1、Chapter 15Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan1Chapter ObjectiveslEstimate values for the costs of debt and preference shares.lCalculate the WACC.lApply the dividend growth model approach and the SML appro
2、ach to determine the cost of equity.lDiscuss alternative approaches to estimating a required rate.lDiscuss the effects of flotation costs on WACC and the NPV of a project.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaol
3、an2The Cost of CapitallVocabulary-the following all mean the same thing:required returnappropriate discount ratecost of capitallCost 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 retur
4、n(costs).Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan3The Cost of CapitallWhen we say a firm has a“cost of capital”of,for example,12%,we are saying:The firm can only have a positive NPV on a project it return exce
5、eds 12%.The firm must earn 12%just to compensate investors for the use of their capital in a project.The use of capital in a project must earn 12%or more,not that it will necessarily cost 12%to borrow funds for the project.lThus cost of capital depends primarily on the USE of funds,not the SOURCE of
6、 funds.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan4l The assumption is made that firms capital structure is fixed-a firms cost of capital then reflects both cost of debt and cost of equity.Type of Financing Mkt V
7、alWeightLong-Term Debt$35M 35%Preferred Stock$15M 15%Common Stock Equity$50M 50%$100M 100%Market Value of Long-Term FinancingCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan5Cost of DebtlCost of Debt is the required r
8、ate of return on investment of the lenders of a company.012nMIIIP)1(1)1()1()1(1kkIkMkIkMPnnniin-=+-+=+=Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan6l Subtract Taxes from the interest of the bond and recalculate yi
9、eld figures.A B Invest.Invest.10001000 10001000 EBIT 200 200 200200-IE 0 50-IE 0 50 EBT 200 150 50 EBT 200 150 50（1-33%1-33%）-Taxes-Taxes（T=33%T=33%）66 -49.5 66 -49.5 =16.5 =16.5万万 Net Income 134 100.5Net Income 134 100.5Adjustment to Cost of DebtInterest33.5 16.549.5Income taxCopyright 2001 Prentic
10、e-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan7Adjustment to Cost of Debt)1()1(1kI（1-T）kMPniin=+=lSubtract Taxes from the interest of the bond and recalculate yield figures.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Manag
11、ement,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan8Flotation CostslThe cost of implementing any financing decision must be incorporated into the cash flows of the project being evaluated.lOnly the incremental costs of financing should be included.Such as underwriting,legal,listing,a
12、nd printing fees.lSubtract Flotation Costs from the price of the security and recalculate yield figures.)1()1(1kI（1-T）kMP-Fniin=+=Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan9lCost of Preferred Stock is the requir
13、ed rate of return on investment of the preferred shareholders of the company.Cost of Preferred Stock012nDDDPP-F)1(1kDnii=+=kDCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan10 Example Assume that Basket Wonders(BW)has
14、 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%Determination of the Cost of Preferred StockCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepare
15、d by Wu Xiaolan11Cost of Equity ApproachesCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan12l The,ke,is the discount rate that equates the present value of all expected future dividends with the current market price o
16、f the stock.D1 D2 D(1+ke)1 (1+ke)2 (1+ke)+.+P0=Dividend Discount ModelCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan13lThe reduces the model to:ke=(D1/P0)+glAssumes that dividends will grow at the constant rate“g”fo
17、rever.“g”depends on historical average.Constant Growth ModelCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan14 Example Assume that Basket Wonders(BW)has common stock outstanding with a current market value of$64.80 pe
18、r 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)+.08 =.05+.08=or Determination of the Cost of Equity CapitalCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xi
19、aolan15 D0(1+g1)t Da(1+g2)t-a(1+ke)t (1+ke)tP0=lThe S S+S St=1at=a+1bt=b+1 Db(1+g3)t-b(1+ke)t+S SGrowth Phases ModelCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan16lThe cost of equity capital,ke,is equated to the re
20、quired rate of return in market equilibrium.The risk-return relationship is described by the Security Market Line(SML).ke =Rj=Rf+(Rm-Rf)bjCapital Asset Pricing ModelCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan17 E
21、xample 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 =4%+9%=Determination of the Cost of Equity(CAPM)Copyright 2001 Prentice-Hall,Inc.Fundamen
22、tals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan18lThe 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*M Risk premium is not the same as CAPM risk premiu
23、m.Before-Tax Cost of Debt Plus Risk PremiumCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan19 Example Assume that Basket Wonders(BW)typically adds a 3%premium to the before-tax cost of debt.?ke =kd+Risk Premium =10%+3
24、%=Determination of the Cost of Equity(kd+R.P.)Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan20WACClWeighted Average Cost of Capital(WACC)-The expected rate of return on a portfolio of all the firms securities.Compan
25、y cost of capital=Weighted average of debt and equity returns.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan21WACClThree Steps to Calculating Cost of Capital:1.Calculate the value of each security as a proportion of
26、 the firms market value.2.Determine the required rate of return on each security.3.Calculate a weighted average of these required returns.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan22Weighted Average Cost of Capi
27、tal(WACC)1kiwikwni=KwWACC；Ki The after-tax cost of the ith method of financing；Wi The weight given to the ith method of financing。Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan23lA measure of business performance.lI
28、t is another way of measuring that firms are earning returns on their invested capital that exceed their cost of capital.lSpecific measure developed by Stern Stewart&Company in late 1980s.lIt is a firms net operating profit after tax(NOPAT)minus a dollar-amount cost of capital charge for the capital
29、 employed.Economic Value AddedCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan24lSince a cost is charged for equity capital also,a positive EVA generally indicates shareholder value is being created.lBased on Economic
30、 NOT Accounting Profit.Economic Value AddedEVA=NOPAT Cost of Capital x Capital Employed =EBIT(1-T)KwCCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan25l Use of CAPM in Project SelectionInitially assume all-equity fina
31、ncing.Determine project beta.Calculate the expected return.Adjust for capital structure of firm.Compare cost to IRR of project.Determining Project-Specific Required Rates of ReturnCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by
32、 Wu Xiaolan26Difficulty in Determining the Expected ReturnlDetermining the SMLLocate 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.Copyright 2001 Prent
33、ice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan27Project Acceptance and/or RejectionSMLXXXXXXXOOOOOOOSYSTEMATIC RISK(Beta)EXPECTED RATE OF RETURNRfAcceptRejectCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by
34、 Van Horne and Wachowicz.Slides prepared by Wu Xiaolan28ExamplelSuppose the stock of Stansfield Enterprises,a publisher of PowerPoint presentations,has a beta of 2.5.The firm is 100-percent equity financed.lAssume a risk-free rate of 5-percent and a market risk premium of 10-percent.lWhat is the app
35、ropriate discount rate for an expansion of this firm?)(FMiFRRRR-+=%105.2%5+=R%30=RCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan29Example(continued)Suppose Stansfield Enterprises is evaluating the following non-mutu
36、ally exclusive projects.Each costs$100 and lasts one year.ProjectProject b bProjects Estimated Cash Flows Next YearIRRNPV at 30%A2.5$15050%$15.38B2.5$13030%$0C2.5$11010%-$15.38Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu
37、Xiaolan30Using the SML to Estimate the Risk-Adjusted Discount Rate for ProjectsAn all-equity firm should accept a project whose IRR exceeds the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.Project IRRFirms risk(beta)SML5%Good projectBad project30%2.5ABCCopy
38、right 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan311.Calculate the required return for Project k(all-equity financed).Rk=Rf+(Rm-Rf)bk2.Adjust for capital structure of the firm(financing weights).Weighted Average Required R
39、eturn=ki%of Debt+Rk%of Equity Determining Project-Specific Required Rate of ReturnCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan32 Example Assume a computer networking project is being considered with an IRR of 19%.
40、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 Rate of Return ExampleCopyright 2001 Prentice-Hall
41、,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan33?ke =Rf+(Rm-Rf)bj=4%+(11.2%-4%)1.5 =4%+10.8%=WACC=.30(6%)+.70(14.8%)=1.8%+10.36%=12.16%IRR =19%WACC=12.16%Do You Accept the Project?Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Mana
42、gement,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan34Determining Group-Specific Required Rates of ReturnlUse of CAPM in Project Selection:Initially assume all-equity financing.Determine group beta.Calculate the expected return.Adjust for capital structure of group.Compare cost to IR
43、R of group project.Copyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan35Comparing Group-Specific Required Rates of ReturnGroup-SpecificRequired ReturnsCompany Costof CapitalSystematic Risk(Beta)Expected Rate of ReturnCop
44、yright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan36lAmount of non-equity financing relative to the proxy firm.Adjust project beta if necessary.lStandard problems in the use of CAPM.Potential insolvency is a total-risk pro
45、blem rather than just systematic risk(CAPM).Qualifications to Using Group-Specific RatesCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan37lAdjusted Present Value(APV)is the sum of the discounted value of a projects op
46、erating cash flows plus the value of any tax-shield benefits of interest associated with the projects financing minus any flotation costs.Adjusted Present ValueAPV=UnleveredProject Value+Value ofProject FinancingCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne
47、and Wachowicz.Slides prepared by Wu Xiaolan38 Adjusted Present ValueAPV=NPV+NPVFlThe value of a project to the firm can be thought of as the value of the project to an unlevered firm(NPV)plus the present value of the financing side effects(NPVF):lThere are four side effects of financing:The Tax Subs
48、idy to DebtThe Costs of Issuing New SecuritiesThe Costs of Financial DistressSubsidies to Debt FinancingCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan39 Example Assume Basket Wonders is considering a new$425,000 aut
49、omated 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 ExampleCopy
50、right 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xiaolan40?What is the NPV?Basket Wonders NPV SolutionCopyright 2001 Prentice-Hall,Inc.Fundamentals of Financial Management,11/e by Van Horne and Wachowicz.Slides prepared by Wu Xia
