-Specific
Required Rate of Return
1. Calculate the required return
for Project k (all-equity
financed). R = R + (R - R )β
k f m f 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
Assume a computer networking project
is being considered with an IRR of 19%.
Examination of firms in the networking
industry allows us to estimate an
all-equitybeta of 1.5. Our firm is financed
with 70% Equity and 30% Debt at ki=6%.
The expected return on the market is
15-32
 Do You Accept the Project?
ke = Rf + (Rm - Rf)βj
= 4% + (11.2% - 4%)1.5
ke = 4% + 10.8% = 14.8%

WACC = .30(6%) + .70(14.8%)

= 1.8% + 10.36% = 12.16%
IRR = 19% > WACC =
12.16% 15-34
 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