Business Finance (MGT 232) Lecture 16

Required Return & Cost of Capital

Overview of the Last Lecture Systematic and unsystematic risk Beta and beta of a portfolio Capital Asset pricing Model Security market line and Intrinsic value

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

Key Sources of Value Creation Industry Attractiveness Other -- e.g., patents, temporary monopoly power, oligopoly pricing Growth phase of product cycle Barriers to competitive entry Marketing and price Superior organizational capability Perceived quality Cost 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).

Market Value of Long-Term Financing Type of Financing Mkt Val Weight Long-Term Debt Rs. 35M 35% Preferred Stock Rs. 15M 15% Common Stock Equity Rs. 50M 50% Rs. 100M 100%

Cost of Debt Cost of Debt is the required rate of return on investment of the lenders of a company kite. ri = rd ( 1 - T )

Determination of the Cost of Debt 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

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

Determination of the Cost of Preferred Stock 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.

Cost of Equity Approaches Dividend Discount Model Capital-Asset Pricing Model Before-Tax Cost of Debt plus Risk Premium

Dividend Discount Model The cost 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 ¥ P0 = + + . . . + ¥ (1+ke)1 (1+ke)2 (1+ke)

Constant Growth Model The constant dividend growth assumption reduces the model to: re = ( D1 / P0 ) + g Assumes that dividends will grow at the constant rate “g” forever.

Determination of the Cost of Equity Capital 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.

The growth phases assumption leads to the following formula: Growth Phases Model The growth phases assumption leads to the following formula:

Capital 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)bj

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%

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

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. re = rd + Risk Premium = 10% + 3% re = 13%

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.

Weighted Average Cost of Capital (WACC) n S Cost of Capital = kx(Wx) x=1

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