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Required Returns

and the Cost of

Capital

Risk

15.1

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

you should be able to:

15.2

1.

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

value creation.

2.

3.

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

4.

including the dividend discount approach, the capital-asset pricing

model (CAPM) approach, and the before-tax cost of debt plus risk

premium approach.

5.

understand its rationale, use, and limitations.

6.

to value creation and the firms cost of capital.

7.

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

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

the Cost of Capital

15.3

Creation of Value

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

Key Sources of

Value Creation

Industry Attractiveness

Growth

phase of

product

cycle

Cost

Marketing

and

price

Barriers to

competitive

entry

temporary

monopoly

power,

oligopoly

pricing

Perceived

quality

Superior

organizational

capability

Competitive Advantage

15.4

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).

15.5

Market Value of

Long-Term Financing

Type of Financing

Mkt Val

Weight

Long-Term Debt

$ 35M

35%

Preferred Stock

$ 15M

15%

$ 100M

15.6

50%

100%

Cost of Debt

Cost of Debt is the required rate

of return on investment of the

lenders of a company.

n

P0 =

Ij + Pj

j

(1

+

k

)

d

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 = 0.1 or 10%

15.9

ki

= 10% ( 1 .40 )

ki

= 6%

Cost of Preferred Stock is the

required rate of return on

investment of the preferred

shareholders of the company.

kP = D P / P 0

15.10

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

15.12

Risk Premium

The cost of equity capital,

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

The constant dividend growth

assumption reduces the model to:

ke = ( D1 / P0 ) + g

Assumes that dividends will grow

at the constant rate g forever.

15.14

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.

15.15

ke

= ( D 1 / P0 ) + g

ke

ke

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

The growth phases assumption

leads to the following formula

(assume 3 growth phases):

a

D0(1 + g1)t

t=1

(1 + ke)t

P0 =

t=b+1

15.16

Da(1 + g2)ta

t=a+1

(1 + ke)t

Db(1 + g3)tb

(1 + ke)t

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 11.4%

ke = Rf + (Rm Rf) j

= 4% + (11.4% 4%)1.25

ke = 4% + 9.25% = 13.25%

15.18

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

15.19

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%

15.20

Comparison of the

Cost of Equity Methods

Constant Growth Model 13.00%

Capital Asset Pricing Model 13.25%

Cost of Debt + Risk Premium 12.75%

Generally, the three methods will not agree.

We must decide how to weight

we will use an average of these three.

15.21

Weighted Average

Cost of Capital (WACC)

n

Cost of Capital =

15.22

x=1

kx(Wx)

WACC

= 0.35(6%) + 0.15(9%) +

0.50(13%)

WACC

= 0.0995 or 9.95%

1. Weighting System

Proportions than WACC

15.23

2.

associated with issuing securities

such as underwriting, legal, listing,

and printing fees.

a. Adjustment to Initial Outlay

b. Adjustment to Discount Rate

15.24

15.25

firms are earning returns on their

invested capital that exceed their

cost of capital.

Stern Stewart and Company in late

1980s.

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

EVA = NOPAT [Cost of

Capital x Capital Employed]

15.26

positive EVA generally indicates shareholder

value is being created.

companys potential after-tax profit if it was allequity-financed or unlevered.

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

Adjustment to

Initial Outlay (AIO)

Add Flotation Costs (FC) to the

Initial Cash Outlay (ICO).

n

CFt

NPV = (1 + k)t ( ICO + FC )

t=1

Impact: Reduces the NPV

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

decreases the NPV.

15.28

Determining Project-Specific

Required Rates of Return

Use of CAPM in Project Selection:

15.29

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

Difficulty in Determining

the Expected Return

Determining the SML:

15.30

easier if asset is traded).

between the market portfolio and the

proxy asset excess returns.

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

Project Acceptance

and/or Rejection

EXPECTED RATE

OF RETURN

Accept

X

X

X

O

Rf

X

O

O

O

SML

Reject

O

15.31

Determining Project-Specific

Required Rate of Return

1. Calculate the required return

for Project k (all-equity financed).

Rk = Rf + (Rm Rf) k

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-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

ke = Rf + (Rm Rf) j

= 4% + (11.2% 4%)1.5

ke = 4% + 10.8% = 14.8%

WACC = 0.30(6%) + 0.70(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.

15.35

project.

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

Comparing Group-Specific

Required Rates of Return

Company Cost

of Capital

Group-Specific

Required Returns

Systematic Risk (Beta)

15.36

Qualifications to Using

Group-Specific Rates

15.37

relative to the proxy firm. Adjust

project beta if necessary.

CAPM. Potential insolvency is a

total-risk problem rather than just

systematic risk (CAPM).

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

Project Evaluation

Based on Total Risk

RiskAdjusted Discount Rate

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

Adjusting for risk correctly

may influence the ultimate

Project decision.

$000s

15

10

5

0

4

15.39

RADR low

risk at 10%

(Accept!)

6

9

12

Discount Rate (%)

RADR high

risk at 15%

(Reject!)

15

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

Firm-Portfolio Approach

C

Indifference

Curves

B

A

Curves show

HIGH

Risk Aversion

STANDARD DEVIATION

15.41

Firm-Portfolio Approach

C

Indifference

Curves

B

A

Curves show

MODERATE

Risk Aversion

STANDARD DEVIATION

15.42

Firm-Portfolio Approach

C

Indifference

Curves

B

A

Curves show

LOW

Risk Aversion

STANDARD DEVIATION

15.43

Financial Leverage

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

j: Beta of a levered firm.

ju: Beta of an unlevered firm

Market Value terms.

TC : The corporate tax rate.

15.44

Adjusted Present Value (APV) is the

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.

APV =

15.45

Unlevered

Project Value

Value of

Project Financing

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).

The firm is in the 40% tax bracket.

15.46

Basket Wonders

NPV Solution

What is the NPV to an all-equityfinanced firm?

firm

NPV = $100,000[PVIFA11%,6] $425,000

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%)

= 10,500Int Yr

3

( 120,000)(7%)

= 8,400Int Yr 4 (

90,000)(7%) = 6,300

Int Yr 5

( 60,000)(7%)

= 4,200Int 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

TSB Yr 3

TSB Yr 4

TSB Yr 5

TSB Yr 6

=

=

=

=

=

15.49

( 10,500)(40%)

( 8,400)(40%)

( 6,300)(40%)

( 4,200)(40%)

( 2,100)(40%)

4,200

3,360

2,520

1,680

840

Basket Wonders

APV Solution

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

TSB Yr 1

TSB Yr 2

TSB Yr 3

TSB Yr 4

TSB Yr 5

TSB Yr 6

$13,513

15.50

($5,040)(.901)

( 4,200)(.812)

( 3,360)(.731)

( 2,520)(.659)

( 1,680)(.593)

( 840)(.535)

= $4,541

= 3,410

= 2,456

= 1,661

=

996

=

449 PV =

Basket Wonders

NPV Solution

What is the APV?

APV

APV = NPV + PV of TS Flotation Cost

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

APV = $1,567

15.51

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