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Lecture Fundamentals of financial management: Chapter 15 - Gregory A. Kuhlemeyer, Carroll College, Waukesha

Chapter 15 - Required returns and the cost of capital. After studying chapter 15, you should be able to: Explain how a firm creates value, and identify the key sources of value creation; define the overall “cost of capital” of the firm, calculate the costs of the individual components of a firm’s overall cost of capital: cost of debt, cost of preferred stock, and cost of equity;. | Chapter 15 Required Returns and the Cost of Capital © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Required Returns and the Cost of Capital Creation of Value Overall Cost of Capital of the Firm Project-Specific Required Rates Group-Specific Required Rates Total Risk Evaluation Key Sources of Value Creation Growth phase of product cycle Barriers to competitive entry Other -- e.g., patents, temporary monopoly power, oligopoly pricing Cost Marketing and price Perceived quality Superior organizational capability Industry Attractiveness Competitive Advantage 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). 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 Long-Term Financing Cost of Debt is the required rate of return on investment of the lenders of a company. ki = kd ( 1 - T ) Cost of Debt P0 = Ij + Pj (1 + kd)j S n j =1 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%. Determination of the Cost of Debt $385.54 = $0 + $1,000 (1 + kd)10 (1 + kd)10 = $1,000 / $385.54 = 2.5938 (1 + kd) = (2.5938) (1/10) = 1.1 kd = .1 or 10% ki = 10% ( 1 - .40 ) ki = 6% Determination of the Cost of Debt 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 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% Determination of the Cost of Preferred Stock Dividend Discount Model . | Chapter 15 Required Returns and the Cost of Capital © 2001 Prentice-Hall, Inc. Fundamentals of Financial Management, 11/e Created by: Gregory A. Kuhlemeyer, Ph.D. Carroll College, Waukesha, WI Required Returns and the Cost of Capital Creation of Value Overall Cost of Capital of the Firm Project-Specific Required Rates Group-Specific Required Rates Total Risk Evaluation Key Sources of Value Creation Growth phase of product cycle Barriers to competitive entry Other -- e.g., patents, temporary monopoly power, oligopoly pricing Cost Marketing and price Perceived quality Superior organizational capability Industry Attractiveness Competitive Advantage 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). Type of Financing Mkt Val Weight Long-Term Debt $ 35M 35% Preferred Stock $ 15M 15% Common Stock Equity $ 50M 50% $ 100M .