Chapter 15 · Van Horne, 13th Ed.

Required Returns & the Cost of Capital

Quick MBA study notes — read in 10 minutes

1The Big Idea

Cost of capital is the minimum return a project must earn to keep lenders, preferred holders, and shareholders as well-off as their next best alternative.

💡

Key Concept Beat the cost of capital → value is created. Miss it → value is destroyed, even if the project looks "profitable" on paper.

Analogy: if your savings account pays 6%, any investment you make must beat 6% — otherwise you're worse off putting money there.

2Where Value Comes From

A project earns excess returns (creates value) because of two things:

Industry attractiveness — growth phase, barriers to entry, pricing power
Competitive advantage — cost, brand, or organizational edge within the industry

💡

Key Concept This is Porter's strategy framework feeding directly into a finance number — strategy and finance are two halves of the same story.

3The Three Component Costs

Source	Formula	Example
Debt (k_i)	k_d(1−t)	11% YTM, 40% tax → 6.6%
Preferred (k_p)	D_p / P₀	$5 ÷ $49 → 10.2%
Equity — DDM	D₁/P₀ + g	$2/$27 + 8% → 15.4%
Equity — CAPM	R_f+(R̄_m−R_f)β	7%+(4%)(1.2) → 11.8%

💡

Key Concept Debt is cheapest because interest is tax-deductible (the "tax shield"). Preferred and equity dividends are paid after tax — no such discount.

💡

Sanity Check k_e should always be greater than k_d — equity holders take more risk than lenders. If your math says otherwise, recheck it.

4WACC — Putting It Together

WACC = k_i·W_i + k_p·W_p + k_e·W_e

Example

Debt 6.6%×30% + Preferred 10.2%×10% + Equity 14%×60% = 11.4% WACC

💡

Key Concept Always use market value weights, not book value — that's what shareholders actually have at stake today.

5When One WACC Isn't Enough

A single WACC is only valid if new projects match the firm's existing risk and financing mix.

For multi-division firms (e.g., FMCG + fintech), one WACC over-accepts risky projects and under-accepts safe ones.

R_k = R_f + (R̄_m − R_f)β_k

💡

Key Concept Fix: use a proxy company's beta to build a project- or division-specific required return instead of one company-wide number.

6Economic Value Added (EVA)

EVA = NOPAT − (Capital Employed × WACC)

Example — Infosys FY07

₹34,910m NOPAT − ₹13,690m capital charge = ₹21,220m EVA

💡

Key Concept Accounting profit ignores the cost of equity. A firm can report a profit and still be destroying shareholder value — EVA is the fix.

7Formula Cheat-Sheet

Concept	Formula
After-tax cost of debt	k_i = k_d(1−t)
Cost of preferred	k_p = D_p/P₀
Cost of equity (DDM)	k_e = D₁/P₀ + g
Cost of equity (CAPM)	k_e = R_f+(R̄_m−R_f)β
WACC	Σ k_x·W_x
EVA	NOPAT − (Capital×WACC)

💡

Cost of capital is the hurdle rate that keeps every investor whole — anything earned above it is real value creation.