Professional Documents
Culture Documents
Required Returns
and the Cost of
Capital
15.1
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
15.2
1.
Explain how a firm creates value and identify the key sources of
value creation.
2.
3.
4.
5.
6.
7.
15.3
Creation of Value
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Key Sources of
Value Creation
Industry Attractiveness
Growth
phase of
product
cycle
Cost
Marketing
and
price
Barriers to
competitive
entry
Perceived
quality
Superior
organizational
capability
Competitive Advantage
15.4
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
15.5
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Market Value of
Long-Term Financing
Type of Financing
Mkt Val
Weight
Long-Term Debt
$ 35M
35%
Preferred Stock
$ 15M
15%
15.6
50%
100%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n
P0 =
Ij + Pj
j
(1
+
k
)
d
j=1
ki = kd ( 1 T )
15.7
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination 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%
15.9
ki
= 10% ( 1 .40 )
ki
= 6%
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
kP = D P / P 0
15.10
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Cost of Equity
Approaches
15.12
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
15.15
ke
= ( D 1 / P0 ) + g
ke
ke
D0(1 + g1)t
t=1
(1 + ke)t
P0 =
t=b+1
15.16
Da(1 + g2)ta
t=a+1
(1 + ke)t
Db(1 + g3)tb
(1 + ke)t
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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) j
15.17
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 11.4%
ke = Rf + (Rm Rf) j
= 4% + (11.4% 4%)1.25
ke = 4% + 9.25% = 13.25%
15.18
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determination 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%
15.20
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Comparison 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.
15.21
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital =
15.22
x=1
kx(Wx)
WACC
= 0.35(6%) + 0.15(9%) +
0.50(13%)
WACC
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
15.23
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
15.24
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
15.25
15.26
Adjustment to
Initial Outlay (AIO)
Add Flotation Costs (FC) to the
Initial Cash Outlay (ICO).
n
CFt
NPV = (1 + k)t ( ICO + FC )
t=1
Impact: Reduces the NPV
15.27
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
15.28
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Project-Specific
Required Rates of Return
Use of CAPM in Project Selection:
15.29
Difficulty in Determining
the Expected Return
Determining the SML:
15.30
Project Acceptance
and/or Rejection
EXPECTED RATE
OF RETURN
Accept
X
X
X
O
Rf
X
O
O
O
SML
Reject
O
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Project-Specific
Required Rate of Return
1. Calculate the required return
for Project k (all-equity financed).
Rk = Rf + (Rm Rf) k
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%.
15.33
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Determining Group-Specific
Required Rates of Return
Use of CAPM in Project Selection:
Initially assume all-equity financing.
15.35
Comparing Group-Specific
Required Rates of Return
Company Cost
of Capital
Group-Specific
Required Returns
Systematic Risk (Beta)
15.36
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Qualifications to Using
Group-Specific Rates
15.37
Project 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.
15.38
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
$000s
15
10
5
0
4
15.39
RADR low
risk at 10%
(Accept!)
6
9
12
Discount Rate (%)
RADR high
risk at 15%
(Reject!)
15
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Firm-Portfolio Approach
C
Indifference
Curves
B
A
Curves show
HIGH
Risk Aversion
STANDARD DEVIATION
15.41
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Firm-Portfolio Approach
C
Indifference
Curves
B
A
Curves show
MODERATE
Risk Aversion
STANDARD DEVIATION
15.42
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Firm-Portfolio Approach
C
Indifference
Curves
B
A
Curves show
LOW
Risk Aversion
STANDARD DEVIATION
15.43
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
APV =
15.45
Unlevered
Project Value
Value of
Project Financing
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders
NPV Solution
What is the NPV to an all-equityfinanced firm?
firm
NPV = $100,000[PVIFA11%,6] $425,000
NPV = $423,054 $425,000
NPV = $1,946
15.47
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders
APV Solution
What is the APV?
APV
First, determine the interest expense.
Int Yr 1 ($180,000)(7%)
= $12,600
Int Yr 2 ( 150,000)(7%)
= 10,500Int Yr
3
( 120,000)(7%)
= 8,400Int Yr 4 (
90,000)(7%) = 6,300
Int Yr 5
( 60,000)(7%)
= 4,200Int Yr 6
( 30,000)(7%)
= 2,100
15.48
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders
APV Solution
Second, calculate the tax-shield benefits.
TSB Yr 1 ($12,600)(40%)
= $5,040
TSB Yr 2
TSB Yr 3
TSB Yr 4
TSB Yr 5
TSB Yr 6
=
=
=
=
=
15.49
( 10,500)(40%)
( 8,400)(40%)
( 6,300)(40%)
( 4,200)(40%)
( 2,100)(40%)
4,200
3,360
2,520
1,680
840
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
$13,513
15.50
($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 =
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Basket Wonders
NPV Solution
What is the APV?
APV
APV = NPV + PV of TS Flotation Cost
APV = $1,946 + $13,513 $10,000
APV = $1,567
15.51
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.