Lesson03 Required Returns and the Cost of Capital

7/21/2019 Lesson03 Required Returns and the Cost of Capital

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15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Lesson 3Lesson 3

Required ReturnsRequired Returns

and the Cost ofand the Cost of

CapitalCapital

Risk


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Risk

15." Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

1. Explain how a firm creates value and identify the key sources ofvalue creation.

2. Define the overall cost of capital of the firm.

!. Calculate the costs of the individual components of a firm"s cost ofcapital # cost of de$t% cost of preferred stock% and cost of equity.

&. Explain and use alternative models to determine the cost of equity%includin' the dividend discount approach% the capital#asset pricin'model (C)*+, approach% and the $efore#tax cost of de$t plus riskpremium approach.

-. Calculate the firm"s wei'hted avera'e cost of capital ()CC, andunderstand its rationale% use% and limitations.

/. Explain how the concept of economic 0alue added (E0), is relatedto value creation and the firm"s cost of capital.

. nderstand the capital#asset pricin' model3s role in computin'pro4ect#specific and 'roup#specific required rates of return.

After Studying Lesson 3,After Studying Lesson 3,

you should be able to:you should be able to:


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* Creation of 0alue

* 5verall Cost of Capital of the 6irm* *ro4ect#7pecific Required Rates

* 8roup#7pecific Required Rates

* 9otal Risk Evaluation

Required Returns andRequired Returns and

the Cost of Capitalthe Cost of Capital


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15.+ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

8rowthphase ofproduct

cycle

:arriers tocompetitiveentry

5ther ##

e.'.% patents%temporarymonopoly

power%oli'opolypricin'

Cost

+arketin'and

price

*erceivedquality

7uperioror'ani;ational

capa$ility


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Cost of Capital is the required rateof return on the various types offinancin'. 9he overall cost ofcapital is a wei'hted avera'e of theindividual required rates of return(costs,.

Oerall Cost ofOerall Cost of

Capital of the !ir"Capital of the !ir"


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15. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

9ype of 6inancin' +kt 0al ei'ht

=on'#9erm De$t > !-+ !-?*referred 7tock > 1-+ 1-?

Common 7tock Equity > -@+ -@?

> 1@@+ 1@@?

#ar$et Value of#ar$et Value of

Long%&er" !inancingLong%&er" !inancing


7/5115.- Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Cost of De$tCost of De$t is the required rateof return on investment of thelenders of a company.

kiA kd( 1 B 9 ,

*@

A


8/5115. Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

)ssume that (as$et )onders *()+ has>1%@@@ par value ;ero#coupon $onds

outstandin'. ()$onds are currentlytradin' at >!-.-& with 1@ years tomaturity. : tax $racket is &@?.

>!-.-& A>@ >1%@@@

(1 kd,1@

'eter"ination of'eter"ination of

the Cost of 'ebtthe Cost of 'ebt


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15.$ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

(1 kd,1@ A >1%@@@ >!-.-&

A 2.-F!

(1 kd, A (2.-F!, (1E1@,

A 1.1kd A @.1 or 1@?

ki A 1@?( 1 B .&@ ,

kkii A

/?/?

'eter"ination of'eter"ination of

the Cost of 'ebtthe Cost of 'ebt


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15.1# Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Cost of *referred 7tockCost of *referred 7tock is therequired rate of return oninvestment of the preferredshareholders of the company.

k*A D* *@

Cost of referred Stoc$Cost of referred Stoc$


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)ssume that (as$et )onders *()+has preferred stock outstandin' with

par value of >1@@% dividend per shareof >/.!@% and a current market value of

>@ per share.

k*A >/.!@ >@

kk**A F?F?

'eter"ination of the'eter"ination of the

Cost of referred Stoc$Cost of referred Stoc$


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15.1" Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

* Dividend Discount +odelDividend Discount +odel

* Capital#)sset *ricin' +odelCapital#)sset *ricin' +odel* :efore#9ax Cost of De$t plus:efore#9ax Cost of De$t plus

Risk *remiumRisk *remium

Cost of -quityCost of -quity

ApproachesApproaches


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9he cost of equity capitalcost of equity capital% ke% is

the discount rate that equates thepresent value of all expected

future dividends with the currentmarket price of the stock.

D1 D2 D

(1 ke,1(1 ke,

2 (1 ke,/ . . . //*@ A

'iidend 'iscount #odel'iidend 'iscount #odel


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15.1+ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

9he constant dividend 'rowthconstant dividend 'rowth

assumptionassumption reduces the model toG

keA ( D1 *@, '

)ssumes that dividends will 'rowat the constant rate ' forever.

Constant .ro/th #odelConstant .ro/th #odel


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)ssume that (as$et )onders *()+ hascommon stock outstandin' with a currentmarket value of >/&.@ per share% currentdividend of >!per share% and a dividend

'rowth rate of ?forever.

ke A ( D1 *@, 'ke A (>!(1.@, >/&.@, @.@

kkee A @.@- @.@A @[email protected]!or 1!?1!?


Cost of -quity CapitalCost of -quity Capital


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D@(1 '1,t Da(1 '2,tBa

(1 ke,t

(1 ke,t

*@

A

9he 'rowth phases assumption'rowth phases assumption

leads to the followin' formulaleads to the followin' formula

(assume ! 'rowth phases,G(assume ! 'rowth phases,G

tA1

a

tAa1

$

tA$1

D$(1 '!,tB$

.ro/th hases #odel.ro/th hases #odel

(1 ke,t


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15.1- Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

9he cost of equity capital% ke% is

equated to the required rate ofreturn in market equili$rium. 9he

risk#return relationship is descri$ed$y the 7ecurity +arket =ine (7+=,.

ke A R4A Rf (RmB Rf,4

Capital AssetCapital Asset

ricing #odelricing #odel


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)ssume that (as$et )onders *()+ has acompany $eta of 1.2-. Research $y Hulie+iller su''ests that the risk#free rate is

&? and the expected return on the marketis 11.&?

ke A Rf (RmB Rf,4A &? (11.&? B &?,1.2-

kkee A &? F.2-? A 1!.2-?1!.2-?


Cost of -quity *CA#+Cost of -quity *CA#+


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15.1$ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

9he cost of equity capital% ke% is the

sum of the $efore#tax cost of de$tand a risk premium in expected

return for common stock over de$t.

ke A kd Risk *remiumI

I Risk premium is not the same as C)*+ riskpremium

(efore%&a0 Cost of 'ebt(efore%&a0 Cost of 'ebt

lus Ris$ re"iu"lus Ris$ re"iu"


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15."# Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

)ssume that (as$et )onders *()+typically adds a 2.-? premium to the

$efore#tax cost of de$t.

ke A kd Risk *remium

A 1@? 2.-?

kkee A 12.-?12.-?


Cost of -quity *$Cost of -quity *$dd1 R22+1 R22+


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15."1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Constant 8rowth +odel 1!.@@?1!.@@?

Capital )sset *ricin' +odel 1!.2-?1!.2-?Cost of De$t Risk *remium 12.-?12.-?

Co"parison of theCo"parison of the

Cost of -quity #ethodsCost of -quity #ethods

8enerally% the three methods will nota'ree.e must decide how to wei'ht B

we will use an avera'e of these three.


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15."" Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Cost of CapitalA kx(x,

)CC A @.!-(/?, @.1-(F?,

@.-@(1!?,)CC A @.@21 @.@1!- @.@/-

A @.@FF-or F.F-?

n

xA1

)eighted Aerage)eighted Aerage

Cost of Capital *)ACC+Cost of Capital *)ACC+


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1.1. ei'htin' 7ystemei'htin' 7ystem

* +ar'inal Capital Costs

* Capital Raised in 'ifferent

*roportions than )CC

Li"itations of the )ACCLi"itations of the )ACC


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15."+ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

2.2. 6lotation Costs6lotation Costs are the costsassociated with issuin' securitiessuch as underwritin'% le'al% listin'%and printin' fees.

a. )d4ustment to


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* ) measure of $usiness performance.

*


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E0)A J5*)9 B KCost of

Capitalx Capital EmployedL* 7ince a cost is char'ed for equity capital also% a

positive E0) 'enerally indicates shareholdervalue is $ein' created.

* :ased on -cono"icJ59Accounting*rofit.

* J5*)9 B net operatin' profit after tax is acompany"s potential after#tax profit if it was all#equity#financed or unlevered.

-cono"ic Value Added-cono"ic Value Added


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15."- Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

)dd !lotation Costs *!C+ to the


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7u$tract !lotation Costs from theproceeds (price, of the security and

recalculate yield fi'ures.

"pactG ncreasesncreasesthe cost for any

capital component with flotation costs.ResultG


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15."$ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

*


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* =ocate a proxy for the pro4ect (much

easier if asset is traded,.

* *lot the Characteristic =ine relationship$etween the market portfolio and the

proxy asset excess returns.

* Estimate $eta and create the 7+=.

'eter"ining the S#LG

'ifficulty in 'eter"ining'ifficulty in 'eter"ining

the -0pected Returnthe -0pected Return


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7+=

M

M

MM

MM

M

55

5

5

5

5

5

7N79E+)9


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15.3" Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

1. Calculate the required returnfor *ro4ect k (all#equity financed,.

RkA Rf (RmB Rf,k

2. )d4ust for capital structure of the

firm (financin' wei'hts,.

ei'hted )vera'e Required Return A KkiL

K? of De$tL KRkLK? of EquityL

'eter"ining ro4ect%Specific'eter"ining ro4ect%Specific

Required Rate of ReturnRequired Rate of Return


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)ssume a computer networkin' pro4ect is$ein' considered with an


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15.3+ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

ke A Rf (RmB Rf,4

A &? (11.2? B &?,1.-

kkee A &? 1@.? A 1&.?1&.?

)CC)CC A @.!@(/?, @.@(1&.?,A 1.? 1@.!/? A 12.1/?12.1/?


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*


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8roup#7pecificRequired Returns

Company Cost

of Capital

7ystematic Risk (:eta,

Expec

tedRateof

Return

Co"paring .roup%SpecificCo"paring .roup%Specific

Required Rates of ReturnRequired Rates of Return


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15.3- Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

* )mount of non#equity financin'relative to the proxy firm. )d4ust

pro4ect $eta if necessary.

* 7tandard pro$lems in the use ofC)*+. *otential insolvency is atotal#risk pro$lem rather than 4ustsystematic risk (C)*+,.

9ualifications to 5sing9ualifications to 5sing

.roup%Specific Rates.roup%Specific Rates


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RiskB)d4usted Discount Rate

)pproach (R)DR,9he required return is increased(decreased, relative to the firm"s

overall cost of capital for pro4ectsor 'roups showin' 'reater

(smaller, than avera'e risk.

ro4ect -aluationro4ect -aluation

(ased on &otal Ris$(ased on &otal Ris$


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15.3$ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

Discount Rate (?,

@ ! / F 12 1-

R)DR B hi'hrisk at 1-?

(Re4ectQ,

R)DR B lowrisk at 1@?()cceptQ,

)d4ustin' for risk correctlymay influence the ultimate

*ro4ect decision.

Jet*resent0

alue

>@@@s

1-

1@

-

@

B&

RA'R and VRA'R and V


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15.+# Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

*ro$a$ility Distri$ution )pproach

)cceptance of a sin'le pro4ectwith a positive J*0 depends onthe dispersion of J*0s and the

utility preferences ofmana'ement.

ro4ect -aluationro4ect -aluation

(ased on &otal Ris$(ased on &otal Ris$


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15.+1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

:

C

)


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15.+" Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

:

C

)


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:

C

)


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15.++ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

44AA 4u4uK 1 (K 1 (:7:7,(1 B,(1 B 99CC, L, L

4G :eta of a levered firm.

4uG :eta of an unlevered firm

(an all#equity financed firm,.

:7G De$t#to#Equity ratio in+arket 0alue terms.

9CG 9he corporate taxrate.

Ad4usting (eta forAd4usting (eta for

!inancial Leerage!inancial Leerage


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)d4usted *resent 0alue ()*0, is thesum of the discounted value of a

pro4ect"s operatin' cash flows plus thevalue of any tax#shield $enefits of

interest associated with the pro4ect"s

financin' minus any flotation costs.

)*0 Anlevered

*ro4ect 0alue

0alue of*ro4ect 6inancin'

Ad4usted resent ValueAd4usted resent Value


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)ssume (as$et )ondersis considerin' anew >&2-%@@@automated $asket weavin'

machine that will save >1@@%@@@per yearfor the next / years. 9he required rate onunlevered equity is 11?.

()can $orrow >1@%@@@ at ? with>1@%@@@ after#tax flotation costs. *rincipalis repaid at >!@%@@@ per year ( interest,.

9he firm is in the &@? tax $racket.

V and AV -0a"pleV and AV -0a"ple

( $ t ) d( $ t ) d


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15.+- Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

hat is the VVto an all#equity#to an all#equity#

financed firmfinanced firmS

J*0A >1@@%@@@K*0&2-%@@@

J*0A >&2!%@-&B>&2-%@@@

J*0J*0AB >1%F&/B >1%F&/

(as$et )onders(as$et )onders

V SolutionV Solution

( $ t ) d( $ t ) d


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hat is theAVAVS

6irst% determine the interest expense.

1@%@@@,(?, A >12%/@@


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15.+$ Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson ducation !imited "##$. %reated &' (regor' )uhleme'e

7econd% calculate the tax#shield $enefits.

97: Nr 1 (>12%/@@,(&@?, A >-%@&@

97: Nr 2 ( 1@%-@@,(&@?, A &%2@@

97: Nr ! ( %&@@,(&@?, A !%!/@

97: Nr & ( /%!@@,(&@?, A 2%-2@97: Nr - ( &%2@@,(&@?, A 1%/@

97: Nr / ( 2%1@@,(&@?, A &@


AV SolutionAV Solution

( $ t ) d( $ t ) d


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9hird% find the *0 of the tax#shield $enefits.

97: Nr 1 (>-%@&@,(.F@1, A >&%-&1

97: Nr 2 ( &%2@@,(.12, A !%&1@

97: Nr ! ( !%!/@,(.!1, A 2%&-/

97: Nr & ( 2%-2@,(./-F, A 1%//1

97: Nr - ( 1%/@,(.-F!, A FF/

97: Nr / ( &@,(.-!-, A &&F *0 A*0 A>1!%-1!>1!%-1!


AV SolutionAV Solution

( $ t ) d( $ t ) d


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hat is theAVAVS

)*0A J*0 *0 of 97B 6lotation Cost

)*0AB>1%F&/ >1!%-1!B >1@%@@@

)*0)*0A >1%-/>1%-/


V SolutionV Solution

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Lesson03 Required Returns and the Cost of Capital