© Prentice Hall, Chapter 10 Establishing Required Rates of Return Shapiro and Balbirer: Modern Corporate Finance: A Multidisciplinary Approach to Value Creation Graphics by Peeradej Supmonchai

© Prentice Hall, Learning Objectives è Describe the relationship between risk and the cost of capital for a project. è Explain the relationship between the weighted average cost of capital (WACC), the expected return on the project, and the expected return on the equity-financed portion of the project. è Calculate the weighted average cost of capital for a company. è Calculate the risk-adjusted required rate of return for a project or a division of a firm using the pure-play technique.

© Prentice Hall, Learning Objectives (Cont.) è Identify and avoid the common errors that are made in using the CAPM to estimate risk- adjusted costs of capital. è Value a leveraged buyout (LBO) using the adjusted net present value (APV) approach. è Compare and contrast the weighted average cost of capital, adjusted net present value, and equity residual approaches to capital budgeting. è Identify the circumstances under which the cost of capital for foreign investments should be higher, lower, or the same as comparable domestic projects.

© Prentice Hall, Components of a Project’s Required Rate of Return è Real risk-free interest rate è Inflation premium è Risk premium

© Prentice Hall, Project’s Cost of Capital è The cost of capital (WACC) is a weighted average after-tax cost of various sources of capital that will be used to finance the project. è If the project’s expected return (IRR) exceeds the WACC, then the expected return on the equity-financed portion will exceed the required rate of return on equity.

© Prentice Hall, Project’s Cost of Capital Where: k d * = the after-tax cost of debt k p = the cost of preferred stock k e = the cost of common stock w d, w p, w e = the proportions of debt, preferred, and common stock that will be used to finance accepted project

© Prentice Hall, Wingler Iron Works - An Example Wingler Iron Works is considering a $1 million expansion project that will be financed with half long-term debt and half common stock. The after-tax cost of newly issued debt is 6%, while Wingler shareholders are assumed to have a required return of 15% on projects of equivalent risk.

© Prentice Hall, Calculating the WACC for the Wingler Project WACC = 6% (0.50) + 15% (0.50) = 10.5%

© Prentice Hall, Wingler Iron Works: Project Returns and Returns to Equity EXPECTED PROJECT RETURNS 9.0% 10.5% 13.0% EXPECTED ANNUAL CASH FLOWS $90,000 $105,000 $130,000 ANNUAL INTEREST EXPENSE (30,000) (30,000) (30,000) EQUITY CASH FLOWS $60,000 $75,000 $100,000 RETURN ON EQUITY-FINANCED PORTION 12.0% 15.0% 20.0%

© Prentice Hall, The Cost of Equity Capital The cost of equity capital is the required rate of return on common stock and, as such, represents the minimum acceptable rate of return on the equity-financed portion of new projects.

© Prentice Hall, Estimating the Cost of Equity: The Constant Dividend Growth Model Where: k e = the cost of equity D 1 =the expected dividend in year 1 P 0 =the current stock price g =the expected compound annual dividend growth rate

© Prentice Hall, Using the Constant Dividend Growth Model - Du Pont Du Pont’s dividends grew at a 14.5% compound annual rate from The company paid dividends of $1.23 a share in 1997, and the stock price was $6006 a share at year end.

© Prentice Hall, Using the Constant Dividend Growth Model - Du Pont

© Prentice Hall, Limitations of the Constant Dividend Growth Model è Inappropriate for those firms that either pay no dividends or have erratic dividend payments. è Past dividend growth rates may not be a good predictor of future dividends.

© Prentice Hall, Estimating the Cost of Equity - The CAPM Where: k e = the cost of equity r f =the risk free rate  i =the beta for the firm’s common stock r m - r f =the market risk premium

© Prentice Hall, Using the CAPM - Du Pont The 30-year Treasury bond rate in January 1998 was 6.0%. Du Pont’s beta is 1.10, and the market risk premium is 7.8%.

© Prentice Hall, Using the CAPM - Du Pont

© Prentice Hall, Cost of Debt Where: k D = the yield to maturity on new debt sold  = the firm’s tax rate

© Prentice Hall, Estimating Du Pont’s Cost of Debt Du Pont has a callable bond maturing in 2002 with a coupon rate of 8.25%. On December 31, 1997, the bond was selling at $ per $100 of face making the yield to maturity on this issue 7.50%. The after-tax cost = 7.50(1-0.35) = 4.88%

© Prentice Hall, Cost of Preferred Stock Where: D P = the preferred stock dividend (per share) P P = the price per share of the proposed stock issue

© Prentice Hall, Estimating Du Pont’s Cost of Preferred Stock Du Pont has a preferred stock issue paying a dividend of $4.50 a share. The issue sold for $83.50 a share on December 31, 1997.

© Prentice Hall, Estimating Du Pont’s Cost of Preferred Stock

© Prentice Hall, Estimating Du Pont’s WACC (1) X (2) = (3) Component Weighted Source Cost Proportion Cost Debt 4.88 % % Preferred Stock Common Stock WACC = %

© Prentice Hall, Flotation Costs Where: k = the component cost without considering flotation costs F =the flotation cost as a proportion of gross proceeds

© Prentice Hall, The Firm’s WACC and Project Risk è Firm’s WACC can only be applied to “average” risk projects. è WACC should be updated periodically to reflect changes in capital market conditions. è The calculated WACC is only an estimate of the “true” cost of capital for a firm. Treating it as a “hard” number is inappropriate.

© Prentice Hall, The Firm’s WACC and Project Risk Since project returns typically increase with risk, using the firm’s overall WACC as a hurdle rate for all projects will lead to the rejection of low-risk projects and the acceptance of high-risk projects. Therefore, the firm’s overall risk may increase.

© Prentice Hall, The Pure-Play Technique The pure-play technique attempts to estimate risk-adjusted required returns by matching the risk of the division or project in question to some publicly traded company in the same line of business. Once the “pure plays” are identified, their market data is used to calculated required returns.

© Prentice Hall, Steps in the Pure-Play Techniqure è Identify pure-play firms è Determine betas for pure plays è Adjust for leverage è Releverage asset betas è Calculate the project’s or division’s cost of equity è Calculate the project’s or division’s required rate of return

© Prentice Hall, Applying the Pure-Play Technique - Time Warner’s Cable Division Pure-Play Equity or Debt To Debt To Firm Market Beta Market Capital Market Equity Cablevision Systems % 214.5% Century Comcast Jones Intercable TCI Group

© Prentice Hall, Adjusting for Leverage The published betas for pure plays reflect their financing mix. Since these debt ratios differ from the firm’s target capital structure, the pure-play technique calls for converting these betas into their unleveraged, or asset, values using the following equation:  U   L /  1  (1   ) D/E 

© Prentice Hall, Adjusting for Leverage - Time Warner’s Cable Division Pure-Play Equity or Debt To Debt To Asset or Firm Market Beta Capital Equity Unlevered Beta Cablevision Systems % 214.5% Century Comcast Jones Intercable TCI Group Average Asset Beta = 0.586

© Prentice Hall, Releveraging Asset Betas The average beta obtained from unleveraging represents that of a firm that uses no debt and has the same business risk as the project or division. We releverage the beta to reflect the firm’s target financing mix as follows:  L *   U  1  (1   *)(D/E)* 

© Prentice Hall, Releveraging Asset Betas - Time Warner’s Cable Division

© Prentice Hall, Calculating the Cost of Equity - Time Warner’s Cable Division

© Prentice Hall, Calculating the WACC - Time Warner’s Cable Division

© Prentice Hall, Common Errors in Calculating the WACC Using the CAPM è Using different capital structure assumptions in computing the cost of equity than are used in calculating the WACC. è Using a different maturity for the risk-free rate in the CAPM than the one used in calculating the market risk premium. è Estimating the market risk premium based on the most recent returns rather than a long-term time series. è Using a negative market risk premium.

© Prentice Hall, Common Errors in Calculating the WACC Using the CAPM (Cont.) è Using the historical average T-bond or T- bill rate instead of the current rate. è Failing to releverage asset betas. è Failing to include taxes in unleveraging and leveraging betas. è Using the historical market return instead of the market risk premium.

© Prentice Hall, Adjusted Net Present Value (APV) An approach to value a project as if it were financed entirely by debt and then adding to this the present value of the tax shields provided by debt financing.

© Prentice Hall, APV Approach - Trifecta Products The managers of Trifecta Products have the opportunity to buy the firm for $30 million. Trifecta is a profitable debt-free business that generates $5 million in cash a year. These cash flows are expected to grow at 3% a year. The managers will provide $2 million of the financing; the additional $28 million will come from an insurance loan carrying a 10% interest rate.

© Prentice Hall, Valuing Trifecta Products If the all-equity cost of capital is 17 %, the NPV of the firm on an all-equity basis would be: $5 million (1.03) NPV = -$30 million +  ( ) = $6,785,714

© Prentice Hall, Valuing Trifecta Products Beginning DebtInterestInterest TaxPresent value* of YearoutstandingShield*Tax 1$28,000**$2,800$980$ ,200 2, ,400 2, ,600 1, ,800 1, ,000 1, ,200 1, , , , $3,779 *Equal to interest times on assumed tax rate of 35 percent ** All figures in thousand $

© Prentice Hall, Valuing Trifecta Products

© Prentice Hall, Capital Budgeting Methods è Weighted Average Cost of Capital (WACC) Approach è Adjusted Present Value (APV) Method è Equity Residual (ER) Method

© Prentice Hall, Weighted Average Cost of Capital Approach Where: k 0 = the discount rate CF t =the project cash flow ignoring debt servicing charges

© Prentice Hall, Adjusted Net Present Value (APV) Method Where: k* = All-equity cost of capital

© Prentice Hall, Equity Residual (ER) Method Where: k e =the levered cost of equity capital LCF t =CF t - debt servicing charges Initial Investment = I 0 - debt (D) used to finance the project

© Prentice Hall, International Dimension of Cost of Capital è Multinational companies can reduce their earnings variability through international diversification. è Because of their low correlation with Western economies, investments in LDCs may provide the greatest diversification benefits. è The systematic risk, and hence required returns, on foreign project is unlikely to be higher than comparable domestic projects.