Chap15_2009-1 - Chapter 15 Required Returns and the Cost of...

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Chapter 15 Required Returns and the Cost of Capital
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Learning Objectives 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 cost of capital - cost of debt, cost of preferred stock, and cost of equity. Explain and use alternative models to determine the cost of equity, including the dividend discount approach, the capital-asset pricing model (CAPM) approach, and the before-tax cost of debt plus risk premium approach. Calculate the firm’s weighted average cost of capital (WACC) and understand its rationale, use, and limitations. Explain how the concept of Economic Value Added (EVA) is related to value creation and the firm’s cost of capital. Understand the capital-asset pricing model's role in computing project- specific and group-specific required rates of return.
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Creation of Value Overall Cost of Capital of the Firm Project-Specific Required Rates Group-Specific Required Rates Total Risk Evaluation Topics
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Growth phase of product cycle Barriers to competitive entry Other -- e.g., patents, temporary monopoly power, oligopoly pricing Cost Marketing Perceived quality Superior organizational capability Industry Attractiveness Competitive Advantage Key Sources of Value Creation
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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).
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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
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Cost of Debt is the required rate of return on investment of the lenders of a company. Cost of Debt n t t d t t k P I P 1 0 ) 1 ( k i = k d ( 1 - T ) P 0 = Current market price I t = Interest payment at t P t = Principal payment at t k i = After-tax cost of debt k d = Before-tax cost of debt T = Marginal tax rate
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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%. Cost of Debt: Example $385.54 = $0 + $1,000 (1 + k d ) 10
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(1 + k d ) 10 = $1,000 / $385.54 = 2.5938 (1 + k d ) = (2.5938) (1/10) = 1.1 k d = .1 or 10% k i = 10% ( 1 - .40 ) k i = 6% Cost of Debt: Example Year Cash Flow 0 $ (385.54) 1 $ - 2 $ - 3 $ - 4 $ - 5 $ - 6 $ - 7 $ - 8 $ - 9 $ - 10 $ 1,000.00 irr= 10.00%
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is the required rate of return on investment of the preferred shareholders of the company. Cost of Preferred Stock
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This note was uploaded on 07/06/2009 for the course BUS BAM314 taught by Professor Na during the Spring '09 term at 東京大学.

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Chap15_2009-1 - Chapter 15 Required Returns and the Cost of...

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