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Creation of Value
Overall Cost of Capital of the Firm
15-2
Cost
Perceived quality
15-3
Competitive Advantage
15-5
Cost of Debt
Cost of Debt is the required rate of return on investment of the lenders of a company.
P0 = S
j =1
Ij + Pj (1 + kd)j
ki = kd ( 1 - T )
15-6
15-7
ki
15-8
= 6%
kP = DP / P0
15-9
kP = $6.30 / $70 kP = 9%
15-10
Discount Model
Pricing
Capital-Asset
Model
Before-Tax
15-11
ke
= ( D 1 / P0 ) + g
ke
15-14
ke
D0(1+g1)t
t=1
(1+ke)t
Db(1+g3)t-b
S
t=a+1
Da(1+g2)t-a
(1+ke)t
(1+ke)t
ke = Rf + (Rm - Rf)bj
= 4% + (11.2% - 4%)1.25
15-17
ke = 4% + 9% = 13%
ke = kd + Risk Premium
= 10% + 3%
ke = 13%
15-19
S
x=1
kx(Wx)
15-22
b.
15-23
A measure of business performance. It is another way of measuring that firms are earning returns on their invested capital that exceed their cost of capital. Specific measure developed by Stern Stewart and Company in late 1980s.
15-24
Since a cost is charged for equity capital also, a positive EVA generally indicates shareholder value is being created.
15-25
Initially assume all-equity financing. Determine project beta. Calculate the expected return. Adjust for capital structure of firm. Compare cost to IRR of project.
Plot
the Characteristic Line relationship between the market portfolio and the proxy asset excess returns.
beta and create the SML.
Estimate
15-29
SML
X
O
X
O
O Reject
Rf
O
SYSTEMATIC RISK (Beta)
15-30
15-31
Compare
project.
15-34
15-35
Amount of non-equity financing relative to the proxy firm. Adjust project beta if necessary.
Standard problems in the use of CAPM. Potential insolvency is a total-risk problem rather than just systematic risk (CAPM).
15-36
Firm-Portfolio Approach
EXPECTED VALUE OF NPV C
Indifference Curves
B
A Curves show HIGH Risk Aversion STANDARD DEVIATION
15-39
Firm-Portfolio Approach
EXPECTED VALUE OF NPV C
Indifference Curves
B
A Curves show MODERATE Risk Aversion STANDARD DEVIATION
15-40
Firm-Portfolio Approach
EXPECTED VALUE OF NPV C Indifference Curves
B
A Curves show LOW Risk Aversion STANDARD DEVIATION
15-41
APV =
15-43
15-44
APV = $1,567
15-49