15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

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15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer. Chapter 15 Chapter 15 Required Required Returns and Returns and the Cost of the Cost of Capital Capital

Transcript of 15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson...

15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Chapter 15Chapter 15

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

CapitalCapital

15.2 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

1. Explain how a firm creates value and identify the key sources of value creation.

2. Define the overall “cost of capital” of the firm.

3. 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.

4. 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.

5. Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations.

6. Explain how the concept of economic Value added (EVA) is related to value creation and the firm’s cost of capital.

7. Understand the capital-asset pricing model's role in computing project-specific and group-specific required rates of return.

After Studying Chapter 15, After Studying Chapter 15, you should be able to:you should be able to:

15.3 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Creation of Value

• Overall Cost of Capital of the Firm

• Project-Specific Required Rates

• Group-Specific Required Rates

• Total Risk Evaluation

Required Returns and Required Returns and the Cost of Capitalthe Cost of Capital

15.4 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Growthphase ofproduct

cycle

Barriers tocompetitive

entry

Other --e.g., patents,

temporarymonopoly

power,oligopolypricing

Cost

Marketingand

price

Perceivedquality

Superiororganizational

capability

Industry AttractivenessIndustry Attractiveness

Competitive AdvantageCompetitive Advantage

Key Sources of Key Sources of Value CreationValue Creation

15.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

The cost of capital (COC) is the rate of return the firm must earn to maintain its market value and attract investors

projects with return > COC will improve the firm’s value

projects with return < COC will harm the firm’s value

15.6 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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).

Overall Cost of Overall Cost of Capital of the FirmCapital of the Firm

15.7 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

COC is estimated

on an after-tax basis

at a point in time

based on expected future values

holding business and financial risk fixed

15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

Target capital structure is the optimal mix of debt and equity financing for the firm

most firms seek to maintain a desired mix of debt and equity funding

each new chunk of capital should fit with the overall mix

15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

A firm is currently faced with an investment opportunity. Assume the following:

Because it can earn 7% on the investment of funds costing only 6%, the firm undertakes the opportunity.

15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

Imagine that one week later a new investment opportunity is available

In this instance, the firm rejects the opportunity, because the 14% financing cost is greater than the 12% expected return.

Is this action in the best interests of its owners?

15.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital No—it accepted a project yielding a 7%

return and rejected one with a 12% return. Is there a better way? Yes: the firm can use a combined cost,

which over the long run would provide for better decisions.

By weighting the cost of each source of financing by its target proportion in the firm’s capital structure, the firm can obtain a weighted average cost that reflects the interrelationship of financing decisions.

15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Capital

Assuming that a 50–50 mix of debt and equity is targeted, the weighted average cost in this example would be 10% [(0.50 x 6% debt) + (0.50 x 14% equity)].

This outcome is clearly more desirable. With this cost, the first opportunity would

have been rejected (7% IRR < 10% weighted average cost), and the second one would have been accepted (12% IRR > 10% weighted average cost).

15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Concept of Cost of CapitalWren Manufacturing is considering projects 263 and

264. The basic variables surrounding each project using the IRR decision technique and the resulting decision actions are summarised in the following table.

15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Concept of Cost of Capitala Evaluate the firm’s decision-making procedures, and

explain why the acceptance of project 263 and rejection of project 264 may not be in the owners’ best interest.

b If the firm maintains a capital structure containing 40% debt and 60% equity, find its weighted average cost using the data in the table.

c Had the firm used the weighted average cost calculated in part b, what actions would have been taken relative to projects 263 and 264?

d Compare and contrast the firm’s actions with your findings in part c. Which decision method seems more appropriate? Explain why.

15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Concept of Cost of Capital

a. The firm is basing its decision on the cost to finance a particular project rather than the firm’s combined cost of capital. This decision-making method may lead to erroneous accept/reject decisions.

b. ka = wiki + wpkp + wsks

ka = 0.40 (7%) + 0.60(16%)

ka = 2.8% + 9.6%

ka = 12.4%

15.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Concept of Cost of Capital

c. Reject project 263. Accept project 264.

d. Opposite conclusions were drawn using the two decision criteria. The overall cost of capital as a criterion provides better decisions because it takes into consideration the long run interrelationship of financing decisions

15.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Sources of finance• The four sources of long-term funds for the business firm:

• debt,

• preference share capital,

• ordinary share equity capital and

• retained earnings.

15.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Sources of financeThis is important!!

The specific cost of each source of financing is the after-tax cost of obtaining the financing today, i.e. the marginal cost of raising the next dollar of funding

It is not the historically based cost reflected by the existing financing in the firm’s accounting records

Only the cost of debt needs to be adjusted for tax.

Why do we not adjust the cost of preference shares and equity for tax?

Because dividends are paid from tax-paid profits. Therefore, the cost of these is an after-tax cost

15.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

15.20 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of DebtCost of Debt

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

• Where P0 = current market price• Pt = maturity value at time t

I = interest payment in $

• After tax cost is:ki = kd (1 – T)

15.21 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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%.

$385.54 =$0 + $1,000

(1 + kd)10

Determination of Determination of the Cost of Debtthe Cost of Debt

15.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

(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 )

kkii = 6%6%

Determination of Determination of the Cost of Debtthe Cost of Debt

15.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of debtDu Chen Corporation is selling $10 million of 20-year, 9%

coupon (stated annual interest rate) bonds, each with a face value of $1,000.

Similar-risk bonds earn returns greater than 9% so the firm must sell the bonds for $980 to compensate for the lower coupon interest rate.

The flotation costs paid to the investment banker are 2% of the face value of the bond (2% × 1000), or $20.

The net proceeds to the firm from the sale of each bond are therefore $960 ($980 – $20).

15.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of debt

• To solve this, we need a financial calculator or a spreadsheet. However there is a Yield to Maturity (YTM) formula that gives an good approximation answer:

• kd = [I + (1,000 – Nd)/n]/(Nd + 1000)/2• Where I = the interest payment in $• Nd = proceeds from the sale of the bond• n = number of periods until the bond

maturity.

15.25 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of debt

The cash flows are:

End of Year Cash flow

0 $960

1-20 -$90

20 -$1,000

Using the YTM formula, the answer is:

15.26 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of debt

15.27 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of debt

Assuming a 30% tax rate and before-tax cost of 9.4%,

ki = 0.094 x (1 – 0.30) = 6.6% = after-tax cost

The explicit cost of long-term debt is less than the explicit cost of other forms of long-term financing, because of the tax-deductibility of interest.

15.28 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Preferred StockCost of Preferred Stock

The cost of preference share capital (kp) is the ratio of the preference share dividend (Dp) to the firm’s net proceeds (Np) from the sale of preference shares

kp = Dp / Np

Example: consider an 8.5% pref issue, at par = $2.00 a share with an issue cost of 11 cents per share

kp = ($0.17) / ($1.89) = 9%

(Np = 2.00 – 0.11 = $1.89)

15.29 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Cost of Preferred StockCost of Preferred StockComparing the 9% cost of preference capital with the 6.6% cost of

long-term debt (bonds) shows that preference capital is more expensive. The difference exists primarily because the cost of the debt (interest) is tax-deductible.

The cost of preference share capital already issued is the dividend (Dp) divided by the market value (P) of preference share capital

kp = Dp / P

If the market value of Du Chen Corporation’s preference share capital is $10 million, and preference dividend payable is $0.9 million, the return on its preference share capital is:

kp = $0.90/$10.00 = 9.0%

15.30 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

15.31 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 Cost Determination of the Cost of Preferred Stockof Preferred Stock

15.32 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Dividend Discount ModelDividend Discount Model

• Capital-Asset Pricing ModelCapital-Asset Pricing Model

• Before-Tax Cost of Debt plus Before-Tax Cost of Debt plus Risk PremiumRisk Premium

Cost of Equity Cost of Equity ApproachesApproaches

15.33 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 =

Dividend Discount ModelDividend Discount Model

15.34 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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.

Constant Growth ModelConstant Growth Model

15.35 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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) + 0.08

kkee = 0.05 + 0.08 = 0.130.13 or 13%13%

Determination of the Cost of Determination of the Cost of Equity CapitalEquity Capital

15.36 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determination of the Cost Determination of the Cost of Equity Capitalof Equity Capital

• Calculate Du Chen Corporation’s cost of ordinary share equity capital, ke. The market price, P0, of its shares is $5. The firm expects to pay a dividend, D1, of 40 cents at the end of the coming year, 2005. The dividends paid over the past 6 years (1999–2004) were:

15.37 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determination of the Cost Determination of the Cost of Equity Capitalof Equity Capital

Calculate the growth rate of dividends:

1999 div/2004 div = 29.7/38.0 = 0.7816

= PVIFk,5 = 5%

Or

2004 div/1999 div = 38.0/29.7 = 1.2794

= FVIFk,5 = 5%

15.38 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Determination of the Cost Determination of the Cost of Equity Capitalof Equity Capital

Substituting D1 = $0.40, P0 = $5.00 and g = 5 per cent into the Equation results in the cost of ordinary equity:

ke = $0.40/$5.00 + 0.05

= 0.08 + 0.05

= 0.13 or 13%

15.39 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

D0(1 + g1)t Da(1 + g2)t–a

(1 + ke)t (1 + ke)tP0 =

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

(assume 3 growth phases):(assume 3 growth phases):

t=1

a

t=a+1

b

t=b+1

Db(1 + g3)t–b

+

Growth Phases ModelGrowth Phases Model

(1 + ke)t

15.40 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

Capital Asset Capital Asset Pricing ModelPricing Model

15.41 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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 11.4%

ke = Rf + (Rm – Rf)j

= 4% + (11.4% – 4%)1.25

kkee = 4% + 9.25% = 13.25%13.25%

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

15.42 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

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

15.43 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Assume that Basket Wonders (BW) typically adds a 2.75% premium to the

before-tax cost of debt.

ke = kd + Risk Premium

= 10% + 2.75%

kkee = 12.75%12.75%

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

15.44 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Constant Growth Model 13.00%13.00%

Capital Asset Pricing Model 13.25%13.25%

Cost of Debt + Risk Premium 12.75%12.75%

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

Generally, the three methods will not agree.We must decide how to weight –

we will use an average of these three.

15.45 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Weighted average cost of capital

The WACC (ka) is determined by weighting the cost of each specific type of capital by its proportion in the firm’s capital structure

ka = (ki x wi) + (kp x wp) + (ke x ws)

Note: (i) The sum of weights must equal one.

(ii) It is the after-tax cost of debt that is used.

15.46 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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%

n

x=1

BW’s Weighted Average BW’s Weighted Average Cost of Capital (WACC)Cost of Capital (WACC)

15.47 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Weighted average cost of capital

The costs of the various types of capital for Du Chen Corporation are:

Cost of debt, ki = 6.6%

Cost of preference capital, kp = 9.0%

Cost of new shares, ke = 14.0%

The company uses the following weights in calculating its WACC:

15.48 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Weighted average cost of capital

15.49 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Weighted average cost of capital

Source Weight Cost WACC

Debt 0.40 6.6% 2.6%

Pref capital 0.10 9.0 0.9

Ord equity 0.50 1 3.0 6.5

Totals 1.00 10.0%

The WACC for Du Chen is 10%.

Assuming an unchanged risk level, the firm should accept all projects that earn a return greater than or equal to 10%

15.50 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

1.1. Weighting SystemWeighting System

• Marginal Capital Costs

• Capital Raised in Different Proportions than WACC

Limitations of the WACCLimitations of the WACC

15.51 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

15.52 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• 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

15.53 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

15.54 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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

Impact: ReducesReduces the NPV

NPV = n

t=1

CFt

(1 + k)t– ( ICO + FC )

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

15.55 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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)

15.56 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• 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 Determining Project-Specific Required Rates of ReturnRequired Rates of Return

15.57 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Locate 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 Difficulty in Determining the Expected Returnthe Expected Return

15.58 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

SML

X

XX

X

XX

X

O O

O

O

O

O

O

SYSTEMATIC RISK (Beta)

EX

PE

CT

ED

RA

TE

OF

RE

TU

RN

Rf

Accept

Reject

Project Acceptance Project Acceptance and/or Rejectionand/or Rejection

15.59 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

1. Calculate the required return for Project k (all-equity financed).

Rk = Rf + (Rm – Rf)k

2. Adjust for capital structure of thefirm (financing weights).

Weighted Average Required Return

= [ki][% of Debt] + [Rk][% of Equity]

Determining Project-Specific Determining Project-Specific Required Rate of ReturnRequired Rate of Return

15.60 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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%.

Project-Specific Required Project-Specific Required Rate of ReturnRate of Return ExampleExample

15.61 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

ke = Rf + (Rm – Rf)j

= 4% + (11.2% – 4%)1.5

kkee = 4% + 10.8% = 14.8%14.8%

WACCWACC = 0.30(6%) + 0.70(14.8%)

= 1.8% + 10.36% = 12.16%12.16% IRRIRR= 19%19% > WACC WACC = 12.16%12.16%

Do You Accept the Project?Do You Accept the Project?

15.62 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• 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 Determining Group-Specific Required Rates of ReturnRequired Rates of Return

15.63 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Group-SpecificRequired Returns

Company Costof Capital

Systematic Risk (Beta)

Exp

ecte

d R

ate

of

Ret

urn

Comparing Group-Specific Comparing Group-Specific Required Rates of ReturnRequired Rates of Return

15.64 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

• Amount 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 Qualifications to Using Group-Specific RatesGroup-Specific Rates

15.65 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Risk–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 Project Evaluation Based on Total RiskBased on Total Risk

15.66 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Discount Rate (%)0 3 6 9 12 15

RADR – “high” risk at 15%

(Reject!)

RADR – “low” risk at 10%(Accept!)

Adjusting for risk correctlymay influence the ultimate

Project decision.

Net

Pre

sen

t V

alu

e

$000s15

10

5

0

–4

RADR and NPVRADR and NPV

15.67 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Probability 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 Project Evaluation Based on Total RiskBased on Total Risk

15.68 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B

C

A

IndifferenceCurves

STANDARD DEVIATION

EX

PE

CT

ED

VA

LU

E O

F N

PV

Curves show“HIGH”

Risk Aversion

Firm-Portfolio ApproachFirm-Portfolio Approach

15.69 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B

C

A

IndifferenceCurves

STANDARD DEVIATION

EX

PE

CT

ED

VA

LU

E O

F N

PV

Curves show“MODERATE”Risk Aversion

Firm-Portfolio ApproachFirm-Portfolio Approach

15.70 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

B

C

A

IndifferenceCurves

STANDARD DEVIATION

EX

PE

CT

ED

VA

LU

E O

F N

PV

Curves show“LOW”

Risk Aversion

Firm-Portfolio ApproachFirm-Portfolio Approach

15.71 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

jj = = juju [ 1 + ( [ 1 + (B/SB/S)(1 – )(1 – TTCC) ]) ]

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.

Adjusting Beta for Adjusting Beta for Financial LeverageFinancial Leverage

15.72 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Adjusted 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 of

Project Financing

Adjusted Present ValueAdjusted Present Value

15.73 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

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.

NPV and APV ExampleNPV and APV Example

15.74 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the NPVNPV to an all-equity- to an all-equity-financed firmfinanced firm?

NPV = $100,000[PVIFA11%,6] – $425,000

NPV = $423,054 – $425,000

NPVNPV = – $1,946– $1,946

Basket Wonders Basket Wonders NPV SolutionNPV Solution

15.75 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the APVAPV?

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

Basket Wonders Basket Wonders APV SolutionAPV Solution

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Second, calculate the tax-shield benefits.

TSB Yr 1 ($12,600)(40%) = $5,040

TSB 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%) = 840

Basket Wonders Basket Wonders APV SolutionAPV Solution

15.77 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

Third, 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 = $13,513PV = $13,513

Basket Wonders Basket Wonders APV SolutionAPV Solution

15.78 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.

What is the APVAPV?

APV = NPV + PV of TS – Flotation Cost

APV = –$1,946 + $13,513 – $10,000

APVAPV = $1,567$1,567

Basket Wonders Basket Wonders NPV SolutionNPV Solution