Download - Returns on cash of capital
15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Chapter 15Chapter 15Required Returns Required Returns
and the Cost of and the Cost of CapitalCapital
15.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1. Explain how a firm creates value and identify the key sources of value creation.
2. Define the overall “cost of capital” of the firm. 3. Calculate the costs of the individual components of a firm’s cost of
capital - cost of debt, cost of preferred stock, and cost of equity. 4. 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.
5. Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations.
6. Explain how the concept of economic Value added (EVA) is related to value creation and the firm’s cost of capital.
7. Understand the capital-asset pricing model's role in computing project-specific and group-specific required rates of return.
After Studying Chapter 15, After Studying Chapter 15, you should be able to:you should be able to:
15.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Creation of Value• Overall Cost of Capital of the Firm• Project-Specific Required Rates• Group-Specific Required Rates• Total Risk Evaluation
Required Returns and Required Returns and the Cost of Capitalthe Cost of Capital
15.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Growthphase ofproduct
cycle
Barriers tocompetitive
entry
Other --e.g., patents,
temporarymonopoly
power,oligopoly
pricing
CostMarketing
andprice
Perceivedquality
Superiororganizational
capability
Industry AttractivenessIndustry Attractiveness
Competitive AdvantageCompetitive Advantage
Key Sources of Key Sources of Value CreationValue Creation
15.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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).
Overall Cost of Overall Cost of Capital of the FirmCapital of the Firm
15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Type of Financing Mkt Val WeightLong-Term Debt $ 35M 35%Preferred Stock $ 15M 15%Common Stock Equity $ 50M 50%
$ 100M 100%
Market Value of Market Value of Long-Term FinancingLong-Term Financing
15.7 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.
ki = kd ( 1 – T )
P0 =Ij + Pj
(1 + kd)jn
j=1
Cost of DebtCost of Debt
15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Determination of Determination of the Cost of Debtthe Cost of Debt
15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
(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 )
kkii = 6%6%
Determination of Determination of the Cost of Debtthe Cost of Debt
15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Cost of Preferred StockCost of Preferred Stock
15.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
kkPP = 9%9%
Determination of the Determination of the Cost of Preferred StockCost of Preferred Stock
15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Dividend Discount ModelDividend Discount Model• Capital-Asset Pricing ModelCapital-Asset Pricing Model• Before-Tax Cost of Debt plus Before-Tax Cost of Debt plus
Risk PremiumRisk Premium
Cost of Equity Cost of Equity ApproachesApproaches
15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The cost of equity capitalcost 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
(1 + ke)1 (1 + ke)2 (1 + ke)+ . . . ++P0 =
Dividend Discount ModelDividend Discount Model
15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
The constant dividend growth constant dividend growth assumptionassumption reduces the model to:
ke = ( D1 / P0 ) + g
Assumes that dividends will grow at the constant rate “g” forever.
Constant Growth ModelConstant Growth Model
15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
kkee = 0.05 + 0.08 = 0.130.13 or 13%13%
Determination of the Determination of the Cost of Equity CapitalCost of Equity Capital
15.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
D0(1 + g1)t Da(1 + g2)t–a
(1 + ke)t (1 + ke)tP0 =
The growth phases assumption growth phases assumption leads to the following formula leads to the following formula
(assume 3 growth phases):(assume 3 growth phases):
t=1
a
t=a+1
b
t=b+1
Db(1 + g3)t–b
+
Growth Phases ModelGrowth Phases Model
(1 + ke)t
15.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Capital Asset Capital Asset Pricing ModelPricing Model
15.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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 kkee = 4% + 9.25% = 13.25%13.25%
Determination of the Determination of the Cost of Equity (CAPM)Cost of Equity (CAPM)
15.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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
Before-Tax Cost of Debt Before-Tax Cost of Debt Plus Risk PremiumPlus Risk Premium
15.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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% kkee = 12.75%12.75%
Determination of the Determination of the Cost of Equity (kCost of Equity (kdd + R.P.) + R.P.)
15.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Constant Growth Model 13.00%13.00%Capital Asset Pricing Model 13.25%13.25%Cost of Debt + Risk Premium 12.75%12.75%
Comparison of the Comparison of the Cost of Equity MethodsCost of Equity Methods
Generally, the three methods will not agree.We must decide how to weight –
we will use an average of these three.
15.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%
n
x=1
Weighted Average Weighted Average Cost of Capital (WACC)Cost of Capital (WACC)
15.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1.1. Weighting SystemWeighting System
• Marginal Capital Costs
• Capital Raised in Different Proportions than WACC
Limitations of the WACCLimitations of the WACC
15.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
2.2. Flotation Costs Flotation Costs are the costs associated with issuing securities such as underwriting, legal, listing, and printing fees.
a. Adjustment to Initial Outlayb. Adjustment to Discount Rate
Limitations of the WACCLimitations of the WACC
15.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Economic Value AddedEconomic Value Added
15.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.• NOPAT – net operating profit after tax is a
company’s potential after-tax profit if it was all-equity-financed or “unlevered.”
Economic Value AddedEconomic Value Added
15.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Add Flotation Costs (FC) to the Initial Cash Outlay (ICO).
Impact: ReducesReduces the NPV
NPV = n
t=1
CFt
(1 + k)t– ( ICO + FC )
Adjustment to Adjustment to Initial Outlay (AIO)Initial Outlay (AIO)
15.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Subtract Flotation Costs from the proceeds (price) of the security and
recalculate yield figures.Impact: IncreasesIncreases the cost for any
capital component with flotation costs.
Result: Increases the WACC, which decreasesdecreases the NPV.
Adjustment to Adjustment to Discount Rate (ADR)Discount Rate (ADR)
15.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• Initially assume all-equity financing.• Determine project beta.• Calculate the expected return.• Adjust for capital structure of firm.• Compare cost to IRR of project.
Use of CAPM in Project Selection:
Determining Project-Specific Determining Project-Specific Required Rates of ReturnRequired Rates of Return
15.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
• Estimate beta and create the SML.
Determining the SML:
Difficulty in Determining Difficulty in Determining the Expected Returnthe Expected Return
15.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
SML
X
XX
X
XX
X
O O
O
O
O
O
O
SYSTEMATIC RISK (Beta)
EXPE
CTE
D R
ATE
OF
RET
UR
N
Rf
Accept
Reject
Project Acceptance Project Acceptance and/or Rejectionand/or Rejection
15.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
1. Calculate the required return for Project k (all-equity financed).
Rk = Rf + (Rm – Rf)k
2. Adjust for capital structure of thefirm (financing weights).
Weighted Average Required Return = [ki][% of Debt] + [Rk][% of Equity]
Determining Project-Specific Determining Project-Specific Required Rate of ReturnRequired Rate of Return
15.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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%.
Project-Specific Required Project-Specific Required Rate of ReturnRate of Return ExampleExample
15.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
ke = Rf + (Rm – Rf)j
= 4% + (11.2% – 4%)1.5 kkee = 4% + 10.8% = 14.8%14.8%
WACCWACC = 0.30(6%) + 0.70(14.8%)= 1.8% + 10.36% = 12.16%12.16%
IRR IRR = 19%19% > WACC WACC = 12.16%12.16%
Do You Accept the Project?Do You Accept the Project?
15.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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.
Use of CAPM in Project Selection:
Determining Group-Specific Determining Group-Specific Required Rates of ReturnRequired Rates of Return
15.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Group-SpecificRequired Returns
Company Costof Capital
Systematic Risk (Beta)
Expe
cted
Rat
e of
Ret
urn
Comparing Group-Specific Comparing Group-Specific Required Rates of ReturnRequired Rates of Return
15.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
• 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).
Qualifications to Using Qualifications to Using Group-Specific RatesGroup-Specific Rates
15.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Risk–Adjusted Discount Rate Approach (RADR)
The required return is increased (decreased) relative to the firm’s
overall cost of capital for projects or groups showing greater
(smaller) than “average” risk.
Project Evaluation Project Evaluation Based on Total RiskBased on Total Risk
15.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Discount Rate (%)0 3 6 9 12 15
RADR – “high” risk at 15%
(Reject!)
RADR – “low” risk at 10%(Accept!)
Adjusting for risk correctlymay influence the ultimate
Project decision.
Net
Pre
sent
Val
ue
$000s15
10
5
0–4
RADR and NPVRADR and NPV
15.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Probability Distribution Approach
Acceptance of a single project with a positive NPV depends on the dispersion of NPVs and the
utility preferences of management.
Project Evaluation Project Evaluation Based on Total RiskBased on Total Risk
15.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B
C
A
IndifferenceCurves
STANDARD DEVIATION
EXPE
CTE
D V
ALU
E O
F N
PV
Curves show“HIGH”
Risk Aversion
Firm-Portfolio ApproachFirm-Portfolio Approach
15.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B
C
A
IndifferenceCurves
STANDARD DEVIATION
EXPE
CTE
D V
ALU
E O
F N
PV
Curves show“MODERATE”Risk Aversion
Firm-Portfolio ApproachFirm-Portfolio Approach
15.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
B
C
A
IndifferenceCurves
STANDARD DEVIATION
EXPE
CTE
D V
ALU
E O
F N
PV
Curves show“LOW”
Risk Aversion
Firm-Portfolio ApproachFirm-Portfolio Approach
15.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
jj = = juju [ 1 + ( [ 1 + (B/SB/S)(1 – )(1 – TTCC) ]) ]
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.
Adjusting Beta for Adjusting Beta for Financial LeverageFinancial Leverage
15.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Adjusted Present Value (APV) is the sum of the discounted value of a project’s
operating cash flows plus the value of any tax-shield benefits of interest
associated with the project’s financing minus any flotation costs.
APV = UnleveredProject Value + Value of
Project Financing
Adjusted Present ValueAdjusted Present Value
15.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
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.
NPV and APV ExampleNPV and APV Example
15.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is the NPVNPV to an all-equity- to an all-equity-financed firmfinanced firm?
NPV = $100,000[PVIFA11%,6] – $425,000
NPV = $423,054 – $425,000NPVNPV = – $1,946– $1,946
Basket Wonders Basket Wonders NPV SolutionNPV Solution
15.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is the APVAPV?First, determine the interest expense.
Int Yr 1 ($180,000)(7%) = $12,600Int 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
Basket Wonders Basket Wonders APV SolutionAPV Solution
15.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Second, calculate the tax-shield benefits.TSB Yr 1 ($12,600)(40%) = $5,040TSB Yr 2 ( 10,500)(40%) = 4,200TSB Yr 3 ( 8,400)(40%) = 3,360TSB Yr 4 ( 6,300)(40%) = 2,520TSB Yr 5 ( 4,200)(40%) = 1,680TSB Yr 6 ( 2,100)(40%) = 840
Basket Wonders Basket Wonders APV SolutionAPV Solution
15.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
Third, find the PV of the tax-shield benefits.
TSB Yr 1 ($5,040)(.901) = $4,541TSB Yr 2 ( 4,200)(.812) = 3,410TSB Yr 3 ( 3,360)(.731) = 2,456TSB Yr 4 ( 2,520)(.659) = 1,661TSB Yr 5 ( 1,680)(.593) = 996TSB Yr 6 ( 840)(.535) = 449 PV = PV = $13,513$13,513
Basket Wonders Basket Wonders APV SolutionAPV Solution
15.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
What is the APVAPV?
APV = NPV + PV of TS – Flotation Cost APV = –$1,946 + $13,513 – $10,000
APVAPV = $1,567$1,567
Basket Wonders Basket Wonders NPV SolutionNPV Solution