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5-1Chapter 15Chapter 15Required ReturnsRequired Returnsand the Cost ofand the Cost ofCapitalCapital© 2001 Prentice-Hall, I...
5-2Required Returns andRequired Returns andthe Cost of Capitalthe Cost of CapitalCreation of ValueOverall Cost of Capital ...
5-3Key Sources ofKey Sources ofValue CreationValue CreationGrowthphase ofproductcycleBarriers tocompetitiveentryOther --e....
5-4Overall Cost ofOverall Cost ofCapital of the FirmCapital of the FirmCost of Capital is the requiredrate of return on th...
5-5Type of Financing Mkt Val WeightLong-Term Debt $ 35M 35%Preferred Stock $ 15M 15%Common Stock Equity $ 50M 50%$ 100M 10...
5-6Cost of DebtCost of Debt is the required rateof return on investment of thelenders of a company.ki = kd ( 1 - T )Cost o...
5-7Assume that Basket Wonders (BW) has$1,000 par value zero-coupon bondsoutstanding. BW bonds are currentlytrading at $385...
5-8(1 + kd)10= $1,000 / $385.54= 2.5938(1 + kd) = (2.5938) (1/10)= 1.1kd = .1 or 10%ki = 10% ( 1 - .40 )kkii = 6%6%Determi...
5-9Cost of Preferred StockCost of Preferred Stock is therequired rate of return oninvestment of the preferredshareholders ...
5-10Assume that Basket Wonders (BW)has preferred stock outstanding withpar value of $100, dividend per shareof $6.30, and ...
5-11Dividend Discount ModelDividend Discount ModelCapital-Asset PricingCapital-Asset PricingModelModelBefore-Tax Cost of D...
5-12Dividend Discount ModelDividend Discount ModelThe cost of equity capitalcost of equity capital, ke, isthe discount rat...
5-13Constant Growth ModelConstant Growth ModelThe constant dividend growthconstant dividend growthassumptionassumption red...
5-14Assume that Basket Wonders (BW) hascommon stock outstanding with a currentmarket value of $64.80 per share, currentdiv...
5-15Growth Phases ModelGrowth Phases ModelD0(1+g1)tDa(1+g2)t-a(1+ke)t(1+ke)tP0 =The growth phases assumptiongrowth phases ...
5-16Capital AssetCapital AssetPricing ModelPricing ModelThe cost of equity capital, ke, isequated to the required rate ofr...
5-17Assume that Basket Wonders (BW) hasa company beta of 1.25. Research byJulie Miller suggests that the risk-freerate is ...
5-18Before-Tax Cost of DebtBefore-Tax Cost of DebtPlus Risk PremiumPlus Risk PremiumThe cost of equity capital, ke, is the...
5-19Assume that Basket Wonders (BW)typically adds a 3% premium to thebefore-tax cost of debt.ke = kd + Risk Premium= 10% +...
5-20Constant Growth Model 13%13%Capital Asset Pricing Model 13%13%Cost of Debt + Risk Premium 13%13%Generally, the three m...
5-21Cost of Capital = kx(Wx)WACC = .35(6%) + .15(9%) +.50(13%)WACC = .021 + .0135 + .065= .0995 or 9.95%Weighted AverageWe...
5-221.1. Weighting SystemWeighting SystemMarginal Capital CostsCapital Raised in DifferentProportions than WACCLimitations...
5-232.2. Flotation CostsFlotation Costs are the costsassociated with issuing securitiessuch as underwriting, legal, listin...
5-24A measure of businessperformance.It is another way of measuring thatfirms are earning returns on theirinvested capital...
5-25EVA = NOPAT – [ Cost ofCapital x Capital Employed ]Since a cost is charged for equity capitalalso, a positive EVA gene...
5-26Add Flotation Costs (FC) to theInitial Cash Outlay (ICO).Impact: ReducesReduces the NPVAdjustment toAdjustment toIniti...
5-27Subtract Flotation Costs from theproceeds (price) of the security andrecalculate yield figures.Impact: IncreasesIncrea...
5-28Initially assume all-equity financing.Determine project beta.Calculate the expected return.Adjust for capital structur...
5-29Difficulty in DeterminingDifficulty in Determiningthe Expected Returnthe Expected ReturnLocate a proxy for the project...
5-30Project AcceptanceProject Acceptanceand/or Rejectionand/or RejectionSMLXXXXXXXO OOOOOOSYSTEMATIC RISK (Beta)EXPECTEDRA...
5-311. Calculate the required returnfor Project k (all-equity financed).Rk = Rf + (Rm - Rf)βk2. Adjust for capital structu...
5-32Assume a computer networking project isbeing considered with an IRR of 19%.Examination of firms in the networkingindus...
5-33ke = Rf + (Rm - Rf)βj= 4% + (11.2% - 4%)1.5kkee = 4% + 10.8% = 14.8%14.8%WACCWACC = .30(6%) + .70(14.8%)= 1.8% + 10.36...
5-34Determining Group-SpecificDetermining Group-SpecificRequired Rates of ReturnRequired Rates of ReturnInitially assume a...
5-35Comparing Group-SpecificComparing Group-SpecificRequired Rates of ReturnRequired Rates of ReturnGroup-SpecificRequired...
5-36Amount of non-equity financingrelative to the proxy firm.Adjust project beta if necessary.Standard problems in the use...
5-37Risk-Adjusted Discount RateApproach (RADR)The required return is increased(decreased) relative to the firm’soverall co...
5-38Probability DistributionApproachAcceptance of a single projectwith a positive NPV depends onthe dispersion of NPVs and...
5-39Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“HIG...
5-40Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“MOD...
5-41Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“LOW...
5-42ββjj == ββjuju [ 1 + ([ 1 + (B/SB/S)(1-)(1-TTCC) ]) ]ββj: Beta of a levered firm.ββju: Beta of an unlevered firm(an al...
5-43Adjusted Present Value (APV) is thesum of the discounted value of aproject’s operating cash flows plus thevalue of any...
5-44Assume Basket Wonders is considering anew $425,000 automated basket weavingmachine that will save $100,000 per yearfor...
5-45What is the NPVNPV to an all-equity-to an all-equity-financed firmfinanced firm?NPV = $100,000[PVIFA11%,6] - $425,000N...
5-46What is the APVAPV?First, determine the interest expense.Int Yr 1 ($180,000)(7%) = $12,600Int Yr 2 ( 150,000)(7%) = 10...
5-47Second, calculate the tax-shield benefits.TSB Yr 1 ($12,600)(40%) = $5,040TSB Yr 2 ( 10,500)(40%) = 4,200TSB Yr 3 ( 8,...
5-48Third, find the PV of the tax-shield benefits.TSB Yr 1 ($5,040)(.901) = $4,541TSB Yr 2 ( 4,200)(.812) = 3,410TSB Yr 3 ...
5-49What is the APVAPV?APV = NPV + PV of TS - Flotation CostAPV = -$1,946 + $13,513 - $10,000APVAPV = $1,567$1,567Basket W...
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Ch 15 - Required Returns and the Cost of Capital

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Financial Management by Van Horne
Ch 15 - Required Returns and the Cost of Capital

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  1. 1. 5-1Chapter 15Chapter 15Required ReturnsRequired Returnsand the Cost ofand the Cost ofCapitalCapital© 2001 Prentice-Hall, Inc.Fundamentals of Financial Management, 11/eCreated by: Gregory A. Kuhlemeyer, Ph.D.Carroll College, Waukesha, WI
  2. 2. 5-2Required Returns andRequired Returns andthe Cost of Capitalthe Cost of CapitalCreation of ValueOverall Cost of Capital of the FirmProject-Specific Required RatesGroup-Specific Required RatesTotal Risk Evaluation
  3. 3. 5-3Key Sources ofKey Sources ofValue CreationValue CreationGrowthphase ofproductcycleBarriers tocompetitiveentryOther --e.g., patents,temporarymonopolypower,oligopolypricingCostMarketingandpricePerceivedqualitySuperiororganizationalcapabilityIndustry AttractivenessIndustry AttractivenessCompetitive AdvantageCompetitive Advantage
  4. 4. 5-4Overall Cost ofOverall Cost ofCapital of the FirmCapital of the FirmCost of Capital is the requiredrate of return on the varioustypes of financing. The overallcost of capital is a weightedaverage of the individualrequired rates of return (costs).
  5. 5. 5-5Type of Financing Mkt Val WeightLong-Term Debt $ 35M 35%Preferred Stock $ 15M 15%Common Stock Equity $ 50M 50%$ 100M 100%Market Value ofMarket Value ofLong-Term FinancingLong-Term Financing
  6. 6. 5-6Cost of DebtCost of Debt is the required rateof return on investment of thelenders of a company.ki = kd ( 1 - T )Cost of DebtCost of DebtP0 =Ij + Pj(1 + kd)jΣnj =1
  7. 7. 5-7Assume that Basket Wonders (BW) has$1,000 par value zero-coupon bondsoutstanding. BW bonds are currentlytrading at $385.54 with 10 years tomaturity. BW tax bracket is 40%.Determination ofDetermination ofthe Cost of Debtthe Cost of Debt$385.54 =$0 + $1,000(1 + kd)10
  8. 8. 5-8(1 + kd)10= $1,000 / $385.54= 2.5938(1 + kd) = (2.5938) (1/10)= 1.1kd = .1 or 10%ki = 10% ( 1 - .40 )kkii = 6%6%Determination ofDetermination ofthe Cost of Debtthe Cost of Debt
  9. 9. 5-9Cost of Preferred StockCost of Preferred Stock is therequired rate of return oninvestment of the preferredshareholders of the company.kP = DP / P0Cost of Preferred StockCost of Preferred Stock
  10. 10. 5-10Assume that Basket Wonders (BW)has preferred stock outstanding withpar value of $100, dividend per shareof $6.30, and a current market value of$70 per share.kP = $6.30 / $70kkPP = 9%9%Determination of theDetermination of theCost of Preferred StockCost of Preferred Stock
  11. 11. 5-11Dividend Discount ModelDividend Discount ModelCapital-Asset PricingCapital-Asset PricingModelModelBefore-Tax Cost of DebtBefore-Tax Cost of Debtplus Risk Premiumplus Risk PremiumCost of EquityCost of EquityApproachesApproaches
  12. 12. 5-12Dividend Discount ModelDividend Discount ModelThe cost of equity capitalcost of equity capital, ke, isthe discount rate that equates thepresent value of all expectedfuture dividends with the currentmarket price of the stock.D1 D2 D(1+ke)1(1+ke)2(1+ke)+ . . . ++P0 =∞∞
  13. 13. 5-13Constant Growth ModelConstant Growth ModelThe constant dividend growthconstant dividend growthassumptionassumption reduces the model to:ke = ( D1 / P0 ) + gAssumes that dividends will growat the constant rate “g” forever.
  14. 14. 5-14Assume that Basket Wonders (BW) hascommon stock outstanding with a currentmarket value of $64.80 per share, currentdividend of $3 per share, and a dividendgrowth rate of 8% forever.ke = ( D1 / P0 ) + gke = ($3(1.08) / $64.80) + .08kkee = .05 + .08 = .13.13 or 13%13%Determination of theDetermination of theCost of Equity CapitalCost of Equity Capital
  15. 15. 5-15Growth Phases ModelGrowth Phases ModelD0(1+g1)tDa(1+g2)t-a(1+ke)t(1+ke)tP0 =The growth phases assumptiongrowth phases assumptionleads to the following formulaleads to the following formula(assume 3 growth phases):(assume 3 growth phases):Σ + Σt=1at=a+1bt=b+1∞ Db(1+g3)t-b(1+ke)t+Σ
  16. 16. 5-16Capital AssetCapital AssetPricing ModelPricing ModelThe cost of equity capital, ke, isequated to the required rate ofreturn in market equilibrium. Therisk-return relationship is describedby the Security Market Line (SML).ke = Rj = Rf + (Rm - Rf)βj
  17. 17. 5-17Assume that Basket Wonders (BW) hasa company beta of 1.25. Research byJulie Miller suggests that the risk-freerate is 4% and the expected return onthe market is 11.2%ke = Rf + (Rm - Rf)βj= 4% + (11.2% - 4%)1.25kkee = 4% + 9% = 13%13%Determination of theDetermination of theCost of Equity (CAPM)Cost of Equity (CAPM)
  18. 18. 5-18Before-Tax Cost of DebtBefore-Tax Cost of DebtPlus Risk PremiumPlus Risk PremiumThe cost of equity capital, ke, is thesum of the before-tax cost of debtand a risk premium in expectedreturn for common stock over debt.ke = kd + Risk Premium** Risk premium is not the same as CAPM riskpremium
  19. 19. 5-19Assume that Basket Wonders (BW)typically adds a 3% premium to thebefore-tax cost of debt.ke = kd + Risk Premium= 10% + 3%kkee = 13%13%Determination of theDetermination of theCost of Equity (kCost of Equity (kdd + R.P.)+ R.P.)
  20. 20. 5-20Constant Growth Model 13%13%Capital Asset Pricing Model 13%13%Cost of Debt + Risk Premium 13%13%Generally, the three methodswill not agree.Comparison of theComparison of theCost of Equity MethodsCost of Equity Methods
  21. 21. 5-21Cost of Capital = kx(Wx)WACC = .35(6%) + .15(9%) +.50(13%)WACC = .021 + .0135 + .065= .0995 or 9.95%Weighted AverageWeighted AverageCost of Capital (WACC)Cost of Capital (WACC)Σnx=1
  22. 22. 5-221.1. Weighting SystemWeighting SystemMarginal Capital CostsCapital Raised in DifferentProportions than WACCLimitations of the WACCLimitations of the WACC
  23. 23. 5-232.2. Flotation CostsFlotation Costs are the costsassociated with issuing securitiessuch as underwriting, legal, listing,and printing fees.a. Adjustment to Initial Outlayb. Adjustment to Discount RateLimitations of the WACCLimitations of the WACC
  24. 24. 5-24A measure of businessperformance.It is another way of measuring thatfirms are earning returns on theirinvested capital that exceed theircost of capital.Specific measure developed byStern Stewart and Company in late1980s.Economic Value AddedEconomic Value Added
  25. 25. 5-25EVA = NOPAT – [ Cost ofCapital x Capital Employed ]Since a cost is charged for equity capitalalso, a positive EVA generally indicatesshareholder value is being created.Based on Economic NOT AccountingProfit.Economic Value AddedEconomic Value Added
  26. 26. 5-26Add Flotation Costs (FC) to theInitial Cash Outlay (ICO).Impact: ReducesReduces the NPVAdjustment toAdjustment toInitial Outlay (AIO)Initial Outlay (AIO)NPV = Σnt=1CFt(1 + k)t- ( ICO + FC )
  27. 27. 5-27Subtract Flotation Costs from theproceeds (price) of the security andrecalculate yield figures.Impact: IncreasesIncreases the cost for anycapital component with flotation costs.Result: Increases the WACC, whichdecreasesdecreases the NPV.Adjustment toAdjustment toDiscount Rate (ADR)Discount Rate (ADR)
  28. 28. 5-28Initially assume all-equity financing.Determine project beta.Calculate the expected return.Adjust for capital structure of firm.Compare cost to IRR of project.Determining Project-SpecificDetermining Project-SpecificRequired Rates of ReturnRequired Rates of ReturnUse of CAPM in Project Selection:
  29. 29. 5-29Difficulty in DeterminingDifficulty in Determiningthe Expected Returnthe Expected ReturnLocate a proxy for the project (mucheasier if asset is traded).Plot the Characteristic Linerelationship between the marketportfolio and the proxy assetexcess returns.Estimate beta and create the SML.Determining the SML:
  30. 30. 5-30Project AcceptanceProject Acceptanceand/or Rejectionand/or RejectionSMLXXXXXXXO OOOOOOSYSTEMATIC RISK (Beta)EXPECTEDRATEOFRETURNRfAcceptReject
  31. 31. 5-311. Calculate the required returnfor Project k (all-equity financed).Rk = Rf + (Rm - Rf)βk2. Adjust for capital structure of thefirm (financing weights).Weighted Average Required Return = [ki][% of Debt] + [Rk][% of Equity]Determining Project-SpecificDetermining Project-SpecificRequired Rate of ReturnRequired Rate of Return
  32. 32. 5-32Assume a computer networking project isbeing considered with an IRR of 19%.Examination of firms in the networkingindustry 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 is11.2% and the risk-free rate is 4%.Project-Specific RequiredProject-Specific RequiredRate of ReturnRate of Return ExampleExample
  33. 33. 5-33ke = Rf + (Rm - Rf)βj= 4% + (11.2% - 4%)1.5kkee = 4% + 10.8% = 14.8%14.8%WACCWACC = .30(6%) + .70(14.8%)= 1.8% + 10.36% = 12.16%12.16%IRRIRR = 19%19% > WACCWACC = 12.16%12.16%Do You Accept the Project?Do You Accept the Project?
  34. 34. 5-34Determining Group-SpecificDetermining Group-SpecificRequired Rates of ReturnRequired Rates of ReturnInitially assume all-equity financing.Determine group beta.Calculate the expected return.Adjust for capital structure of group.Compare cost to IRR of groupproject.Use of CAPM in Project Selection:
  35. 35. 5-35Comparing Group-SpecificComparing Group-SpecificRequired Rates of ReturnRequired Rates of ReturnGroup-SpecificRequired ReturnsCompany Costof CapitalSystematic Risk (Beta)ExpectedRateofReturn
  36. 36. 5-36Amount of non-equity financingrelative to the proxy firm.Adjust project beta if necessary.Standard problems in the use ofCAPM. Potential insolvency is atotal-risk problem rather thanjust systematic risk (CAPM).Qualifications to UsingQualifications to UsingGroup-Specific RatesGroup-Specific Rates
  37. 37. 5-37Risk-Adjusted Discount RateApproach (RADR)The required return is increased(decreased) relative to the firm’soverall cost of capital for projectsor groups showing greater(smaller) than “average” risk.Project EvaluationProject EvaluationBased on Total RiskBased on Total Risk
  38. 38. 5-38Probability DistributionApproachAcceptance of a single projectwith a positive NPV depends onthe dispersion of NPVs and theutility preferences ofmanagement.Project EvaluationProject EvaluationBased on Total RiskBased on Total Risk
  39. 39. 5-39Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“HIGH”Risk Aversion
  40. 40. 5-40Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“MODERATE”Risk Aversion
  41. 41. 5-41Firm-Portfolio ApproachFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTEDVALUEOFNPVCurves show“LOW”Risk Aversion
  42. 42. 5-42ββjj == ββjuju [ 1 + ([ 1 + (B/SB/S)(1-)(1-TTCC) ]) ]ββj: Beta of a levered firm.ββju: Beta of an unlevered firm(an all-equity financed firm).B/S: Debt-to-Equity ratio inMarket Value terms.TC : The corporate tax rate.Adjusting Beta forAdjusting Beta forFinancial LeverageFinancial Leverage
  43. 43. 5-43Adjusted Present Value (APV) is thesum of the discounted value of aproject’s operating cash flows plus thevalue of any tax-shield benefits ofinterest associated with the project’sfinancing minus any flotation costs.Adjusted Present ValueAdjusted Present ValueAPV =UnleveredProject Value+Value ofProject Financing
  44. 44. 5-44Assume Basket Wonders is considering anew $425,000 automated basket weavingmachine that will save $100,000 per yearfor the next 6 years. The required rate onunlevered equity is 11%.BW can borrow $180,000 at 7% with$10,000 after-tax flotation costs. Principalis repaid at $30,000 per year (+ interest).The firm is in the 40% tax bracket.NPV and APV ExampleNPV and APV Example
  45. 45. 5-45What is the NPVNPV to an all-equity-to an all-equity-financed firmfinanced firm?NPV = $100,000[PVIFA11%,6] - $425,000NPV = $423,054 - $425,000NPVNPV = -$1,946-$1,946Basket WondersBasket WondersNPV SolutionNPV Solution
  46. 46. 5-46What is the APVAPV?First, determine the interest expense.Int Yr 1 ($180,000)(7%) = $12,600Int Yr 2 ( 150,000)(7%) = 10,500Int Yr 3 ( 120,000)(7%) = 8,400Int Yr 4 ( 90,000)(7%) = 6,300Int Yr 5 ( 60,000)(7%) = 4,200Int Yr 6 ( 30,000)(7%) = 2,100Basket WondersBasket WondersAPV SolutionAPV Solution
  47. 47. 5-47Second, calculate the tax-shield benefits.TSB Yr 1 ($12,600)(40%) = $5,040TSB Yr 2 ( 10,500)(40%) = 4,200TSB Yr 3 ( 8,400)(40%) = 3,360TSB Yr 4 ( 6,300)(40%) = 2,520TSB Yr 5 ( 4,200)(40%) = 1,680TSB Yr 6 ( 2,100)(40%) = 840Basket WondersBasket WondersAPV SolutionAPV Solution
  48. 48. 5-48Third, find the PV of the tax-shield benefits.TSB Yr 1 ($5,040)(.901) = $4,541TSB Yr 2 ( 4,200)(.812) = 3,410TSB Yr 3 ( 3,360)(.731) = 2,456TSB Yr 4 ( 2,520)(.659) = 1,661TSB Yr 5 ( 1,680)(.593) = 996TSB Yr 6 ( 840)(.535) = 449PV = $13,513PV = $13,513Basket WondersBasket WondersAPV SolutionAPV Solution
  49. 49. 5-49What is the APVAPV?APV = NPV + PV of TS - Flotation CostAPV = -$1,946 + $13,513 - $10,000APVAPV = $1,567$1,567Basket WondersBasket WondersNPV SolutionNPV Solution
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