Chapter 15

Required Returns
and the Cost of
Capital
© 2001 Prentice-Hall, Inc.
Fundamentals of Financial Management, 11/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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 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
● Total Risk Evaluation

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 Key Sources of
Value Creation
Industry Attractiveness

Growth Barriers to Other --

phase competitiv e.g.,
of e patents,
product entry temporary
cycle monopoly
power,
oligopoly
pricing
Marketin Superior
g Perceive
Cos d organizationa
and l
t quality
price capability

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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).

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 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 50%
$ 100M 100%

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 Cost of Debt
Cost of Debt is the required rate of
return on investment of the
lenders of a company.
n
Ij + Pj
P0 = Σ (1 + kd)j
j
ki = k =1(
d 1-T)

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 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
=
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 Determination of
the Cost of Debt
(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 )

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ki = 6%
 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
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 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%
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 Cost of Equity
Approaches

●Dividend Discount Model

●Capital-Asset Pricing
Model
●Before-Tax Cost of Debt plus
Risk Premium

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 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
D1 stock.
D2 D∞
P0 = + +...
(1+ke)1 (1+ke)2 + (1+ke) ∞

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 Constant Growth Model

The constant dividend growth

assumption reduces the model
to:

ke = ( D1 / P0 ) + g

Assumes that dividends will grow

15-* at the constant rate “g” forever.
 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%
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 Growth Phases Model

The growth phases assumption

leads to the following formula
(assume 3 growth phases):
a D0(1+g1)t b Da(1+g2)t-a
P0 = Σ + +
t= (1+ke)t Σt=a+ (1+ke)t
1 1
∞ Db(1+g3)t-b
Σ
t=b+ (1+ke)t
1
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 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).

15-* ke = Rj = Rf + (Rm - Rf)βj

 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
ke = 4% + 9% = 13%
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 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*

15-* * Risk premium is not the same as CAPM

 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%

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 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.

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 Weighted Average Cost
of Capital (WACC)
n
Cost of Capital = kxΣ
(Wx)
x=1

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

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

1.Weighting System
● Marginal Capital Costs
● Capital Raised in Different
Proportions than WACC

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 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
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 Economic Value Added
●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.

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 Economic Value Added

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.

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 Adjustment to
Initial Outlay (AIO)

Add Flotation Costs (FC) to the

Initial Cash Outlay (ICO).

n CFt
NPV = Σ - ( ICO + FC )
t= (1 + k) t

1
Impact: Reduces the NPV

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 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.

15-* Result: Increases the WACC, which

 Determining 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.

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 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 the proxy asset excess
returns.
●Estimate beta and create the SML.

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 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)

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 Determining Project-Specific
Required Rate of Return

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]
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 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%.
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 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%
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 Determining 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.

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 Comparing Group-Specific
Required Rates of Return
Expected Rate of Return

Company Cost
of Capital

Group-Specific
Required Returns

Systematic Risk (Beta)

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 Qualifications to Using
Group-Specific Rates
●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).
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 Project Evaluation
Based on Total Risk

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.
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 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.
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 EXPECTED VALUE OF NPV Firm-Portfolio Approach
Indifferenc
C e
Curves

B
A
Curves show
“HIGH”
Risk Aversion

STANDARD DEVIATION
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 EXPECTED VALUE OF NPV Firm-Portfolio Approach
Indifferenc
C e
Curves

B
A
Curves show
“MODERATE”
Risk Aversion

STANDARD DEVIATION
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 EXPECTED VALUE OF NPV Firm-Portfolio Approach

C Indifferenc
e
Curves
B
A
Curves show
“LOW”
Risk Aversion

STANDARD DEVIATION
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 Adjusting Beta for
Financial Leverage
βj = βju [ 1 + (B/S)(1-TC) ]
βj: Beta of a levered firm.
βju: 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.
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 Adjusted Present Value
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.

Unlevered Value of
APV = Project Value
+ Project Financing
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 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.
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 Basket Wonders
NPV Solution

What is the NPV to an all-equity-

financed firm?

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

NPV = $423,054 - $425,000
NPV = -$1,946
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 Basket Wonders
APV Solution
What is the APV?
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
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 Basket Wonders
APV Solution
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

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 Basket Wonders
APV Solution
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 = $13,513
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 Basket Wonders
NPV Solution

What is the APV?

APV = NPV + PV of TS - Flotation Cost

APV = -$1,946 + $13,513 - $10,000
APV = $1,567

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