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Lesson 3

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.

After Studying Lesson 3,


you should be able to:

15.2

1.

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

2.

Define the overall cost of capital of the firm.

3.

Calculate the costs of the individual components of a firms cost of


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

4.

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.

5.

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


understand its rationale, use, and limitations.

6.

Explain how the concept of economic Value added (EVA) is related


to value creation and the firms cost of capital.

7.

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


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.

Required Returns and


the Cost of Capital

15.3

Creation of Value

Overall Cost of Capital of the Firm

Project-Specific Required Rates

Group-Specific Required Rates

Total Risk Evaluation

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

Other -e.g., patents,


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

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

Market Value of
Long-Term Financing
Type of Financing

Mkt Val

Weight

Long-Term Debt

$ 35M

35%

Preferred Stock

$ 15M

15%

Common Stock Equity $ 50M


$ 100M

15.6

50%

100%

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

P0 =

Ij + Pj

j
(1
+
k
)
d
j=1

ki = kd ( 1 T )
15.7

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 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

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%

15.9

ki

= 10% ( 1 .40 )

ki

= 6%

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
15.10

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 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

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

Cost of Equity
Approaches

15.12

Dividend Discount Model

Capital-Asset Pricing Model

Before-Tax Cost of Debt plus


Risk Premium

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,
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

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.
15.14

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

Determination of the
Cost of Equity 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

= ($3(1.08) / $64.80) + 0.08

ke

= 0.05 + 0.08 = 0.13 or 13%


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

Growth Phases Model


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

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) j
15.17

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) j
= 4% + (11.4% 4%)1.25
ke = 4% + 9.25% = 13.25%
15.18

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
15.19

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%
15.20

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

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

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 =

15.22

x=1

kx(Wx)

WACC

= 0.35(6%) + 0.15(9%) +
0.50(13%)

WACC

= 0.021 + 0.0135 + 0.065


= 0.0995 or 9.95%

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

15.23

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.
a. Adjustment to Initial Outlay
b. Adjustment to Discount Rate

15.24

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

Economic Value Added

15.25

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

Economic Value Added


EVA = NOPAT [Cost of
Capital x Capital Employed]

15.26

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 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

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

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

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

Determining Project-Specific
Required Rates of Return
Use of CAPM in Project Selection:

15.29

Initially assume all-equity financing.

Determine project beta.

Calculate the expected return.

Adjust for capital structure of firm.

Compare cost to IRR of project.


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

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.


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

SYSTEMATIC RISK (Beta)


15.31

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) k

2. Adjust for capital structure of the


firm (financing weights).
Weighted Average Required Return = [ki]
[% of Debt] + [Rk][% of Equity]
15.32

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

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

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

Do You Accept the Project?


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

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

Determining Group-Specific
Required Rates of Return
Use of CAPM in Project Selection:
Initially assume all-equity financing.

15.35

Determine group beta.

Calculate the expected return.

Adjust for capital structure of group.

Compare cost to IRR of group


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

Expected Rate of Return

Comparing Group-Specific
Required Rates of Return
Company Cost
of Capital

Group-Specific
Required Returns
Systematic Risk (Beta)

15.36

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

Qualifications to Using
Group-Specific Rates

15.37

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).
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

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

RADR and NPV


Adjusting for risk correctly
may influence the ultimate
Project decision.

Net Present Value

$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

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

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

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

EXPECTED VALUE OF NPV

Firm-Portfolio Approach
C

Indifference
Curves

B
A
Curves show
HIGH
Risk Aversion
STANDARD DEVIATION

15.41

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

EXPECTED VALUE OF NPV

Firm-Portfolio Approach
C

Indifference
Curves

B
A
Curves show
MODERATE
Risk Aversion
STANDARD DEVIATION

15.42

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

EXPECTED VALUE OF NPV

Firm-Portfolio Approach
C

Indifference
Curves

B
A
Curves show
LOW
Risk Aversion
STANDARD DEVIATION

15.43

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

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

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

Adjusted Present Value


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

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

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).
The firm is in the 40% tax bracket.
15.46

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

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

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

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

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

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

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

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 =

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

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

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