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Required Returns
and the Cost of
Capital
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
15-1
After studying Chapter 15,
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.
15-2
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
Key Sources of
Value Creation
Industry Attractiveness
Marketing Superior
and Perceived
Cost quality organizational
price capability
15-4
Competitive Advantage
Overall Cost of
Capital of the Firm
15-5
Market Value of
Long-Term Financing
15-6
Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n
P0 = S
Ij + Pj
(1 + kd)j
j =1
ki = kd ( 1 - T )
15-7
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
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 )
ki = 6%
15-9
Cost of Preferred Stock
kP = DP / P0
15-10
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
Cost of Equity
Approaches
15-12
Dividend Discount Model
15-13
Constant Growth Model
ke = ( D1 / P0 ) + g
15-15
ke = .05 + .08 = .13 or 13%
Growth Phases Model
ke = Rj = Rf + (Rm - Rf)bj
15-17
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)bj
= 4% + (11.2% - 4%)1.25
15-18
ke = 4% + 9% = 13%
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
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%
15-20
Comparison of the
Cost of Equity Methods
15-21
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = S kx(Wx)
x=1
1. Weighting System
Marginal Capital Costs
15-23
Limitations of the WACC
n CFt
NPV = S t
- ( ICO + FC )
t=1 (1 + k)
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
Project decision.
10 RADR – “low”
risk at 10%
(Accept!) RADR – “high”
5
risk at 15%
(Reject!)
0
-4
0 3 6 9 12 15
Discount Rate (%)
15-39
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
EXPECTED VALUE OF NPV Firm-Portfolio Approach
Indifference
C Curves
B
A
Curves show
“HIGH”
Risk Aversion
STANDARD DEVIATION
15-41
EXPECTED VALUE OF NPV Firm-Portfolio Approach
Indifference
C Curves
B
A
Curves show
“MODERATE”
Risk Aversion
STANDARD DEVIATION
15-42
EXPECTED VALUE OF NPV Firm-Portfolio Approach
C Indifference
Curves
B
A
Curves show
“LOW”
Risk Aversion
STANDARD DEVIATION
15-43
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
Adjusted Present Value
Unlevered Value of
APV = Project Value
+ Project Financing
15-45
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
Basket Wonders
NPV Solution
15-49
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
Basket Wonders
NPV Solution
15-51