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Required Returns and The Cost of Capital
Required Returns and The Cost of Capital
Required
Required Returns
Returns
and
and the
the Cost
Cost of
of
Capital
Capital
15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
After Studying Chapter 15,
you should be able to:
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 firm’s 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 firm’s 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 firm’s cost of capital.
7. Understand the capital-asset pricing model's role in computing
project-specific and group-specific required rates of return.
15.2 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
Creation of Value
Overall Cost of Capital of the Firm
Project-Specific Required Rates
Group-Specific Required Rates
Total Risk Evaluation
15.3 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
Marketing Superior
and Perceived
Cost quality organizational
price 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 50%
$ 100M 100%
15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Debt
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%
ki = 10% ( 1 – .40 )
ki = 6%
15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Preferred Stock
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
Dividend Discount Model
Capital-Asset Pricing Model
Before-Tax
Cost of Debt plus
Risk Premium
15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Dividend Discount Model
15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Constant Growth Model
ke = ( D1 / P0 ) + g
ke = Rj = Rf + (Rm – Rf)bj
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)bj
= 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*
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%
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 = S
kx(Wx)
x=1
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
15.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
15.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Economic Value Added
15.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Adjustment to
Initial Outlay (AIO)
CFt n
NPV = S (1 + k)t – ( ICO + FC )
t=1
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:
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.
15.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Company Cost
of Capital
Group-Specific
Required Returns
15.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Project Evaluation
Based on Total Risk
Project decision.
10 RADR – “low”
risk at 10%
(Accept!)
5 RADR – “high”
risk at 15%
(Reject!)
0
–4
0 3 6 9 12 15
Discount Rate (%)
15.39 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
Indifference
C 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
Indifference
C 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
bj = bju [ 1 + (B/S)(1 – TC) ]
bj: Beta of a levered firm.
bju: 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
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
15.45 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
15.49 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 ($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
15.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders
NPV Solution
15.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.