After Studying Chapter 15, you should be able to:
Explain how a firm creates value and identify the key sources of value creation.
Define the overall “cost of capital” of the firm.
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.
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.
Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations.
Explain how the concept of economic Value added (EVA) is related to value creation and the firm’s cost of capital.
Understand the capital-asset pricing model's role in computing project-specific and group-specific required rates of return.

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Chapter 15Required Returns and the Cost of CapitalExplain how a firm creates value and identify the key sources of value creation.Define the overall “cost of capital” of the firm. 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. 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.Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations. Explain how the concept of economic Value added (EVA) is related to value creation and the firm’s cost of capital.Understand the capital-asset pricing model's role in computing project-specific and group-specific required rates of return.After Studying Chapter 15, you should be able to: Creation of Value Overall Cost of Capital of the Firm Project-Specific Required Rates Group-Specific Required Rates Total Risk EvaluationRequired Returns and the Cost of CapitalGrowthphase ofproductcycleBarriers tocompetitiveentryOther --e.g., patents,temporarymonopolypower,oligopolypricingCostMarketingandpricePerceivedqualitySuperiororganizationalcapabilityIndustry AttractivenessCompetitive AdvantageKey Sources of Value CreationCost 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 Capital of the FirmType of Financing Mkt Val WeightLong-Term Debt $ 35M 35%Preferred Stock $ 15M 15%Common Stock Equity $ 50M 50% $ 100M 100%Market Value of Long-Term FinancingCost 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)jSnj=1Cost of DebtAssume 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)10Determination 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% ki = 10% ( 1 – .40 ) ki = 6%Determination of the Cost of DebtCost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company.kP = DP / P0Cost of Preferred StockAssume 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%Determination of the Cost of Preferred StockDividend Discount ModelCapital-Asset Pricing ModelBefore-Tax Cost of Debt plus Risk PremiumCost of Equity Approaches The cost 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 Model The constant dividend growth assumption reduces the model to:ke = ( D1 / P0 ) + gAssumes that dividends will grow at the constant rate “g” forever.Constant Growth ModelAssume 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 ke = 0.05 + 0.08 = 0.13 or 13%Determination of the Cost of Equity Capital D0(1 + g1)t Da(1 + g2)t–a(1 + ke)t (1 + ke)tP0 = The growth phases assumption leads to the following formula (assume 3 growth phases):S+ St=1at=a+1bt=b+1¥Db(1 + g3)t–b+SGrowth Phases Model(1 + ke)t 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)bjCapital Asset Pricing ModelAssume 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)bj = 4% + (11.4% – 4%)1.25 ke = 4% + 9.25% = 13.25%Determination of the Cost of Equity (CAPM) 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 premiumBefore-Tax Cost of Debt Plus Risk PremiumAssume 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%Determination of the Cost of Equity (kd + R.P.)Constant Growth Model 13.00%Capital Asset Pricing Model 13.25%Cost of Debt + Risk Premium 12.75% Comparison of the Cost of Equity MethodsGenerally, the three methods will not agree.We must decide how to weight –we will use an average of these three.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%Snx=1Weighted Average Cost of Capital (WACC)1. Weighting System Marginal Capital Costs Capital Raised in Different Proportions than WACCLimitations of the WACCFlotation 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 RateLimitations of the WACCA 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 AddedEVA = 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 AddedAdd Flotation Costs (FC) to the Initial Cash Outlay (ICO).Impact: Reduces the NPVNPV =Snt=1CFt(1 + k)t– ( ICO + FC )Adjustment to Initial Outlay (AIO)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.Adjustment to Discount Rate (ADR) 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 Required Rates of ReturnLocate 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 the Expected ReturnSMLXXXXXXXOOOOOOOSYSTEMATIC RISK (Beta)EXPECTED RATE OF RETURNRfAcceptRejectProject Acceptance and/or Rejection 1. Calculate the required return for Project k (all-equity financed).Rk = Rf + (Rm – Rf)bk 2. Adjust for capital structure of the firm (financing weights).Weighted Average Required Return = [ki][% of Debt] + [Rk][% of Equity] Determining Project-Specific Required Rate of ReturnAssume 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 Rate of Return Example ke = Rf + (Rm – Rf)bj = 4% + (11.2% – 4%)1.5 ke = 4% + 10.8% = 14.8%WACC = 0.30(6%) + 0.70(14.8%) = 1.8% + 10.36% = 12.16% IRR = 19% > WACC = 12.16%Do You Accept the Project?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 Required Rates of ReturnGroup-SpecificRequired ReturnsCompany Costof CapitalSystematic Risk (Beta)Expected Rate of ReturnComparing Group-Specific Required Rates of ReturnAmount 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 Group-Specific RatesRisk–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 Based on Total RiskDiscount Rate (%)0 3 6 9 12 15RADR – “high” risk at 15%(Reject!)RADR – “low” risk at 10%(Accept!)Adjusting for risk correctlymay influence the ultimateProject decision.Net Present Value$000s151050–4RADR and NPVProbability 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 Based on Total RiskBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTED VALUE OF NPVCurves show“HIGH”Risk AversionFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTED VALUE OF NPVCurves show“MODERATE”Risk AversionFirm-Portfolio ApproachBCAIndifferenceCurvesSTANDARD DEVIATIONEXPECTED VALUE OF NPVCurves show“LOW”Risk AversionFirm-Portfolio Approachbj = bju [ 1 + (B/S)(1 – TC) ] bj: Beta of a levered firm. bju: 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 Financial LeverageAdjusted 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 ofProject FinancingAdjusted Present ValueAssume 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 ExampleWhat is the NPV to an all-equity-financed firm?NPV = $100,000[PVIFA11%,6] – $425,000NPV = $423,054 – $425,000NPV = – $1,946Basket Wonders NPV SolutionWhat is the APV?First, determine the interest expense. Int Yr 1 ($180,000)(7%) = $12,600 Int Yr 2 ( 150,000)(7%) = 10,500 Int Yr 3 ( 120,000)(7%) = 8,400 Int Yr 4 ( 90,000)(7%) = 6,300 Int Yr 5 ( 60,000)(7%) = 4,200 Int Yr 6 ( 30,000)(7%) = 2,100Basket Wonders APV SolutionSecond, 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%) = 840Basket Wonders APV SolutionThird, 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 = $13,513Basket Wonders APV SolutionWhat is the APV?APV = NPV + PV of TS – Flotation Cost APV = –$1,946 + $13,513 – $10,000APV = $1,567Basket Wonders NPV Solution