4-14-1

Business Finance(MGT 232)

Lecture 16

4-24-2

Required Return & Cost of Required Return & Cost of CapitalCapital

Required Return & Cost of Required Return & Cost of CapitalCapital

4-3

• Systematic and unsystematic risk• Beta and beta of a portfolio• Capital Asset pricing Model• Security market line and Intrinsic value

Overview of the Last Lecture

4-4

Required Returns and the Cost of Capital

Required Returns and the Cost of Capital

– Creation of Value– Overall Cost of Capital of the Firm– Cost of debt– Cost of Preferred Stock– Cost of Common Equity– WACC– Limitations of WACC

– Creation of Value– Overall Cost of Capital of the Firm– Cost of debt– Cost of Preferred Stock– Cost of Common Equity– WACC– Limitations of WACC

4-5

Key Sources of Value Creation

Key Sources of Value Creation

Cost

Marketingandprice

Perceivedquality

Superiororganizational

capability

Industry AttractivenessIndustry Attractiveness

Competitive AdvantageCompetitive Advantage

4-6

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).

4-7

Type of Financing Mkt Val WeightLong-Term Debt Rs. 35M 35%Preferred Stock Rs. 15M 15%Common Stock Equity Rs. 50M 50%

Rs. 100M 100%

Market Value of Long-Term Financing

4-8

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

ri = rd ( 1 - T )

Cost of Debt

4-9

Assume that Basket Wonders (BW) has Rs. 1,000 par value zero-coupon bonds

outstanding. BW bonds are currently trading at Rs. 385.54 with 10 years to maturity. BW

tax bracket is 40%.

Determination of the Cost of Debt

4-10

Determination of the Cost of Debt

4-11

Cost of Preferred Stock Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company.

rP = DP / Vp

Cost of Preferred Stock

4-12

Assume that Basket Wonders (BW) has preferred stock outstanding with par value of Rs. 100, dividend per share of Rs. 6.30, and a current market value of Rs. 70 per

share.

Determination of the Cost of Preferred Stock

4-13

• Dividend Discount ModelDividend Discount Model• Capital-Asset Pricing Capital-Asset Pricing

ModelModel• Before-Tax Cost of Debt plus Before-Tax Cost of Debt plus

Risk PremiumRisk Premium

Cost of Equity Approaches

4-14

Dividend Discount ModelDividend Discount Model

The cost of equity capitalcost of equity capital, re, 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 =

4-15

Constant Growth ModelConstant Growth Model

The constant dividend growth constant dividend growth assumptionassumption reduces the model to:

re = ( D1 / P0 ) + g

Assumes that dividends will grow at the constant rate “g” forever.

4-16

Assume that Basket Wonders (BW) has common stock outstanding with a current market value of Rs. 64.80 per share, current dividend of Rs. 3 per share, and a dividend growth rate of 8% forever.

Determination of the Cost of Equity Capital

4-17

Growth Phases ModelGrowth Phases Model

The growth phases assumption growth phases assumption leads to the following formula:leads to the following formula:

4-18

Capital Asset Pricing ModelCapital Asset Pricing Model

The cost of equity capital, re, is equated to the required rate of return in market

equilibrium. The risk-return relationship is described by the Security Market Line

(SML).

re = Rj = Rf + (Rm - Rf)j

4-19

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%

Determination of the Cost of Equity (CAPM)

4-20

Before-Tax Cost of Debt Plus Risk Premium

Before-Tax Cost of Debt Plus Risk Premium

The cost of equity capital, re, is the sum of the before-tax cost of debt and a risk

premium in expected return for common stock over debt.

re = Rd + Risk Premium*

* Risk premium is not the same as CAPM risk premium

4-21

Assume that Basket Wonders (BW) typically adds a 3% premium to the before-tax cost of

debt. re = rd + Risk Premium

= 10% + 3% rree = 13%13%

Determination of the Cost of Equity (kd + R.P.)

4-22

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 Cost of Equity Methods

4-23

Cost of Capital = kx(Wx)

Weighted Average Cost of Capital (WACC)

n

x=1

4-24

Summary

– Creation of Value– Overall Cost of Capital of the Firm• Cost of debt• Cost of Preferred Stock• Cost of Common Equity

– WACC– Limitations of WACC