Chapter 15
Required Returns
and the Cost of
Capital
15-1
© Pearson Education Limited 2004
Fundamentals of Financial Management, 12/e
Created by: Gregory A. Kuhlemeyer, Ph.D.
Carroll College, Waukesha, WI
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).
15-2
Market Value of
Long-Term Financing
15-3
Type of Financing
Mkt Val
Weight
Long-Term Debt
$ 35M
35%
Preferred Stock
$ 15M
15%
Common Stock Equity $ 50M
50%
$ 100M
100%
Cost of Debt
Cost of Debt is the required rate
of return on investment of the
lenders of a company.
n
P0 = S
j =1
Ij + Pj
(1 + kd)j
ki = kd ( 1 - T )
15-4
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%.
$385.54 =
15-5
$0 + $1,000
(1 + kd)10
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%
15-6
ki
= 10% ( 1 - .40 )
ki
= 6%
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
15-7
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%
15-8
Cost of Equity
Approaches
 Dividend
Discount Model
 Capital-Asset
Pricing
Model
 Before-Tax
Cost of Debt
plus Risk Premium
15-9
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
2
(1+ke) (1+ke)
(1+ke)
15-10
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.
15-11
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.
15-12
ke
= ( D 1 / P0 ) + g
ke
= ($3(1.08) / $64.80) + .08
ke
= .05 + .08 = .13 or 13%
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
15-13
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)bj
= 4% + (11.2% - 4%)1.25
15-14
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
15-15
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%
15-16
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.
15-17
Weighted Average
Cost of Capital (WACC)
n
Cost of Capital =
S
x=1
15-18
kx(Wx)
WACC
= .35(6%) + .15(9%) +
.50(13%)
WACC
= .021 + .0135 + .065
= .0995 or 9.95%
Limitations of the WACC
1. Weighting System
15-19

Marginal Capital Costs

Capital Raised in Different
Proportions than WACC
Limitations of the WACC
2. Flotation Costs are the costs
associated with issuing securities
such as underwriting, legal, listing,
and printing fees.
15-20
a.
Adjustment to Initial Outlay
b.
Adjustment to Discount Rate
Economic Value Added
15-21

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 Added
EVA = NOPAT – [Cost of
Capital x Capital Employed]
15-22

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 allequity-financed or “unlevered.”
Adjustment to
Initial Outlay (AIO)
Add Flotation Costs (FC) to the
Initial Cash Outlay (ICO).
n
CFt
- ( ICO + FC )
NPV = S
t
(1
+
k)
t=1
Impact: Reduces the NPV
15-23
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.
15-24