1 / 24

Business Finance (MGT 232)

Learn about the required rate of return, overall cost of capital, and different types of financing in business finance. Explore methods for determining the cost of debt, preferred stock, and common equity. Discover the weighted average cost of capital (WACC) and its limitations.

annaalexander
Download Presentation

Business Finance (MGT 232)

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Business Finance(MGT 232) Lecture 16

  2. Required Return & Cost of Capital

  3. Overview of the Last Lecture • Systematic and unsystematic risk • Beta and beta of a portfolio • Capital Asset pricing Model • Security market line and Intrinsic value

  4. Required Returns and the Cost of Capital • Creation of Value • Overall Cost of Capital of the Firm • Cost of debt • Cost of Preferred Stock • Cost of Common Equity • WACC • Limitations of WACC

  5. Key Sources of Value Creation Industry Attractiveness Other -- e.g., patents, temporary monopoly power, oligopoly pricing Growth phase of product cycle Barriers to competitive entry Marketing and price Superior organizational capability Perceived quality Cost Competitive Advantage

  6. 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).

  7. Market Value of Long-Term Financing Type of FinancingMkt ValWeight Long-Term Debt Rs. 35M 35% Preferred Stock Rs. 15M 15% Common Stock Equity Rs. 50M 50% Rs. 100M 100%

  8. Cost of Debt Cost of Debtis the required rate of return on investment of the lenders of a company kite. ri= rd( 1 - T )

  9. Determination of the Cost of Debt Assume that Basket Wonders (BW) has Rs. 1,000 par value zero-coupon bonds outstanding. BW bonds are currently trading at Rs. 385.54 with 10 years to maturity. BW tax bracket is 40%.

  10. Determination of the Cost of Debt

  11. Cost of Preferred Stock Cost of Preferred Stock is the required rate of return on investment of the preferred shareholders of the company. rP= DP / Vp

  12. Determination of the Cost of Preferred Stock Assume that Basket Wonders (BW) has preferred stock outstanding with par value of Rs. 100, dividend per share of Rs. 6.30, and a current market value of Rs. 70 per share.

  13. Cost of Equity Approaches • Dividend Discount Model • Capital-Asset Pricing Model • Before-Tax Cost of Debt plus Risk Premium

  14. Thecost of equity capital, re, is the discount rate that equates the present value of all expected future dividends with the current market price of the stock. Dividend Discount Model D1D2D ¥ P0 = + + . . . + ¥ • (1+ke)1 (1+ke)2 (1+ke)

  15. Theconstant dividend growth assumption reduces the model to: re= ( D1 / P0 ) + g Assumes that dividends will grow at the constant rate “g” forever. Constant Growth Model

  16. Determination of the Cost of Equity Capital Assume that Basket Wonders (BW) has common stock outstanding with a current market value of Rs. 64.80 per share, current dividend of Rs. 3 per share, and a dividend growth rate of 8% forever.

  17. Growth Phases Model • The growth phases assumption leads to the following formula:

  18. The cost of equity capital, re, is equated to the required rate of return in market equilibrium. The risk-return relationship is described by the Security Market Line (SML). re = Rj = Rf + (Rm - Rf)bj Capital Asset Pricing Model

  19. 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%

  20. The cost of equity capital, re, is the sum of the before-tax cost of debt and a risk premium in expected return for common stock over debt. re = Rd + Risk Premium* * Risk premium is not the same as CAPM risk premium Before-Tax Cost of Debt Plus Risk Premium

  21. 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. re = rd+ Risk Premium = 10% + 3% re = 13%

  22. 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.

  23. Weighted Average Cost of Capital (WACC) Cost of Capital = kx(Wx) n S x=1

  24. Summary • Creation of Value • Overall Cost of Capital of the Firm • Cost of debt • Cost of Preferred Stock • Cost of Common Equity • WACC • Limitations of WACC

More Related