Required Returns

and the Cost of

Capital
Mousumi Bhattacharya, IIM Shillong,
PGPEX

15-1
 Required Returns and
the Cost of Capital
Creation of Value
Overall Cost of Capital of the Firm
Project-Specific Required Rates
Total Risk Evaluation

15-2
 Key Sources of
Value Creation
Industry Attractiveness

Growth Barriers to Other --

phase of competitive e.g., patents,
product entry temporary
cycle monopoly
power,
oligopoly
pricing

Marketing Superior
and Perceived
Cost quality organizational
price capability

15-3
Competitive Advantage
 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).

15-4
 Market Value of
Long-Term Financing

Type of Financing Mkt Val Weight

Long-Term Debt $ 35M 35%
Preferred Stock $ 15M 15%
Common Stock Equity $ 50M 50%
$ 100M 100%

15-5
 Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n
Ij + Pj
P0 = (1 + kd)j
j =1

ki = kd ( 1 - T )
15-6
 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%.

15-7
 Determination of
the Cost of Debt
(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 )
ki = 6%
15-8
 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

15-9
 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%
15-10
 Cost of Equity
Approaches

Dividend Discount Model

Capital-Asset Pricing
Model
Before-TaxCost of Debt
plus Risk Premium

15-11
 Dividend Discount Model

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
P0 = + +...+
(1+ke) (1+ke)
1 2 (1+ke)

15-12
 Constant Growth Model

The constant dividend growth

assumption reduces the model to:

ke = ( D1 / P0 ) + g

Assumes that dividends will grow

at the constant rate g forever.
15-13
 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.
ke = ( D1 / P0 ) + g
ke = ($3(1.08) / $64.80) + .08

15-14
ke = .05 + .08 = .13 or 13%
 Growth Phases Model

The growth phases assumption

leads to the following formula
(assume 3 growth phases):
a D0(1+g1)t b Da(1+g2)t-a
P0 = (1+ke)t

(1+ke)t
+
t=1 t=a+1
Db(1+g3)t-b

t=b+1 (1+ke)t
15-15
 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
15-16
 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 11.2%
ke = Rf + (Rm - Rf)j
= 4% + (11.2% - 4%)1.25

15-17
ke = 4% + 9% = 13%
 Before-Tax Cost of Debt
Plus 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
15-18
 Determination of the
Cost of Equity (kd + R.P.)
Assume that Basket Wonders (BW)
typically adds a 3% premium to the
before-tax cost of debt.
ke = kd + Risk Premium
= 10% + 3%
ke = 13%

15-19
 Comparison of the
Cost of Equity Methods

Constant Growth Model 13%

Capital Asset Pricing Model 13%
Cost of Debt + Risk Premium 13%
Generally, the three methods
will not agree.

15-20
 Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = kx(Wx)
x=1

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

.50(13%)
WACC = .021 + .0135 + .065
= .0995 or 9.95%
15-21
 Limitations of the WACC

1. Weighting System
Marginal Capital Costs

Capital Raised in Different

Proportions than WACC

15-22
 Limitations of the WACC

2. 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
15-23
 Economic Value Added
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.
15-24
 Economic Value Added

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.
15-25
 Adjustment to
Initial Outlay (AIO)

Add Flotation Costs (FC) to the

Initial Cash Outlay (ICO).

n CFt
NPV = - ( ICO + FC )
t=1 (1 + k)t

Impact: Reduces the NPV

15-26
 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.
15-27
 Determining Project-Specific
Required Rates of Return

Use of CAPM in Project Selection:

Initially assume all-equity financing.
Determine project beta.
Calculate the expected return.
Adjust for capital structure of firm.
Compare cost to IRR of project.
15-28
 Difficulty in Determining
the Expected Return
Determining the SML:
Locate a proxy for the project (much
easier if asset is traded).
Plotthe Characteristic Line
relationship between the market
portfolio and the proxy asset excess
returns.
Estimate beta and create the SML.
15-29
 Project Acceptance
and/or Rejection

Accept X SML
EXPECTED RATE

X X
OF RETURN

X X O
X X
O O
O O Reject O
Rf O

SYSTEMATIC RISK (Beta)

15-30
 Determining Project-Specific
Required Rate of Return

1. Calculate the required return

for Project k (all-equity financed).
Rk = Rf + (Rm - Rf)k
2. Adjust for capital structure of the
firm (financing weights).
Weighted Average Required Return =
[ki][% of Debt] + [Rk][% of Equity]
15-31
 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%.
15-32
 Do You Accept the Project?
ke = Rf + (Rm - Rf)j
= 4% + (11.2% - 4%)1.5
ke = 4% + 10.8% = 14.8%
WACC = .30(6%) + .70(14.8%)
= 1.8% + 10.36% = 12.16%
IRR = 19% > WACC = 12.16%
15-33
 Adjusting Beta for
Financial Leverage
j = ju [ 1 + (B/S)(1-TC) ]
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.
15-34
 Adjusted Present Value

Adjusted Present Value (APV) is the

sum of the discounted value of a
projects operating cash flows plus the
value of any tax-shield benefits of
interest associated with the projects
financing minus any flotation costs.

Unlevered Value of
APV = Project Value
+ Project Financing
15-35
 NPV and APV Example
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.
15-36
 Basket Wonders
NPV Solution

What is the NPV to an all-equity-

financed firm?

NPV = $100,000[PVIFA11%,6] - $425,000

NPV = $423,054 - $425,000
NPV = -$1,946
15-37
 Basket Wonders
APV Solution
What 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%) = 2,100
15-38
 Basket Wonders
APV Solution
Second, calculate the tax-shield benefits.
TSB Yr 1 ($12,600)(40%) = $5,040
TSB Yr 2 ( 10,500)(40%) = 4,200
TSB Yr 3 ( 8,400)(40%) = 3,360
TSB Yr 4 ( 6,300)(40%) = 2,520
TSB Yr 5 ( 4,200)(40%) = 1,680
TSB Yr 6 ( 2,100)(40%) = 840

15-39
 Basket Wonders
APV Solution
Third, find the PV of the tax-shield benefits.
TSB Yr 1 ($5,040)(.901) = $4,541
TSB Yr 2 ( 4,200)(.812) = 3,410
TSB Yr 3 ( 3,360)(.731) = 2,456
TSB Yr 4 ( 2,520)(.659) = 1,661
TSB Yr 5 ( 1,680)(.593) = 996
TSB Yr 6 ( 840)(.535) = 449
PV = $13,513
15-40
 Basket Wonders
NPV Solution

What is the APV?

APV = NPV + PV of TS - Flotation Cost

APV = -$1,946 + $13,513 - $10,000
APV = $1,567

15-41