Title: Chapter 15 -- Required Returns and the Cost of Capital
1Chapter 15
Required Returns and the Cost of Capital
2After 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.
3Required Returns and the Cost of Capital
- Overall Cost of Capital of the Firm
- Project-Specific Required Rates
- Group-Specific Required Rates
- Total Risk Evaluation
4Cost of Capital
- The cost of capital (COC) is the rate of return
the firm must earn to maintain its market value
and attract investors - projects with return gt COC will improve the
firms value - projects with return lt COC will harm the firms
value
5Overall 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). - By weighting the cost of each source of financing
by its target proportion in the firms capital
structure, the firm can obtain a weighted average
cost that reflects the interrelationship of
financing decisions. The formula for doing this
is ka wiki wpkp wsks This is explained
later.
6Cost of Capital
- COC is estimated
- on an after-tax basis
- at a point in time
- based on expected future values
- holding business and financial risk fixed
7Cost of Capital
- Target capital structure is the optimal mix of
debt and equity financing for the firm - most firms seek to maintain a desired mix of debt
and equity funding - each new chunk of capital should fit with the
overall mix
8Cost of Capital
- A firm is currently faced with an investment
opportunity. Assume the following - Because it can earn 7 on the investment of funds
costing only 6, the firm undertakes the
opportunity.
9Cost of Capital
- Imagine that one week later a new investment
opportunity is available - In this instance, the firm rejects the
opportunity, because the 14 financing cost is
greater than the 12 expected return. - Is this action in the best interests of its
owners?
10Cost of Capital
- Noit accepted a project yielding a 7 return and
rejected one with a 12 return. - Is there a better way?
- Yes the firm can use a combined cost, which over
the long run would provide for better decisions. - By weighting the cost of each source of financing
by its target proportion in the firms capital
structure, the firm can obtain a weighted average
cost that reflects the interrelationship of
financing decisions.
11Cost of Capital
- Assuming that a 5050 mix of debt and equity is
targeted, the weighted average cost in this
example would be 10 (0.50 x 6 debt) (0.50 x
14 equity). - This outcome is clearly more desirable.
- With this cost, the first opportunity would have
been rejected (7 IRR lt 10 weighted average
cost), and the second one would have been
accepted (12 IRR gt 10 weighted average cost).
12Concept of Cost of Capital
- Wren Manufacturing is considering projects 263
and 264. The basic variables surrounding each
project using the IRR decision technique and the
resulting decision actions are summarised in the
following table.
13Concept of Cost of Capital
- a Evaluate the firms decision-making procedures,
and explain why the acceptance of project 263 and
rejection of project 264 may not be in the
owners best interest. - b If the firm maintains a capital structure
containing 40 debt and 60 equity, find its
weighted average cost using the data in the
table. - c Had the firm used the weighted average cost
calculated in part b, what actions would have
been taken relative to projects 263 and 264? - d Compare and contrast the firms actions with
your findings in part c. Which decision method
seems more appropriate? Explain why.
14Concept of Cost of Capital
- a. The firm is basing its decision on the cost to
finance a particular project rather than the
firms combined cost of capital. This
decision-making method may lead to erroneous
accept/reject decisions. - b. ka wiki wpkp wsks
- ? ka 0.40 (7) 0.60(16)
- ? ka 2.8 9.6
- ? ka 12.4
- ?
15Concept of Cost of Capital
- c. Reject project 263. Accept project 264.
- d. Opposite conclusions were drawn using the two
decision criteria. The overall cost of capital as
a criterion provides better decisions because it
takes into consideration the long run
interrelationship of financing decisions
16Sources of finance
- The four sources of long-term funds for the
business firm - debt,
- preference share capital,
- ordinary share equity capital and
- retained earnings.
17Sources of finance
- This is important!!
- The specific cost of each source of financing is
the after-tax cost of obtaining the financing
today, i.e. the marginal cost of raising the next
dollar of funding - It is not the historically based cost reflected
by the existing financing in the firms
accounting records - Only the cost of debt needs to be adjusted for
tax. - Why do we not adjust the cost of preference
shares and equity for tax? - Because dividends are paid from tax-paid profits.
Therefore, the cost of these is an after-tax cost
18Market 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
19Cost of Debt
- Cost of Debt is the required rate of return on
investment of the lenders of a company. - Where P0 current market price
- Pt maturity value at time t
- I interest payment in
-
- After tax cost is
- ki kd (1 T)
20Determination 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
21Determination 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
22Cost of debt
- Du Chen Corporation is selling 10 million of
20-year, 9 coupon (stated annual interest rate)
bonds, each with a face value of 1,000. - Similar-risk bonds earn returns greater than 9
so the firm must sell the bonds for 980 to
compensate for the lower coupon interest rate. - The flotation costs paid to the investment banker
are 2 of the face value of the bond (2 1000),
or 20. - The net proceeds to the firm from the sale of
each bond are therefore 960 (980 20).
23Cost of debt
- To solve this, we need a financial calculator or
a spreadsheet. However there is a Yield to
Maturity (YTM) formula that gives a good
approximation answer - kd I (1,000 Nd)/n/(Nd 1000)/2
- Where I the interest payment in
- Nd proceeds from the sale of the bond
- n number of periods until the bond maturity.
24Cost of debt
- The cash flows are
- End of Year Cash flow
- 0 960
- 1-20 -90
- -1,000
- Using the YTM formula, the answer is
25Cost of debt
26Cost of debt
- Assuming a 30 tax rate and before-tax cost of
9.4, - ki 0.094 x (1 0.30) 6.6 after-tax
cost - The explicit cost of long-term debt is less than
the explicit cost of other forms of long-term
financing, because of the tax-deductibility of
interest.
27Cost of Preferred Stock
- The cost of preference share capital (kp) is the
ratio of the preference share dividend (Dp) to
the firms net proceeds (Np) from the sale of
preference shares - ? kp Dp / Np
- Example consider an 8.5 pref issue, at par
2.00 a share with an issue cost of 11 cents per
share - ? kp (0.17) / (1.89) 9
- (Np 2.00 0.11 1.89)
28Cost of Preferred Stock
- Comparing the 9 cost of preference capital with
the 6.6 cost of long-term debt (bonds) shows
that preference capital is more expensive. The
difference exists primarily because the cost of
the debt (interest) is tax-deductible. - The cost of preference share capital already
issued is the dividend (Dp) divided by the market
value (P) of preference share capital - kp Dp / P
- If the market value of Du Chen Corporations
preference share capital is 10 million, and
preference dividend payable is 0.9 million, the
return on its preference share capital is - kp 0.90/10.00 9.0
29Cost 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
30Determination 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
31Cost of Equity Approaches
- Dividend Discount Model
- Capital-Asset Pricing Model
- Before-Tax Cost of Debt plus Risk Premium
32Dividend 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 ke)1 (1 ke)2 (1 ke)
33Constant 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.
34Determination 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 ( D1
/ P0 ) g ke (3(1.08) / 64.80) 0.08 ke
0.05 0.08 0.13 or 13
35Determination of the Cost of Equity Capital
- Calculate Du Chen Corporations cost of ordinary
share equity capital, ke. The market price, P0,
of its shares is 5. The firm expects to pay a
dividend, D1, of 40 cents at the end of the
coming year, 2005. The dividends paid over the
past 6 years (19992004) were
36Determination of the Cost of Equity Capital
- Calculate the growth rate of dividends
- 1999 div/2004 div 29.7/38.0 0.7816
- PVIFk,5 5
- Or
- 2004 div/1999 div 38.0/29.7 1.2794
- FVIFk,5 5
37Determination of the Cost of Equity Capital
- Substituting D1 0.40, P0 5.00 and g 5
per cent into the Equation results in the cost of
ordinary equity - ke 0.40/5.00 0.05
- 0.08 0.05
- 0.13 or 13
38Growth Phases Model
The growth phases assumption leads to the
following formula (assume 3 growth phases)
D0(1 g1)t Da(1 g2)ta
a
b
P0
?
?????
(1 ke)t (1 ke)t
t1
ta1
?
Db(1 g3)tb
?
(1 ke)t
tb1
39Capital 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)?j
40Determination 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)?j 4 (11.4 4)1.25 ke 4
9.25 13.25
41Before-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
42Determination of the Cost of Equity (kd R.P.)
Assume that Basket Wonders (BW) typically adds a
2.75 premium to the before-tax cost of debt.
ke kd Risk Premium 10 2.75 ke
12.75
43Comparison of the Cost of Equity Methods
Constant Growth Model 13.00 Capital Asset
Pricing Model 13.25 Cost of Debt Risk
Premium 12.75
Generally, the three methods will not agree. We
must decide how to weight we will use an
average of these three.
44Weighted average cost of capital
- The WACC (ka) is determined by weighting the cost
of each specific type of capital by its
proportion in the firms capital structure - ? ka (ki x wi) (kp x wp) (ke x ws)
- Note (i) The sum of weights must equal one.
- (ii) It is the after-tax cost of debt that is
used.
45BWs Weighted Average Cost of Capital (WACC)
n
?
Cost of Capital kx(Wx) WACC 0.35(6)
0.15(9) 0.50(13) WACC 0.021 0.0135
0.065 0.0995 or 9.95
x1
46Weighted average cost of capital
- The costs of the various types of capital for Du
Chen Corporation are - Cost of debt, ki 6.6
- Cost of preference capital, kp 9.0
- Cost of new shares, ke 14.0
- The company uses the following weights in
calculating its WACC
47Weighted average cost of capital
48Weighted average cost of capital
- Source Weight Cost WACC
- Debt 0.40 6.6 2.6
- Pref capital 0.10 9.0 0.9
- Ord equity 0.50 1 3.0 6.5
- Totals 1.00 10.0
- The WACC for Du Chen is 10.
- Assuming an unchanged risk level, the firm should
accept all projects that earn a return greater
than or equal to 10
49Limitations of the WACC
- 1. Weighting System
- Marginal Capital Costs
- Capital Raised in Different Proportions than
WACC
50Limitations of the WACC
- 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
51Adjustment to Initial Outlay (AIO)
Add Flotation Costs (FC) to the Initial Cash
Outlay (ICO). Impact Reduces the NPV
n
CFt
( ICO FC )
?
NPV
(1 k)t
t1
52Adjustment 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.
53Determining 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.
54Determining Project-Specific Required Rate of
Return
1. Calculate the required return for
Project k (all-equity financed). Rk Rf (Rm
Rf)?k 2. Adjust for capital structure of
the firm (financing weights). Weighted Average
Required Return ki of Debt Rk of
Equity
55Project-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
ki6. The expected return on the market is 11.2
and the risk-free rate is 4.
56Do You Accept the Project?
ke Rf (Rm Rf)?j 4 (11.2
4)1.5 ke 4 10.8 14.8 WACC
0.30(6) 0.70(14.8) 1.8 10.36
12.16 IRR 19
gt WACC 12.16
57Determining 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.
58Comparing Group-Specific Required Rates of Return
Company Cost of Capital
Expected Rate of Return
Group-Specific Required Returns
Systematic Risk (Beta)
59Project Evaluation Based on Total Risk
RiskAdjusted 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.
60RADR and NPV
Adjusting for risk correctly may influence the
ultimate Project decision.
000s
15
10
RADR low risk at 10 (Accept!)
Net Present Value
5
RADR high risk at 15 (Reject!)
0
4
0 3 6 9 12
15
Discount Rate ()
61Adjusting 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.
62Adjusted 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.
Unlevered Project Value
Value of Project Financing
APV
63 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.
64Basket Wonders NPV Solution
What is the NPV to an all-equity-financed
firm? NPV 100,000PVIFA11,6 425,000 NPV
423,054 425,000 NPV 1,946
65Basket 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
66Basket 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
67Basket 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
68Basket Wonders NPV Solution
What is the APV? APV NPV PV of TS
Flotation Cost APV 1,946 13,513
10,000 APV 1,567