Establishing

1
Chapter 10

• Establishing
• Required Rates of Return

Shapiro and Balbirer Modern Corporate Finance
A Multidisciplinary Approach to Value
Creation Graphics by Peeradej Supmonchai
2
Learning Objectives

• Describe the relationship between risk and the
  cost of capital for a project.
• Explain the relationship between the weighted
  average cost of capital (WACC), the expected
  return on the project, and the expected return on
  the equity-financed portion of the project.
• Calculate the weighted average cost of capital
  for a company.
• Calculate the risk-adjusted required rate of
  return for a project or a division of a firm
  using the pure-play technique.

3
Learning Objectives (Cont.)

• Identify and avoid the common errors that are
  made in using the CAPM to estimate risk-adjusted
  costs of capital.
• Value a leveraged buyout (LBO) using the adjusted
  net present value (APV) approach.
• Compare and contrast the weighted average cost of
  capital, adjusted net present value, and equity
  residual approaches to capital budgeting.
• Identify the circumstances under which the cost
  of capital for foreign investments should be
  higher, lower, or the same as comparable domestic
  projects.

4
Components of a Projects Required Rate of Return

• Real risk-free interest rate
• Inflation premium
• Risk premium

5
Projects Cost of Capital

• The cost of capital (WACC) is a weighted average
  after-tax cost of various sources of capital that
  will be used to finance the project.
• If the projects expected return (IRR) exceeds
  the WACC, then the expected return on the
  equity-financed portion will exceed the required
  rate of return on equity.

6
Projects Cost of Capital

• Where
• kd the after-tax cost of debt
• kp the cost of preferred stock
• ke the cost of common stock
• wd, wp, we the proportions of debt,
  preferred, and common stock that will be used
  to finance accepted project

7
Wingler Iron Works - An Example

• Wingler Iron Works is considering a 1 million
  expansion project that will be financed with half
  long-term debt and half common stock. The
  after-tax cost of newly issued debt is 6, while
  Wingler shareholders are assumed to have a
  required return of 15 on projects of equivalent
  risk.

8
Calculating the WACC for the Wingler Project

• WACC 6 (0.50) 15 (0.50) 10.5

9
Wingler Iron Works Project Returns and Returns
to Equity

• EXPECTED PROJECT RETURNS
  9.0 10.5 13.0
• EXPECTED ANNUAL CASH FLOWS 90,000
  105,000 130,000
• ANNUAL INTEREST EXPENSE
  (30,000) (30,000) (30,000)
• EQUITY CASH FLOWS
  60,000 75,000 100,000
• RETURN ON EQUITY-FINANCED PORTION 12.0
  15.0 20.0

10
The Cost of Equity Capital

• The cost of equity capital is the required rate
  of return on common stock and, as such,
  represents the minimum acceptable rate of return
  on the equity-financed portion of new projects.

11
Estimating the Cost of EquityThe Constant
Dividend Growth Model

• Where
• ke the cost of equity
• D1 the expected dividend in year 1
• P0 the current stock price
• g the expected compound annual dividend
  growth rate

12
Using the Constant Dividend Growth Model - Du Pont

• Du Ponts dividends grew at a 14.5 compound
  annual rate from 1982-1997. The company paid
  dividends of 1.23 a share in 1997, and the stock
  price was 6006 a share at year end.

13
Using the Constant Dividend Growth Model - Du
Pont
14
Limitations of the Constant Dividend Growth Model

• Inappropriate for those firms that either pay no
  dividends or have erratic dividend payments.
• Past dividend growth rates may not be a good
  predictor of future dividends.

15
Estimating the Cost of Equity - The CAPM

• Where
• ke the cost of equity
• rf the risk free rate
• ?i the beta for the firms common stock
• rm - rf the market risk premium

16
Using the CAPM - Du Pont

• The 30-year Treasury bond rate in January 1998
  was 6.0. Du Ponts beta is 1.10, and the market
  risk premium is 7.8.

17
Using the CAPM - Du Pont
18
Cost of Debt

• Where
• kD the yield to maturity on new debt sold
• t the firms tax rate

19
Estimating Du Ponts Cost of Debt

• Du Pont has a callable bond maturing in 2002 with
  a coupon rate of 8.25. On December 31, 1997, the
  bond was selling at 108.75 per 100 of face
  making the yield to maturity on this issue 7.50.
• The after-tax cost 7.50(1-0.35) 4.88

20
Cost of Preferred Stock

• Where
• DP the preferred stock dividend (per share)
• PP the price per share of the proposed
  stock issue

21
Estimating Du Ponts Cost of Preferred Stock

• Du Pont has a preferred stock issue paying a
  dividend of 4.50 a share. The issue sold for
  83.50 a share on December 31, 1997.

22
Estimating Du Ponts Cost of Preferred Stock
23
Estimating Du Ponts WACC

• (1) X (2)
  (3)
• Component
  Weighted
• Source Cost
  Proportion Cost
  
• Debt 4.88
  0.079 0.387
• Preferred Stock 5.40
  0.002 0.011
• Common Stock 15.50
  0.919 14.245
• WACC
  14.641

24
Flotation Costs

• Where
• k the component cost without considering
  flotation costs
• F the flotation cost as a proportion of
  gross proceeds

25
The Firms WACC and Project Risk

• Firms WACC can only be applied to average risk
  projects.
• WACC should be updated periodically to reflect
  changes in capital market conditions.
• The calculated WACC is only an estimate of the
  true cost of capital for a firm. Treating it as
  a hard number is inappropriate.

26
The Firms WACC and Project Risk

• Since project returns typically increase with
  risk, using the firms overall WACC as a hurdle
  rate for all projects will lead to the rejection
  of low-risk projects and the acceptance of
  high-risk projects. Therefore, the firms overall
  risk may increase.

27
The Pure-Play Technique

• The pure-play technique attempts to estimate
  risk-adjusted required returns by matching the
  risk of the division or project in question to
  some publicly traded company in the same line of
  business. Once the pure plays are identified,
  their market data is used to calculated required
  returns.

28
Steps in the Pure-Play Techniqure

• Identify pure-play firms
• Determine betas for pure plays
• Adjust for leverage
• Releverage asset betas
• Calculate the projects or divisions cost of
  equity
• Calculate the projects or divisions required
  rate of return

29
Applying the Pure-Play Technique -Time Warners
Cable Division

• Pure-Play Equity or
  Debt To Debt To
• Firm Market Beta
  Market Capital Market Equity
• Cablevision Systems 1.20 68.2
  214.5
• Century 1.01
  64.8 184.1
• Comcast 1.18
  48.5 94.8
  
• Jones Intercable 1.07
  60.7 154.5
• TCI Group 1.17
  50.0 100.0

30
Adjusting for Leverage

• The published betas for pure plays reflect their
  financing mix. Since these debt ratios differ
  from the firms target capital structure, the
  pure-play technique calls for converting these
  betas into their unleveraged, or asset, values
  using the following equation
• bU bL / 1 (1 - t) D/E

31
Adjusting for Leverage - Time Warners Cable
Division

• Pure-Play Equity or Debt
  To Debt To Asset or
• Firm Market Beta
  Capital Equity Unlevered
• Beta
• Cablevision Systems 1.20 68.2
  214.5 0.501
• Century 1.01
  64.8 184.1 0.460
• Comcast 1.18
  48.5 94.8 0.730
• Jones Intercable 1.07
  60.7 154.5 0.534
• TCI Group 1.17
  50.0 100.0 0.705
• Average
  Asset Beta 0.586

32
Releveraging Asset Betas

• The average beta obtained from unleveraging
  represents that of a firm that uses no debt and
  has the same business risk as the project or
  division. We releverage the beta to reflect the
  firms target financing mix as follows
• bL bU 1 (1 - t)(D/E)

33
Releveraging Asset Betas - Time Warners Cable
Division
34
Calculating the Cost of Equity - Time Warners
Cable Division
35
Calculating the WACC - Time Warners Cable
Division
36
Common Errors in Calculating the WACC Using the
CAPM

• Using different capital structure assumptions in
  computing the cost of equity than are used in
  calculating the WACC.
• Using a different maturity for the risk-free rate
  in the CAPM than the one used in calculating the
  market risk premium.
• Estimating the market risk premium based on the
  most recent returns rather than a long-term time
  series.
• Using a negative market risk premium.

37
Common Errors in Calculating the WACC Using the
CAPM (Cont.)

• Using the historical average T-bond or T-bill
  rate instead of the current rate.
• Failing to releverage asset betas.
• Failing to include taxes in unleveraging and
  leveraging betas.
• Using the historical market return instead of the
  market risk premium.

38
Adjusted Net Present Value (APV)

• An approach to value a project as if it were
  financed entirely by debt and then adding to this
  the present value of the tax shields provided by
  debt financing.

39
APV Approach - Trifecta Products

• The managers of Trifecta Products have the
  opportunity to buy the firm for 30 million.
  Trifecta is a profitable debt-free business that
  generates 5 million in cash a year. These cash
  flows are expected to grow at 3 a year. The
  managers will provide 2 million of the
  financing the additional 28 million will come
  from an insurance loan carrying a 10 interest
  rate.

40
Valuing Trifecta Products

• If the all-equity cost of capital is 17 , the
  NPV of the firm on an all-equity basis would be
• 5 million (1.03)
• NPV -30 million ¾¾¾¾¾¾¾
  
• 
  (0.17 - 0.03)
• 6,785,714

41
Valuing Trifecta Products

• Beginning Debt Interest Interest Tax Present
  value
• of Year outstanding Shield Tax Shields _at_10
• 1 28,000 2,800 980 891
• 2 25,200 2,520 882 729
• 3 22,400 2,240 784 598
• 4 19,600 1,960 686 469
• 5 16,800 1,680 588 365
• 6 14,000 1,400 490 277
• 7 11,200 1,120 392 201
• 8 8,400 840 294 137
• 9 5,600 560 196 83
• 10 2,800 280 98 38
• 3,779
• Equal to interest times on assumed tax rate of
  35 percent
• All figures in thousand

42
Valuing Trifecta Products
43
Capital Budgeting Methods

• Weighted Average Cost of Capital (WACC) Approach
• Adjusted Present Value (APV) Method
• Equity Residual (ER) Method

44
Weighted Average Cost of Capital Approach

• Where
• k0 the discount rate
• CFt the project cash flow ignoring debt
  servicing charges

45
Adjusted Net Present Value (APV) Method

• Where
• k All-equity cost of capital

46
Equity Residual (ER) Method

• Where
• ke the levered cost of equity
  capital
• LCFt CFt - debt servicing
  charges
• Initial Investment I0 - debt (D) used to
  finance the project

47
International Dimension of Cost of Capital

• Multinational companies can reduce their earnings
  variability through international
  diversification.
• Because of their low correlation with Western
  economies, investments in LDCs may provide the
  greatest diversification benefits.
• The systematic risk, and hence required returns,
  on foreign project is unlikely to be higher than
  comparable domestic projects.