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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 firms 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 firms 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 firms 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
Ij + Pj
P0 = (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 = D P / P 0
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
Dividend Discount Model
Capital-Asset Pricing
Model
Before-Tax Cost of Debt
plus Risk Premium
15-12
Dividend Discount Model
15-13
Constant Growth Model
ke = ( D1 / P0 ) + g
ke = Rj = Rf + (Rm - Rf) j
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) j
= 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*
15-20
Comparison of the
Cost of Equity Methods
15-21
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = kx(Wx)
x=1
1. Weighting System
Marginal Capital Costs
Capital Raised in Different
Proportions than WACC
15-23
Limitations of the WACC
15-25
Economic Value Added
n CFt
NPV = - ( ICO + FC )
t=1 (1 + k) t
Accept
X SML
EXPECTED RATE
X X
OF RETURN
X X O
X X
O O
O O Reject O
Rf O
15-35
Comparing Group-Specific
Required Rates of Return
Expected Rate of Return
Company Cost
of Capital
Group-Specific
Required Returns
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
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
j = ju [ 1 + (B/S)(1-TC) ]
j: Beta of a levered firm.
ju: 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
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