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Required Return and the Cost of Capital

Required Return and the Cost of Capital. Creation of value.

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Required Return and the Cost of Capital

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  1. Required Return and the Cost of Capital

  2. Creation of value If the return on a project exceeds what the financial markets require, it is said to ear an excess return. This excess return, as we define it, represents the creation of value. Simply put, the project earns more than its economic keep. Finding and undertaking these value-creating projects increases a company’s common stock share price.

  3. Industry Attractiveness 1.Growth phase of product cycle 2.Barriers to competitive entry 3.Other protective devices---e.g patents, temporary monopoly power, oligopoly price Competitive Advantage 1.Cost 2.Marketing and price 3.Perceived quality 4.Superior organizational capability Creation of Value

  4. Over Cost of Capital of the Firm A company can be viewed as a collection of projects. As a result, the use of an overall cost of capital as the acceptance criterion fro investment decisions is appropriate only under certain circumstances. These circumstances are that the current projects of the firm are of similar risk and that investment proposals under consideration are of the same character.

  5. Over Cost of Capital of the Firm If investment proposals vary widely with respect to risk, the required rate of return for the company as a whole is not appropriate as the sole acceptance criterion.

  6. Over Cost of Capital of the Firm • Cost of Debt 15.1

  7. Over Cost of Capital of the Firm • Because interest charges are tax deductible to the issuer, the after-tax cost of debt is substantially less than the before-tax cost. • If the before-tax cost, was found to be 11 percent and the marginal tax rate was 40 percent, the after-cost of debt would be 6.6 percent.

  8. Over Cost of Capital of the Firm • Cost of Preferred Stock

  9. Cost of Equity: Dividend Discount Model Approach Cost of Equity: CAPM Approach Over Cost of Capital of the Firm

  10. Beta Beta is a measure of the responsiveness of the excess returns for a security (in excess of the risk-free rate) to those of the market, using some broad-based index, such as the S&P 500 Index as a surrogate for the market portfolio.

  11. Over Cost of Capital of the Firm • Cost of Equity: Before –Tax Cost of Debt Plus Risk Premium Approach Cost of equity=Before-tax cost of debt+ Risk premium in expected return for stock over debt

  12. Over Cost of Capital of the Firm • Weighted Average Cost of Capital In calculating proportions, it is important that we use market value as opposed to book value weights.

  13. EVA Another way of expecting the fact that to create value a company must earn returns on invested capital greater than its cost of capital is through the concept of Economic Value Added (EVA). EVA is the economic profit a company earns after all capital costs are deducted. It is a firm’s net operating profit after tax (NOPAT) minus a dollar-amount cost of capital charge for the capital employed.

  14. EVA • The method of calculating EVA includes a long list of possible adjustments to the accounting figures. • EVA’s strength comes from its explicit recognition that a firm is not really creating shareholder value until it is able to cover all of its capital costs. Accounting profit calculations explicitly consider debt financing charges but exclude the costs related to equity financing .

  15. EVA • Economic profit, and hence EVA, differs from accounting profit in that it includes a charge for all the company’s capital-both debt and equity.

  16. The CAPM: Project-specific and Group-specific Required Rates of Return • CAPM Approach to Project Selection All projects with internal rate of return lying on or above the security market line should be accepted, because they are expected to provide returns greater than or equal to their respective returns. All projects lying below the line will be rejected. The goal of the firm, in this context, is to search for investment opportunities lying above the line.

  17. The CAPM: Project-specific and Group-specific Required Rates of Return 1.Application of the model-the use of proxy companies Estimating the beta for a project in applying the CAPM approach to project selection: Identify a company or companies with systematic risk characteristics similar to those of the project in question

  18. The CAPM: Project-specific and Group-specific Required Rates of Return 2.Finding Proxy Companies The search for the companies of a similar nature to the project in question is usually industry based. One option is to turn to the North American Industry Classification System (NAICS).

  19. The CAPM: Project-specific and Group-specific Required Rates of Return • Group-Specific Required Return Companies categorize projects into roughly risk-equivalent groups and then apply the same CAPM-determined required return to all projects included within that group. Advantage: It is not time-consuming It is easier to find proxy companies

  20. The CAPM: Project-specific and Group-specific Required Rates of Return The greater the systematic risk of the group, the greater its required return. The “group-specific required return approach” to protect selection is illustrated as below: Projects from a group that provide expected returns above their group-specific required return should be accetped.

  21. The CAPM: Project-specific and Group-specific Required Rates of Return • Some Qualifications Certain problems in the application of the CAPM approach: 1)The proportion of non-equity financing allocated to a project should not be out of line with that for the proxy company being used. If not be the same, the proxy company’s beta should be adjusted. 2)CAPM model assumes that only systematic risk of the firm is important. However the probability of a firm being insolvent depends on its total risk. So, estimating the impact of a new project on both systematic and total risk.

  22. Evaluation of Projects on the Basis of Their Total Risk • Risk-Adjusted Discounted Rate Approach RADR approach allows for 1)Adjusting the required return upwardfrom the firm’s overall cost of capital for projects or groups showing greater than “average” risk and 2)…downward…less The project- or group-specific required return then becomes the risk-adjusted discount rate.

  23. Evaluation of Projects on the Basis of Their Total Risk • Probability Distribution Approach For risky investments, the expected net present value would have to exceed zero. How much it would have to exceed before acceptance were warranted depends on the amount of dispersion of the probability distribution and utility preference of management with respect to risk.

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