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Chapter 15Chapter 15

Required Returns Required Returns and the Cost of and the Cost of

CapitalCapital

Required Returns Required Returns and the Cost of and the Cost of

CapitalCapital© Pearson Education Limited 2004

Fundamentals of Financial Management, 12/eCreated by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

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Overall Cost of Overall Cost of Capital of the FirmCapital 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).

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Type of Financing Mkt Val Weight

Long-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

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Cost of Debt Cost of Debt is the required rate of return on investment of the lenders of a company.

ki = kd ( 1 - T )

Cost of DebtCost of Debt

P0 =Ij + Pj

(1 + kd)jn

j =1

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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%.

Determination of Determination of the Cost of Debtthe Cost of Debt

$385.54 =$0 + $1,000

(1 + kd)10

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(1 + kd)10 = $1,000 / $385.54= 2.5938

(1 + kd) = (2.5938) (1/10)

= 1.1 kd = .1 or 10%

ki = 10% ( 1 - .40 )

kkii = 6%6%

Determination of Determination of the Cost of Debtthe Cost of Debt

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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

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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

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Dividend Discount ModelDividend Discount Model

Capital-Asset Pricing Capital-Asset Pricing ModelModel

Before-Tax Cost of Debt Before-Tax Cost of Debt plus Risk Premiumplus Risk Premium

Cost of Equity Cost of Equity ApproachesApproaches

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Dividend Discount ModelDividend Discount ModelDividend Discount ModelDividend Discount Model

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 =

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Constant Growth ModelConstant Growth ModelConstant Growth ModelConstant Growth Model

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.

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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) + .08

kkee = .05 + .08 = .13.13 or 13%13%

Determination of the Determination of the Cost of Equity CapitalCost of Equity Capital

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Capital Asset Capital Asset Pricing ModelPricing ModelCapital Asset Capital Asset Pricing ModelPricing 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

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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 11.2%

ke = Rf + (Rm - Rf)j

= 4% + (11.2% - 4%)1.25

kkee = 4% + 9% = 13%13%

Determination of the Determination of the Cost of Equity (CAPM)Cost of Equity (CAPM)

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Before-Tax Cost of Debt Before-Tax Cost of Debt Plus Risk PremiumPlus Risk PremiumBefore-Tax Cost of Debt Before-Tax Cost of Debt Plus Risk PremiumPlus 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

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Assume that Basket Wonders (BW) typically adds a 3% premium to the

before-tax cost of debt.

ke = kd + Risk Premium

= 10% + 3%

kkee = 13%13%

Determination of the Determination of the Cost of Equity (kCost of Equity (kdd + R.P.) + R.P.)

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Constant Growth Model 13%13%

Capital Asset Pricing Model 13%13%

Cost of Debt + Risk Premium 13%13%

Generally, the three methods will not agree.

Comparison of the Comparison of the Cost of Equity MethodsCost of Equity Methods

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Cost of Capital = kx(Wx)

WACC = .35(6%) + .15(9%) + .50(13%)

WACC = .021 + .0135 + .065 = .0995 or 9.95%

Weighted Average Weighted Average Cost of Capital (WACC)Cost of Capital (WACC)

n

x=1

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1.1. Weighting SystemWeighting System

Marginal Capital Costs

Capital Raised in Different Proportions than WACC

Limitations of the WACCLimitations of the WACC

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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 Outlay

b. Adjustment to Discount Rate

Limitations of the WACCLimitations of the WACC

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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

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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

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Add Flotation Costs (FC) to the Initial Cash Outlay (ICO).

Impact: ReducesReduces the NPV

Adjustment to Adjustment to Initial Outlay (AIO)Initial Outlay (AIO)

NPV = n

t=1

CFt

(1 + k)t- ( ICO + FC )

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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)