Slide Set-3

Cost of Capital

15.1 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 
Lets
Profit related
Revisit Ratios
 Operating Profit, Net Profit, ROE (RONW), ROCE (ROI)
 Efficiency Related
 Total Assets Turnover
 Liquidity Related
 Current Ratio
 Solvency Related
 Debt Ratio, Interest Coverage
 Market Realated
 Price-to-Earnigns, EPS, Div Yield

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

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

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

Cost of Debt is the required rate

of return on investment of the
lenders of a company.
n Ij + Pj
P0 = S (1 + k ) j
j=1 d

ki = kd ( 1 – T )
15.5 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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%.
$0 + $1,000
$385.54 =
(1 + kd)10

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

15.8 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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%
15.9 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Cost of Equity
Approaches
• Dividend Discount Model
• Capital-Asset Pricing Model

15.10 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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
(1 + ke) (1 + ke) 2 (1 + ke)

15.11 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
15.12 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 = ( D 1 / P0 ) + g
ke = ($3(1.08) / $64.80) + 0.08
ke = 0.05 + 0.08 = 0.13 or 13%
15.13 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 = S (1 + ke)t
+ S (1 + ke)t
+
t=1 t=a+1
 Db(1 + g3)t–b
S
t=b+1 (1 + ke)t
15.14 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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)bj
15.15 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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 11.4%
ke = Rf + (Rm – Rf)bj
= 4% + (11.4% – 4%)1.25
ke = 4% + 9.25% = 13.25%
15.16 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Determination of the
Cost of Equity (kd + R.P.)
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%
ke = 12.75%

15.17 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Comparison of the
Cost of Equity Methods
Constant Growth Model 13.00%
Capital Asset Pricing Model 13.25%
Cost of Debt + Risk Premium 12.75%
Generally, the three methods will not agree.
We must decide how to weight –
we will use an average of these three.

15.18 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 Weighted Average
Cost of Capital (WACC)
n
Cost of Capital = S kx(Wx)
x=1

WACC = 0.35(6%) + 0.15(9%) +

0.50(13%)
WACC = 0.021 + 0.0135 + 0.065
= 0.0995 or 9.95%
15.19 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 BREAK…

Class resumes at 1 pm

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

1. Weighting System
• Marginal Capital Costs

• Capital Raised in Different

Proportions than WACC

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

15.22 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
15.23 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.
 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.
• NOPAT – net operating profit after tax is a
company’s potential after-tax profit if it was all-
equity-financed or “unlevered.”
15.24 Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition. © Pearson Education Limited 2009. Created by Gregory Kuhlemeyer.