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- 1. 5-1 Chapter 15Chapter 15 Required ReturnsRequired Returns and the Cost ofand the Cost of CapitalCapital © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI
- 2. 5-2 After studying Chapter 15,After studying Chapter 15, you should be able to:you should be able to: Explain how a firm creates value and identify the key sources of value creation. Define the overall “cost of capital” of the firm. Calculate the costs of the individual components of a firm’s cost of capital - cost of debt, cost of preferred stock, and cost of equity. 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. Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations. Explain how the concept of Economic Value Added (EVA) is related to value creation and the firm’s cost of capital. Understand the capital-asset pricing model's role in computing project-specific and group-specific required rates of return.
- 3. 5-3 Required Returns andRequired Returns and the Cost of Capitalthe Cost of Capital Creation of Value Overall Cost of Capital of the Firm Project-Specific Required Rates Group-Specific Required Rates Total Risk Evaluation
- 4. 5-4 Key Sources ofKey Sources of Value CreationValue Creation Growth phase of product cycle Barriers to competitive entry Other -- e.g., patents, temporary monopoly power, oligopoly pricing Cost Marketing and price Perceived quality Superior organizational capability Industry AttractivenessIndustry Attractiveness Competitive AdvantageCompetitive Advantage
- 5. 5-5 Overall Cost ofOverall Cost of Capital of the FirmCapital 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).
- 6. 5-6 Type of Financing Mkt Val Weight Long-Term Debt $ 35M 35% Preferred Stock $ 15M 15% Common Stock Equity $ 50M 50% $ 100M 100% Market Value ofMarket Value of Long-Term FinancingLong-Term Financing
- 7. 5-7 Cost of DebtCost of Debt is the required rate of return on investment of the lenders of a company. ki = kd ( 1 - T ) Cost of DebtCost of Debt P0 = Ij + Pj (1 + kd)jΣ n j =1
- 8. 5-8 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%. Determination ofDetermination of the Cost of Debtthe Cost of Debt $385.54 = $0 + $1,000 (1 + kd)10
- 9. 5-9 (1 + kd)10 = $1,000 / $385.54 = 2.5938 (1 + kd) = (2.5938) (1/10) = 1.1 kd = .1 or 10% ki = 10% ( 1 - .40 ) kkii = 6%6% Determination ofDetermination of the Cost of Debtthe Cost of Debt
- 10. 5-10 Cost of Preferred StockCost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company. kP = DP / P0 Cost of Preferred StockCost of Preferred Stock
- 11. 5-11 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 kkPP = 9%9% Determination of theDetermination of the Cost of Preferred StockCost of Preferred Stock
- 12. 5-12 Dividend Discount ModelDividend Discount Model Capital-Asset PricingCapital-Asset Pricing ModelModel Before-Tax Cost of DebtBefore-Tax Cost of Debt plus Risk Premiumplus Risk Premium Cost of EquityCost of Equity ApproachesApproaches
- 13. 5-13 Dividend Discount ModelDividend Discount Model The cost of equity capitalcost 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 (1+ke)1 (1+ke)2 (1+ke) + . . . ++P0 = ∞ ∞
- 14. 5-14 Constant Growth ModelConstant Growth Model The constant dividend growthconstant dividend growth assumptionassumption reduces the model to: ke = ( D1 / P0 ) + g Assumes that dividends will grow at the constant rate “g” forever.
- 15. 5-15 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 = ( D1 / P0 ) + g ke = ($3(1.08) / $64.80) + .08 kkee = .05 + .08 = .13.13 or 13%13% Determination of theDetermination of the Cost of Equity CapitalCost of Equity Capital
- 16. 5-16 Growth Phases ModelGrowth Phases Model D0(1+g1)t Da(1+g2)t-a (1+ke)t (1+ke)t P0 = The growth phases assumptiongrowth phases assumption leads to the following formulaleads to the following formula (assume 3 growth phases):(assume 3 growth phases): Σ + Σ t=1 a t=a+1 b t=b+1 ∞ Db(1+g3)t-b (1+ke)t + Σ
- 17. 5-17 Capital AssetCapital Asset Pricing ModelPricing 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
- 18. 5-18 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 kkee = 4% + 9% = 13%13% Determination of theDetermination of the Cost of Equity (CAPM)Cost of Equity (CAPM)
- 19. 5-19 Before-Tax Cost of DebtBefore-Tax Cost of Debt Plus Risk PremiumPlus 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
- 20. 5-20 Assume that Basket Wonders (BW) typically adds a 3% premium to the before-tax cost of debt. ke = kd + Risk Premium = 10% + 3% kkee = 13%13% Determination of theDetermination of the Cost of Equity (kCost of Equity (kdd + R.P.)+ R.P.)
- 21. 5-21 Constant Growth Model 13%13% Capital Asset Pricing Model 13%13% Cost of Debt + Risk Premium 13%13% Generally, the three methods will not agree. Comparison of theComparison of the Cost of Equity MethodsCost of Equity Methods
- 22. 5-22 Cost of Capital = kx(Wx) WACC = .35(6%) + .15(9%) + .50(13%) WACC = .021 + .0135 + .065 = .0995 or 9.95% Weighted AverageWeighted Average Cost of Capital (WACC)Cost of Capital (WACC) Σ n x=1
- 23. 5-23 1.1. Weighting SystemWeighting System Marginal Capital Costs Capital Raised in Different Proportions than WACC Limitations of the WACCLimitations of the WACC
- 24. 5-24 2.2. Flotation CostsFlotation 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 Limitations of the WACCLimitations of the WACC
- 25. 5-25 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. Economic Value AddedEconomic Value Added
- 26. 5-26 EVA = NOPAT – [Cost of Capital x Capital Employed] 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 company’s potential after-tax profit if it was all- equity-financed or “unlevered.” Economic Value AddedEconomic Value Added
- 27. 5-27 Add Flotation Costs (FC) to the Initial Cash Outlay (ICO). Impact: ReducesReduces the NPV Adjustment toAdjustment to Initial Outlay (AIO)Initial Outlay (AIO) NPV = Σ n t=1 CFt (1 + k)t - ( ICO + FC )
- 28. 5-28 Subtract Flotation Costs from the proceeds (price) of the security and recalculate yield figures. Impact: IncreasesIncreases the cost for any capital component with flotation costs. Result: Increases the WACC, which decreasesdecreases the NPV. Adjustment toAdjustment to Discount Rate (ADR)Discount Rate (ADR)
- 29. 5-29 Initially assume all-equity financing. Determine project beta. Calculate the expected return. Adjust for capital structure of firm. Compare cost to IRR of project. Determining Project-SpecificDetermining Project-Specific Required Rates of ReturnRequired Rates of Return Use of CAPM in Project Selection:
- 30. 5-30 Difficulty in DeterminingDifficulty in Determining the Expected Returnthe Expected Return 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. Determining the SML:
- 31. 5-31 Project AcceptanceProject Acceptance and/or Rejectionand/or Rejection SML X X X X X X X O O O O O O O SYSTEMATIC RISK (Beta) EXPECTEDRATE OFRETURN Rf Accept Reject
- 32. 5-32 1. Calculate the required return for Project k (all-equity financed). Rk = Rf + (Rm - Rf)βk 2. Adjust for capital structure of the firm (financing weights). Weighted Average Required Return = [ki] [% of Debt] + [Rk][% of Equity] Determining Project-SpecificDetermining Project-Specific Required Rate of ReturnRequired Rate of Return
- 33. 5-33 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%. Project-Specific RequiredProject-Specific Required Rate of ReturnRate of Return ExampleExample
- 34. 5-34 ke = Rf + (Rm - Rf)βj = 4% + (11.2% - 4%)1.5 kkee = 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?
- 35. 5-35 Determining Group-SpecificDetermining Group-Specific Required Rates of ReturnRequired Rates of Return 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. Use of CAPM in Project Selection:
- 36. 5-36 Comparing Group-SpecificComparing Group-Specific Required Rates of ReturnRequired Rates of Return Group-Specific Required Returns Company Cost of Capital Systematic Risk (Beta) ExpectedRateofReturn
- 37. 5-37 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). Qualifications to UsingQualifications to Using Group-Specific RatesGroup-Specific Rates
- 38. 5-38 Risk-Adjusted Discount Rate Approach (RADR) The required return is increased (decreased) relative to the firm’s overall cost of capital for projects or groups showing greater (smaller) than “average” risk. Project EvaluationProject Evaluation Based on Total RiskBased on Total Risk
- 39. 5-39 RADR and NPVRADR and NPV Discount Rate (%) 0 3 6 9 12 15 RADR – “high” risk at 15% (Reject!) RADR – “low” risk at 10% (Accept!) Adjusting for risk correctly may influence the ultimate Project decision. NetPresentValue $000s 15 10 5 0 -4
- 40. 5-40 Probability Distribution Approach Acceptance of a single project with a positive NPV depends on the dispersion of NPVs and the utility preferences of management. Project EvaluationProject Evaluation Based on Total RiskBased on Total Risk
- 41. 5-41 Firm-Portfolio ApproachFirm-Portfolio Approach B C A Indifference Curves STANDARD DEVIATION EXPECTEDVALUEOFNPV Curves show “HIGH” Risk Aversion
- 42. 5-42 Firm-Portfolio ApproachFirm-Portfolio Approach B C A Indifference Curves STANDARD DEVIATION EXPECTEDVALUEOFNPV Curves show “MODERATE” Risk Aversion
- 43. 5-43 Firm-Portfolio ApproachFirm-Portfolio Approach B C A Indifference Curves STANDARD DEVIATION EXPECTEDVALUEOFNPV Curves show “LOW” Risk Aversion
- 44. 5-44 ββjj == 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 in Market Value terms. TC : The corporate tax rate. Adjusting Beta forAdjusting Beta for Financial LeverageFinancial Leverage
- 45. 5-45 Adjusted Present Value (APV) is the sum of the discounted value of a project’s operating cash flows plus the value of any tax-shield benefits of interest associated with the project’s financing minus any flotation costs. Adjusted Present ValueAdjusted Present Value APV = Unlevered Project Value + Value of Project Financing
- 46. 5-46 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. NPV and APV ExampleNPV and APV Example
- 47. 5-47 What is the NPVNPV to an all-equity-to an all-equity- financed firmfinanced firm? NPV = $100,000[PVIFA11%,6] - $425,000 NPV = $423,054 - $425,000 NPVNPV = -$1,946-$1,946 Basket WondersBasket Wonders NPV SolutionNPV Solution
- 48. 5-48 What is the APVAPV? First, determine the interest expense. Int Yr 1 ($180,000)(7%) = $12,600 Int Yr 2 ( 150,000)(7%) = 10,500 Int Yr 3 ( 120,000)(7%) = 8,400 Int Yr 4 ( 90,000)(7%) = 6,300 Int Yr 5 ( 60,000)(7%) = 4,200 Int Yr 6 ( 30,000)(7%) = 2,100 Basket WondersBasket Wonders APV SolutionAPV Solution
- 49. 5-49 Second, calculate the tax-shield benefits. TSB Yr 1 ($12,600)(40%) = $5,040 TSB Yr 2 ( 10,500)(40%) = 4,200 TSB Yr 3 ( 8,400)(40%) = 3,360 TSB Yr 4 ( 6,300)(40%) = 2,520 TSB Yr 5 ( 4,200)(40%) = 1,680 TSB Yr 6 ( 2,100)(40%) = 840 Basket WondersBasket Wonders APV SolutionAPV Solution
- 50. 5-50 Third, find the PV of the tax-shield benefits. TSB Yr 1 ($5,040)(.901) = $4,541 TSB Yr 2 ( 4,200)(.812) = 3,410 TSB Yr 3 ( 3,360)(.731) = 2,456 TSB Yr 4 ( 2,520)(.659) = 1,661 TSB Yr 5 ( 1,680)(.593) = 996 TSB Yr 6 ( 840)(.535) = 449 PV = $13,513PV = $13,513 Basket WondersBasket Wonders APV SolutionAPV Solution
- 51. 5-51 What is the APVAPV? APV = NPV + PV of TS - Flotation Cost APV = -$1,946 + $13,513 - $10,000 APVAPV = $1,567$1,567 Basket WondersBasket Wonders NPV SolutionNPV Solution

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