Chapter 15

Required Returns and the Cost of Capital

15-1

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

15-2

Key Sources of Value Creation

Industry Attractiveness
Other -e.g., patents, temporary monopoly power, oligopoly pricing

Growth phase of product cycle

Barriers to competitive entry

Cost

Marketing and price

Perceived quality

Superior organizational capability

15-3

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).
15-4

Market Value of Long-Term Financing

Type of Financing
Long-Term Debt Preferred Stock

Mkt Val Weight

$ 35M $ 15M $ 100M 35% 15% 50% 100%

Common Stock Equity $ 50M

15-5

Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company.

P0 = S
j =1

Ij + Pj (1 + kd)j

ki = kd ( 1 - T )
15-6

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%.
$385.54 =
$0 + $1,000 (1 + kd)10

15-7

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
15-8

= 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 = DP / P0
15-9

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%
15-10

Cost of Equity Approaches

Dividend

Discount Model
Pricing

Capital-Asset

Model
Before-Tax

Cost of Debt plus Risk Premium

15-11

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 stock.
D1 D2 D + +...+ P0 = 1 2 (1+ke) (1+ke) (1+ke)
15-12

Constant Growth Model

The constant dividend growth assumption reduces the model to: ke = ( D1 / P0 ) + g
Assumes that dividends will grow at the constant rate g forever.
15-13

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
15-14

= ($3(1.08) / $64.80) + .08

= .05 + .08 = .13 or 13%

ke

Growth Phases Model

The growth phases assumption leads to the following formula (assume 3 growth phases):
P0 = S S
t=b+1
15-15

D0(1+g1)t

t=1

(1+ke)t
Db(1+g3)t-b

S
t=a+1

Da(1+g2)t-a

(1+ke)t

(1+ke)t

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). ke = Rj = Rf + (Rm - Rf)bj
15-16

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
15-17

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
15-18

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%
15-19

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.
15-20

Weighted Average Cost of Capital (WACC)

Cost of Capital = WACC WACC
15-21

S
x=1

kx(Wx)

= .35(6%) + .15(9%) + .50(13%) = .021 + .0135 + .065 = .0995 or 9.95%

Limitations of the WACC

1. Weighting System

Marginal Capital Costs Capital Raised in Different Proportions than WACC

15-22

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.
15-23

Adjustment to Discount Rate

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.

15-24

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.

15-25

Adjustment to Initial Outlay (AIO)

Add Flotation Costs (FC) to the Initial Cash Outlay (ICO).
CFt - ( ICO + FC ) NPV = S t (1 + k) t=1 Impact: Reduces the NPV
15-26

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. Result: Increases the WACC, which decreases the NPV.
15-27

Determining Project-Specific Required Rates of Return

Use of CAPM in Project Selection:

15-28

Initially assume all-equity financing. Determine project beta. Calculate the expected return. Adjust for capital structure of firm. Compare cost to IRR of project.

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.
beta and create the SML.

Estimate
15-29

Project Acceptance and/or Rejection

Accept EXPECTED RATE OF RETURN X X X O O X X O

SML

X
O

X
O

O Reject

Rf

O
SYSTEMATIC RISK (Beta)

15-30

Determining Project-Specific Required Rate of Return

1. Calculate the required return for Project k (all-equity financed).
Rk = Rf + (Rm - Rf)bk

2. Adjust for capital structure of the firm (financing weights).

Weighted Average Required Return = [ki][% of Debt] + [Rk][% of Equity]

15-31

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%.
15-32

Do You Accept the Project?

ke = Rf + (Rm - Rf)bj = 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%
15-33

Determining Group-Specific Required Rates of Return

Use of CAPM in Project Selection:
Initially

assume all-equity financing. group beta. the expected return.

Determine Calculate Adjust

for capital structure of group.

Compare

cost to IRR of group

project.
15-34

Comparing Group-Specific Required Rates of Return

Expected Rate of Return Company Cost of Capital

Group-Specific Required Returns

Systematic Risk (Beta)

15-35

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).

15-36

Project Evaluation Based on Total Risk

Risk-Adjusted Discount Rate Approach (RADR)
The required return is increased (decreased) relative to the firms overall cost of capital for projects or groups showing greater (smaller) than average risk.
15-37

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.
15-38

Firm-Portfolio Approach
EXPECTED VALUE OF NPV C

Indifference Curves

B
A Curves show HIGH Risk Aversion STANDARD DEVIATION

15-39

Firm-Portfolio Approach
EXPECTED VALUE OF NPV C

Indifference Curves

B
A Curves show MODERATE Risk Aversion STANDARD DEVIATION

15-40

Firm-Portfolio Approach
EXPECTED VALUE OF NPV C Indifference Curves

B
A Curves show LOW Risk Aversion STANDARD DEVIATION

15-41

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.
15-42

Adjusted Present Value

Adjusted Present Value (APV) is the
sum of the discounted value of a projects operating cash flows plus the value of any tax-shield benefits of interest associated with the projects financing minus any flotation costs.

APV =
15-43

Unlevered Project Value

Value of Project Financing

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.

15-44

Basket Wonders NPV Solution

What is the NPV to an all-equityfinanced firm?
NPV = $100,000[PVIFA11%,6] - $425,000 NPV = $423,054 - $425,000 NPV = -$1,946
15-45

Basket Wonders APV Solution

What is the APV?
First, determine the interest expense. Int Yr 1 Int Yr 2 Int Yr 3 Int Yr 4 Int Yr 5 Int Yr 6
15-46

($180,000)(7%) ( 150,000)(7%) ( 120,000)(7%) ( 90,000)(7%) ( 60,000)(7%) ( 30,000)(7%)

= $12,600 = 10,500 = 8,400 = 6,300 = 4,200 = 2,100

Basket Wonders APV Solution

Second, calculate the tax-shield benefits. TSB Yr 1 TSB Yr 2 TSB Yr 3 TSB Yr 4 TSB Yr 5 TSB Yr 6
15-47

($12,600)(40%) ( 10,500)(40%) ( 8,400)(40%) ( 6,300)(40%) ( 4,200)(40%) ( 2,100)(40%)

= $5,040 = 4,200 = 3,360 = 2,520 = 1,680 = 840

Basket Wonders APV Solution

Third, find the PV of the tax-shield benefits.
TSB Yr 1 TSB Yr 2 TSB Yr 3 TSB Yr 4 TSB Yr 5 TSB Yr 6
15-48

($5,040)(.901) ( 4,200)(.812) ( 3,360)(.731) ( 2,520)(.659) ( 1,680)(.593) ( 840)(.535)

= $4,541 = 3,410 = 2,456 = 1,661 = 996 = 449 PV = $13,513

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
15-49