COST OF CAPITAL Compute the cost of debt. Compute the cost of preferred stock.


 Rolf Rice
 4 years ago
 Views:
Transcription
1 OBJECTIVE 1 Compute the cost of debt. The method of computing the yield to maturity for bonds will be used how to compute the cost of debt. Because interest payments are tax deductible, only aftertax costs are used. OBJECTIVE 2 Compute the cost of preferred stock. The preferred stock is priced using the formula for the value of perpetuity. The formula for finding the price of perpetuity is used to estimate the component cost of preferred stock. One important point to remember is that unlike bonds, preferred dividend payments are not tax deductible. Therefore, no adjustment is necessary to convert the cost of preferred to an aftertax basis.
2 OBJECTIVE 3 Compute the cost of equity. There are several different models discussed that can be used to compute the cost of equity financing. The reason for using multiple models is that the inputs to each model are uncertain. By combining the results, a better estimate of cost can be achieved. OBJECTIVE 3 Compute the weighted average cost of capital. Once all of the component costs are found, the weighted average cost of capital (WACC) is computed where the weights are the proportion of each source of capital in the firm's target capital structure. The WACC is men used as the discount rate in capital budgeting problems
3 Finding the Aftertax Cost of Debt The beforetax cost of longterm debt k d. Remember that k d is also called the yield to maturity on a bond (In most cases, firms accumulate longterm debt through borrowing in the form of bond issues with fixed coupon interest payments). Therefore, the cost of debt will be a function of the coupon payments required by the investors is these newly issued bonds.
4 A) BEFORETAX COST OF DEBT When the net proceeds from the sale of a bond are equal to its face value, the coupon interest rate can be used for the bond's beforetax cost. Also, when the yield to maturity (YTM) for other bonds of similar risk is available, the similar bond's YTM can be used for the firm's beforetax cost of longterm debt. This is termed a cost quotation. When the net proceeds from the sale of the bond differ from the face value of the bond, it is necessary to either calculate the cost or to approximate the cost. The calculation of the beforetax cost of debt for a bond involves finding the yield to maturity for the bond by either the trial and error approach, or by using a handheld business/financial calculator.
5 The equation used for approximating the beforetax cost of loafterm debt for a bond is the YTM approximation formula:
6 B) AFTERTAX COST OF DEBT As mentioned earlier, the cost of financing must be stated on an aftertax basis. The interest on debt is tax deductible, so it reduces the firm's taxable income by the amount of deductible interest. The equation used to find the aftertax cost of debt is demonstrated in the following formula: Where: K d = the before tax cost of debt T = corporate tax rate
7 Example: Velvet Corporation needs to issue new longterm debt in order to raise capital. Their existing longterm bonds have various coupons, but currently have a YTM of approximately 10%. Therefore Velvet believes they could issue new, 20year annualpay bonds with a 10% coupon. Velvet will incur a $20 flotation cost an each bond sold, meaning they will net only $980 per bond. Velvet has a corporate tax rate of 40%. What is the aftertax cost of debt for Velvet Corporation?
8 The first step in solving the problem is to find k d. the beforelax cost of debt. In this case the easiest approach is to plug the information into a financial calculator and solve for YTM. However, if you don't have access to a financial calculator, you can use the approximation formula,
9 Once you have obtained the beforetax cost of debt, k d, the next step is to convert it to the aftertax cost of debt. Since the interest on the debt is tax deductible. Velvet is only paying 6.14% for the debt and is receiving a 4.10% (10.24%6.14%) tax deduction for every dollar spent on interest expense.
10 Finding the Cost of Preferred Stock Preferred stock is a special form of ownership because its dividends must be distributed before any other dividends are paid to the common stockholders. Most preferred stock dividends are stated as a dollar amount but sometimes they are stated as a percentage of the stock's par value. In order to calculate the cost of preferred stock, it is necessary to convert the dividend of any preferred stock that is stated as a percentage into a dollar amount. Once the dividend is stated as a dollar amount, the cost of the preferred stock can be found by using the following equation: Where: kp = cost of preferred stock Dp = annual dollar dividend Np = net proceeds from the sale of me stock Preferred stock dividends are paid out of the firm's aftertax cash flows, so no tax adjustments are necessary.
11 Example: Velvet Corporation's outstanding preferred stock currently yields 11%. Velvet can issue new $100 par preferred with an 11% dividend, but will incur flotation costs of 5%. Find the cost of newly issued preferred stock.
12 Solution: COST OF CAPITAL
13 Finding the Cost of Equity Some people assume equity has no real cost. This seems logical because dividend payments are not required on common stock, and the firm is not required to pay them. However, it is important to remember that investors require compensation for the risks they take. Common stock, being riskier than either bonds or preferred stock, carries a higher required rates of return, in other words; investors require compensation in the form of dividends and/or capital gains which exceeds that of the firm's bondholders and preferred stockholders.
14 A) CAPM The Capital Asset Pricing Model (CAPM) can be used to estimate the cost of common stock equity. The CAPM describes the relationship between the required return, or the cost of common equity in this case, and the nondiversificable risk of the firm as measured by the beta coefficient, (S. The following equation. represents the basic CAPM; Where: Rf = riskfree rate of return, β= beta coefficient, k m = market required rate of return.
15 B) GORDON GROWTH MODEL The constant growth valuation model is presented in the following equation: Where: P o = value of common stock, D 1 = pershare dividend expected at the end of year 1, k s = required return on common stock, g = constant rate of growth in dividends.
16 To find the cost of common equity, simply solve the cost of equity (k e ), which is the same as the required rate of return on equity (k s ).
17 C) BOND YIELD PLUS RISK PREMIUM Another way to compute the cost of equity involves adding a risk premium to the firm's cost of debt. This method is quite intuitive since stockholders will always require a premium above the yield earned by the firm's bondholders, in order to compensate for the additional risk of owning equity. This method is specified in equation: Where: δ= the equity risk premium.
18 We now have three separate methods for finding the cost of equity, k e. The following example requires the utilization of all three methods. Work through it carefully to make sure you understand each one. Skiing Tours Inc. has a beta of 1.2. The riskfree rate is 10 percent, and the market risk premium (k m R f ) is 5 percent. Skiing Tours is a constant growth firm, which just paid a dividend of $2.04, and its common stock sells for $27. per share. The firm's beforetax cost of debt, k d, is 12% and their policy is to use a risk premium of 4 percentage points when using the bondyieldplusriskpremium method to find k e. Flotation costs on new common stock total 10 percent, and the firm is expected to grow at a constant 8% indefinitely. Find the cost of equity using all three methods.
19 Using the CAPM approach, the solution is as follows;
20 Using the constant growth model, the solution is as follows:
21 Finally, the bond yield plus risk premium approach would yield the following solution for k e.
22 The previous example was set up so that the cost of equity would be 16% in all three cases. In practice, however, the three estimates will usually be quite different. Then it is the responsibility of the analyst to decide whether to throw one or more of the estimates out, or whether to use some type of average value. Reconciling the estimates is totally at the discretion of the analyst, so it is important to have a good understanding of the problems associated with each method in order to arrive at the best possible estimate of k e.
23 D) RETAINED EARNINGS VERSUS NEW EQUITY The equity financing component of about eighty percent of all new projects comes from retained earnings. However, when retained earnings are used up, the firm must issue new common equity in order to maintain the same mix of debt, preferred stock and common equity in its capital structure. The cost of new common equity is always higher than the cost of retained earnings due to the costs associated with issuing the new stock (flotation costs). The Gordon Growth Model is used to calculate the cost of new equity, with the flotation costs being factored into the price of the stock in the numerator of the equation.
24 The process is illustrated in the following example. Assume Siding Tours Inc. (from the previous example) has flotation costs of $2.00 per share for the issuance of new common equity. What is the cost of this new equity, and haw does this compare with the cost of retained earnings?
25 To solve this problem, let's first recalculate the cost of retained earnings, using the original data.
26 Now we can factor flotation costs into the denominator of the equation and solve for the cost of new common equity. The price of the common stock in the denominator of the equation is now the net proceeds received by the firm from the issuance.
27 Note that the flotation costs associated with the issuance of new equity drove k e from 16% to 16.8%.
28 Finding the Weighted Average Cost of Capital The weighted average cost of capital aftertax (WACC) is found by weighting the cost of each specific type of capital in the firm's capital structure to find the average cost of funds over the long run. To determine the WACC, simply add the total dollar amount of all capital in a firm's capital structure and divide each individual capital component by the total to find its proportion.
29 Velvet Corporation has the following capital structure, as determined from the company's balance sheet: Determine each component's weight for use in the WACC.
30 To solve this problem, we must recognize that the total dollar amount of financed capital is $500,000. Then, simply divide the amount of the financed capital being used by $500,000 as is illustrated in the following solution.
31 Once the weights have been determined, the cost of each component is multiplied by its weight to determine the WACC. Where: ω d = proportion of debt in the target capital structure, k d = cost of debt, ω p = proportion of preferred stock in the target capital structure, k p = cost of preferred stock. ω e = proportion of equity in the target capital structure, k e = cost of equity, T = the firm's tax rate.
32 The Marginal Cost of Capital Schedule The firm's weighted average cost of capital is a key input in the decision making process, so it is important to understand that as new amounts of financing are introduced, the WACC changes. With increased amounts of financing, the cost of the various types of financing will increase due to the increased risk to the fund's suppliers. The weighted marginal cost of capital is simply the WACC at any point in time that has been adjusted to reflect new financing. To calculate the WMCC, the breaking point, which is the level of total new financing at which the cost of one of the financing components rises, thereby causing an upward shift in the WMCC has to be calculated.
33 The breaking point can be calculated by using the following equation; Where: BP i = breaking point for financing source i, TC i = amount of funds available from financing source i at a given cost ω i = capital structure weight.
34 Once the break points have been calculated, the WMCCAT over the various ranges must be determined. When these new ranges are grouped together, they can be used to prepare a WMCCAT schedule, which is a graph that relates the firm's WACCAT to the level of new financing.
35 THE INVESTMENT OPPORTUNITIES SCHEDULE (IOS) The firm's investment opportunities schedule is simply a ranking of projects from the highest return to the lowest return. The IOS graphically presents the return on the different investment opportunities facing a firm and the marginal cost of capital. If a project's return is above the WMCCAT, the project should be accepted. If the project falls below the WMCCAT, the project should be rejected. In the above graph, the solid line is the return on three different investments available to the firm. It is called the investment opportunity schedule. The dotted line is the cost of capital at various amounts of investment. This is the marginal cost of capital schedule. In the above example, projects A and B would be accepted and project C would be rejected.
36 Sample Problems and Solutions Example 1: Cost of debt Find the cost of debt for a bond that is selling for $950, has 5 years to maturity and has a coupon interest rate of 10%. Assume the tax rate is 40%.
37 Sample Problems and Solutions Example 1 Solution: The cost of debt is found using the procedure shown earlier for computing yield to maturity. The difference is that the market price is adjusted to reflect any discounts, fees, or costs that the firm must pay. In this problem, no costs are mentioned so we assume that there are none. The YTM can be found easily on a financial calculator or by using the approximation equation
38 Sample Problems and Solutions Example 1 Solution: The final step is to convert the cost of debt to the aftertax cost of debt using equation.
39 Sample Problems and Solutions Example 2: Cost of longterm debt Laurie's Rose Distributors is contemplating expansion by selling public bonds. Her investment banker advises that the bonds should sell for $1,100 less 3% for fees. If the bonds have a coupon rate of 10% and mature in 10 years, what is Laurie's cost of debt? Assume a 40% tax rate.
40 Sample Problems and Solutions Example 2 Solution: The YTM estimation equation can be used. The market price will be $1,100  (1.100 x 0.03) = $1,067.
41 Sample Problems and Solutions Example 3: Cost of preferred stock Compute the cost of preferred stock financing if the annual dividend is $2, the current market price of the stock is $23, and the flotation costs are $1 per share.
42 Sample Problems and Solutions Example 3  Solution: Preferred stock pays a dividend in perpetuity, meaning forever. By rearranging the equation for the value of perpetuity we can find the return (cost) for preferred stock. No tax adjustment is needed since preferred stock dividends are not tax deductible.
43 Sample Problems and Solutions Example 4: Cost of equity Compute the cost of equity if common stock is selling for $35., the growth rate is expected to be 5% and next year's dividend is expected to be $3.
44 Sample Problems and Solutions Example 4  Solution: Given the available information, the only model that can be used is the Gordon Growth Model. By rearranging the term we find that: Note: The most common mistake made when using this equation is to mix decimals and percentages. For example, avoid the following: K s = 3/35 + 5% = = 5.086%.
45 Sample Problems and Solutions Example 5: Cost of equity Compute the cost of equity if the firm's beta is 1.12, the risk free rate of interest is 7% and the return on the market is 13%.
46 Sample Problems and Solutions Example 5  Solution: The only method to solve for the cost of equity that is possible, given the above information, is the CAPM,
47 Sample Problems and Solutions Example 6: Cost of equity Compute the cost of equity if new stock must be sold and the flotation costs are expected to be 5% of the current market price of the stock. The stock is selling for $35., the growth rate is expected to be 5% and the next dividend is expected to be $3.
48 Sample Problems and Solutions Example 6  Solution: When flotation costs exist, the cost to the firm rises because, although the firm pays out the same amount, it receives a lesser amount. In this example, when stock is sold, the public will pay $35. per share, but the firm will receive only $33.25 (35 X (1.05)) of the proceeds. Note: Compare this result to example 4. The only difference was that flotation costs are included here. As a result, the cost of equity increases.
49 Sample Problems and Solutions Example 7: Weighted average cost of capital Compute the weighted average cost of capital for Bob's Crystal Pool Supply given that the target capital structure is 60% common equity, 30% debt and 10% preferred stock. K d = 10%(aftertax), K p s 12%, and K s =13.7%.
50 Sample Problems and Solutions Example 7  Solution:
51 Sample Problems and Solutions Example 8: Marginal cost of capital schedule (simple) Suppose that Richard's Pool Basketball Inc. had a target capital structure of 10% preferred, 30% debt and 60% equity. Its tax rate is 40%. The firm's dividend next period will be $2 and the growth rate is expected to be constant at 5%. The current price of that stock is $20. If new equity is sold the firm expects to get $18 from the sale. The pretax cost of debt is 12%. The cost of preferred is 14%. The firm has $10 in retained earnings. What is the marginal cost of capital schedule?
52 Sample Problems and Solutions Example 8  Solution: These problems can seem difficult because a number of steps are involved. First, you must find the cost of each component. Second you must find breakpoints where the costs change. Third, you must compute the weighted average cost at each of the breakpoints. Finally, you can graph the results. Step 1: Compute the cost of each component a. retained earnings  K e = $2/ = 0.15 b. new equity  K e = 2/ = Step 2: Compute the break points $10/0.6= $16.67 Step 3: Compute the cost below and above the breakpoint a. Cost of capital $0 to $16.67 WACC = 0.6(0.15) + 0.3(0.12)(10.4)+ 0.1(0.14) = b. Cost of capital above $16.67 WACC = 0.6(0.161) + 0.3(0.12)(0.6) + 0.1(0.14) = 0.132
53 Sample Problems and Solutions Example 8  Solution:
54 Sample Problems and Solutions Example 9: Marginal cost of capital schedule (complex) Linda's Drivethrough Lumber Express has a target capital structure of 60% common stock, 30% debt and 10% preferred stock. The cost for retained earnings is 15% and the cost of new or external equity is 16%. Linda's Lumber expects to have $20 million of retained earnings available. Linda can sell $15 million of firstmortgage bonds with an aftertax cost of 9%. The firm's bankers feel the company can sell $10 million of debentures with a cost of 9.5% aftertax. Additional debt would cost 10% aftertax. The cost of preferred stock is 14%. Compute the marginal cost of capital schedule and breakpoints.
55 Sample Problems and Solutions Example 9  Solution: Step 1: Find the breakpoints To find the breakpoints divide the amount of money available at a particular cost by the proportion of the target capital structure made up by that component. a) $20 million/0.60 = $33.33 million b) $15 million/0.30 = $50 million c) $10 million/0.30 = $33.33 million $20 million can be raised from retained earnings before the cost of retained equity must go up due to flotation costs incurred by selling stocks publicly. $15 million in low cost debt can be sold before more costly debt roust be used. After the $10 million or 9.5% debt is gone, 10% debt must be used.
56 Sample Problems and Solutions Example 9  Solution: Step 2: Compute the WACC for each break point Look over the breakpoints and find the lowest one. There are two at $33 million, but the one for debt is after the $50 million breakpoint. Therefore, the first actual breakpoint is at $33 million due to using up retained earnings. The WACC will be computed using the lowest cost of each component. WACC 0 to $33 million = 0.6(0.15)4. 0.3(0.09) + 0.1(0.14) = = 13.10% The next breakpoint occurs because Linda's runs out of firstmortgage bonds. A total of $50 million will be raised before this occurs. In the range between $33 million and $50 million equity will cost more but all other components will slay the same as above. WACC $33million to $50million = 0.6(0.16) + 0.3(.09) + 0.1(0.14) = =13.7%
57 Sample Problems and Solutions Example 9  Solution: The next breakpoint occurs because Linda's runs out of 9.5% debt. A total of $83 million will have been raised when this happens. WACC $50million to $83million = 0.6(0.16) + 0.3(0.095) + 0.1(0.14) = = 13.8% The last breakpoint is when the firm must begin using 10% debt. WACC over $83million = 0.6(0.16) + 0.3(0.10) + 0.1(0.14) = 0.14 = 14%
58 Sample Problems and Solutions Example 9  Solution:
Chapter 11 Calculating the Cost of Capital
Chapter 11 Calculating the Cost of Capital (def)  Cost of obtaining money to fund asset purchase  use as estimate of r (discount rate) If we can earn more than the cost of capital (r) from a project
More informationThe Cost of Capital. Chapter 10. Cost of Debt (r d ) The Cost of Capital. Calculating the cost of obtaining funds for a project
The Cost of Capital Chapter 10 (def)  Cost of obtaining money to fund asset purchase  use as estimate of r (discount rate) If we can earn more than the cost of capital (r) from a project than company
More informationHow To Calculate The Cost Of Capital Of A Firm
Sample Problems Chapter 10 Title: Cost of Debt 1. Costly Corporation plans a new issue of bonds with a par value of $1,000, a maturity of 28 years, and an annual coupon rate of 16.0%. Flotation costs associated
More informationBH Chapter 9 The Cost of Capital
1 Capital Budgeting Overview Capital Budgeting is the set of valuation techniques for real asset investment decisions. Capital Budgeting Steps estimating expected future cash flows for the proposed real
More informationChapter 9 The Cost of Capital ANSWERS TO SELEECTED ENDOFCHAPTER QUESTIONS
Chapter 9 The Cost of Capital ANSWERS TO SELEECTED ENDOFCHAPTER QUESTIONS 91 a. The weighted average cost of capital, WACC, is the weighted average of the aftertax component costs of capital debt,
More informationThings to Absorb, Read, and Do
Things to Absorb, Read, and Do Things to absorb  Everything, plus remember some material from previous chapters. This chapter applies Chapter s 6, 7, and 12, Risk and Return concepts to the market value
More informationChapter 11 The Cost of Capital ANSWERS TO SELECTED ENDOFCHAPTER QUESTIONS
Chapter 11 The Cost of Capital ANSWERS TO SELECTED ENDOFCHAPTER QUESTIONS 111 a. The weighted average cost of capital, WACC, is the weighted average of the aftertax component costs of capital debt,
More informationThe cost of capital. A reading prepared by Pamela Peterson Drake. 1. Introduction
The cost of capital A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction... 1 2. Determining the proportions of each source of capital that will be raised... 3 3. Estimating the marginal
More informationCHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING
CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING Answers to Concepts Review and Critical Thinking Questions 1. No. The cost of capital depends on the risk of the project, not the source of the money.
More informationBonds, Preferred Stock, and Common Stock
Bonds, Preferred Stock, and Common Stock I. Bonds 1. An investor has a required rate of return of 4% on a 1year discount bond with a $100 face value. What is the most the investor would pay for 2. An
More informationSTUDENT CAN HAVE ONE LETTER SIZE FORMULA SHEET PREPARED BY STUDENT HIM/HERSELF. FINANCIAL CALCULATOR/TI83 OR THEIR EQUIVALENCES ARE ALLOWED.
Test IIIFINN3120090 Fall 2009 (2.5 PTS PER QUESTION. MAX 100 PTS) Type A Name ID PRINT YOUR NAME AND ID ON THE TEST, ANSWER SHEET AND FORMULA SHEET. TURN IN THE TEST, OPSCAN ANSWER SHEET AND FORMULA
More informationWeighted Average Cost of Capital (WACC)
Financial Modeling Templates (WACC) http://spreadsheetml.com/finance/weightedaveragecostofcapital.shtml Copyright (c) 20092014, ConnectCode All Rights Reserved. ConnectCode accepts no responsibility for
More informationa) The Dividend Growth Model Approach: Recall the constant dividend growth model for the price of a rm s stock:
Cost of Capital Chapter 14 A) The Cost of Capital: Some Preliminaries: The Security market line (SML) and capital asset pricing model (CAPM) describe the relationship between systematic risk and expected
More informationNIKE Case Study Solutions
NIKE Case Study Solutions Professor Corwin This case study includes several problems related to the valuation of Nike. We will work through these problems throughout the course to demonstrate some of the
More informationThe Marginal Cost of Capital and the Optimal Capital Budget
WEB EXTENSION12B The Marginal Cost of Capital and the Optimal Capital Budget If the capital budget is so large that a company must issue new equity, then the cost of capital for the company increases.
More informationCHAPTER 14 COST OF CAPITAL
CHAPTER 14 COST OF CAPITAL Answers to Concepts Review and Critical Thinking Questions 1. It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than this,
More informationMBA 8230 Corporation Finance (Part II) Practice Final Exam #2
MBA 8230 Corporation Finance (Part II) Practice Final Exam #2 1. Which of the following input factors, if increased, would result in a decrease in the value of a call option? a. the volatility of the company's
More informationCHAPTER 8 INTEREST RATES AND BOND VALUATION
CHAPTER 8 INTEREST RATES AND BOND VALUATION Solutions to Questions and Problems 1. The price of a pure discount (zero coupon) bond is the present value of the par value. Remember, even though there are
More informationENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure
ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure Chapter 9 Valuation Questions and Problems 1. You are considering purchasing shares of DeltaCad Inc. for $40/share. Your analysis of the company
More informationFinance 3130 Corporate Finiance Sample Final Exam Spring 2012
Finance 3130 Corporate Finiance Sample Final Exam Spring 2012 True/False Indicate whether the statement is true or falsewith A for true and B for false. 1. Interest paid by a corporation is a tax deduction
More informationCHAPTER 8. Problems and Questions
CHAPTER 8 Problems and Questions 1. Plastico, a manufacturer of consumer plastic products, is evaluating its capital structure. The balance sheet of the company is as follows (in millions): Assets Liabilities
More informationCHAPTER 16. Dilutive Securities and Earnings Per Share ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Concepts for Analysis
CHAPTER 16 Dilutive Securities and Earnings Per Share ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1. Convertible debt and preferred
More informationChapter 13, ROIC and WACC
Chapter 13, ROIC and WACC Lakehead University Winter 2005 Role of the CFO The Chief Financial Officer (CFO) is involved in the following decisions: Management Decisions Financing Decisions Investment Decisions
More informationChapter 7. . 1. component of the convertible can be estimated as 1100796.15 = 303.85.
Chapter 7 71 Income bonds do share some characteristics with preferred stock. The primary difference is that interest paid on income bonds is tax deductible while preferred dividends are not. Income bondholders
More informationChapter Review Problems
Chapter Review Problems State all stock and bond prices in dollars and cents. Unit 14.1 Stocks 1. When a corporation earns a profit, the board of directors is obligated by law to immediately distribute
More informationSpring 2012. True/False Indicate whether the statement is true or false.
Corporation Finance Spring 2012 Sample Exam 2B True/False Indicate whether the statement is true or false. 1. The total return on a share of stock refers to the dividend yield less any commissions paid
More informationFNCE 301, Financial Management H Guy Williams, 2006
Stock Valuation Stock characteristics Stocks are the other major traded security (stocks & bonds). Options are another traded security but not as big as these two.  Ownership Stockholders are the owner
More information Once we have computed the costs of the individual components of the firm s financing,
WEIGHTED AVERAGE COST OF CAPITAL  Once we have computed the costs of the individual components of the firm s financing, we would assign weight to each financing source according to some standard and then
More informationINTERVIEWS  FINANCIAL MODELING
420 W. 118th Street, Room 420 New York, NY 10027 P: 2128544613 F: 2128546190 www.sipa.columbia.edu/ocs INTERVIEWS  FINANCIAL MODELING Basic valuation concepts are among the most popular technical
More informationPRACTICE EXAM QUESTIONS ON WACC
Dr. Sudhakar Raju Financial Statements Analysis (FN 6450) PRACTICE EXAM QUESTIONS ON WACC 1. The return shareholders require on their investment in a firm is called the: a. dividend yield. B. cost of equity.
More informationHow To Value Bonds
Chapter 6 Interest Rates And Bond Valuation Learning Goals 1. Describe interest rate fundamentals, the term structure of interest rates, and risk premiums. 2. Review the legal aspects of bond financing
More informationDUKE UNIVERSITY Fuqua School of Business. FINANCE 351  CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.
DUK UNIRSITY Fuqua School of Business FINANC 351  CORPORAT FINANC Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%. Consider a firm that earns $1,000
More informationChapter 11 The Cost of Capital
Chapter 11 The Cost of Capital LEARNING OBJECTIVES (Slide 112) 1. Understand the different kinds of financing available to a company: debt financing, equity financing, and hybrid equity financing. 2.
More informationCIS September 2012 Exam Diet. Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis
CIS September 2012 Exam Diet Examination Paper 2.2: Corporate Finance Equity Valuation and Analysis Fixed Income Valuation and Analysis Corporate Finance (1 13) 1. Assume a firm issues N1 billion in debt
More informationt = 1 2 3 1. Calculate the implied interest rates and graph the term structure of interest rates. t = 1 2 3 X t = 100 100 100 t = 1 2 3
MØA 155 PROBLEM SET: Summarizing Exercise 1. Present Value [3] You are given the following prices P t today for receiving risk free payments t periods from now. t = 1 2 3 P t = 0.95 0.9 0.85 1. Calculate
More informationFINC 3630: Advanced Business Finance Additional Practice Problems
FINC 3630: Advanced Business Finance Additional Practice Problems Accounting For Financial Management 1. Calculate free cash flow for Home Depot for the fiscal yearended February 1, 2015 (the 2014 fiscal
More information2.2 Cost Of Capital. This Section includes : COSTVOLUMEPROFIT Financial Management ANALYSIS Decisions
2.2 Cost Of Capital This Section includes : Cost of CapitalKey Concepts Importance Classification Determination of Cost of Capital Computation Weighted Average Cost of Capital INTRODUCTION: It has been
More informationFinancial Statement and Cash Flow Analysis
Chapter 2 Financial Statement and Cash Flow Analysis Answers to Concept Review Questions 1. What role do the FASB and SEC play with regard to GAAP? The FASB is a nongovernmental, professional standards
More informationCFAspace. CFA Level II. Provided by APF. Academy of Professional Finance 专 业 金 融 学 院
CFAspace Provided by APF CFA Level II Equity Investments Free Cash Flow Valuation Part I CFA Lecturer: Hillary Wang Content Free cash flow to the firm, free cash flow to equity Ownership perspective implicit
More informationBond Valuation. What is a bond?
Lecture: III 1 What is a bond? Bond Valuation When a corporation wishes to borrow money from the public on a longterm basis, it usually does so by issuing or selling debt securities called bonds. A bond
More informationProblem 1 Problem 2 Problem 3
Problem 1 (1) Book Value Debt/Equity Ratio = 2500/2500 = 100% Market Value of Equity = 50 million * $ 80 = $4,000 Market Value of Debt =.80 * 2500 = $2,000 Debt/Equity Ratio in market value terms = 2000/4000
More informationPractice Exam (Solutions)
Practice Exam (Solutions) June 6, 2008 Course: Finance for AEO Length: 2 hours Lecturer: Paul Sengmüller Students are expected to conduct themselves properly during examinations and to obey any instructions
More informationCopyright 2009 Pearson Education Canada
The consequence of failing to adjust the discount rate for the risk implicit in projects is that the firm will accept highrisk projects, which usually have higher IRR due to their highrisk nature, and
More informationSAMPLE FACT EXAM (You must score 70% to successfully clear FACT)
SAMPLE FACT EXAM (You must score 70% to successfully clear FACT) 1. What is the present value (PV) of $100,000 received five years from now, assuming the interest rate is 8% per year? a. $600,000.00 b.
More informationA Basic Introduction to the Methodology Used to Determine a Discount Rate
A Basic Introduction to the Methodology Used to Determine a Discount Rate By Dubravka Tosic, Ph.D. The term discount rate is one of the most fundamental, widely used terms in finance and economics. Whether
More informationChapter 5: Valuing Bonds
FIN 302 Class Notes Chapter 5: Valuing Bonds What is a bond? A longterm debt instrument A contract where a borrower agrees to make interest and principal payments on specific dates Corporate Bond Quotations
More informationCHAPTER 7: FIXEDINCOME SECURITIES: PRICING AND TRADING
CHAPTER 7: FIXEDINCOME SECURITIES: PRICING AND TRADING Topic One: Bond Pricing Principles 1. Present Value. A. The presentvalue calculation is used to estimate how much an investor should pay for a bond;
More informationLOS 42.a: Define and interpret free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).
The following is a review of the Equity Investments principles designed to address the learning outcome statements set forth by CFA Institute. This topic is also covered in: Free Cash Flow Valuation This
More information6. Debt Valuation and the Cost of Capital
6. Debt Valuation and the Cost of Capital Introduction Firms rarely finance capital projects by equity alone. They utilise long and short term funds from a variety of sources at a variety of costs. No
More informationEstimating Cost of Capital. 2. The cost of capital is an opportunity cost it depends on where the money goes, not where it comes from
Estimating Cost of Capal 1. Vocabulary the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capal (or cost of money) 2. The cost of capal is an opportuny cost
More informationCorporate Finance: Final Exam
Corporate Finance: Final Exam Answer all questions and show necessary work. Please be brief. This is an open books, open notes exam. For partial credit, when discounting, please show the discount rate
More informationCHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles
CHAPTER 20 Hybrid Financing: Preferred Stock, Warrants, and Convertibles 1 Topics in Chapter Types of hybrid securities Preferred stock Warrants Convertibles Features and risk Cost of capital to issuers
More informationCost of Capital Basics
Cost of Capital Basics The corporate cost of capital is a blend (weighted average) of the costs of the financing components. It is used as a benchmark rate of return in new new project evaluations. Key
More informationCost of Capital and Project Valuation
Cost of Capital and Project Valuation 1 Background Firm organization There are four types: sole proprietorships partnerships limited liability companies corporations Each organizational form has different
More informationCOST OF CAPITAL. Please note that in finance, we are concerned with MARKET VALUES (unlike accounting, which is concerned with book values).
COST OF CAPITAL Cost of capital calculations are a very important part of finance. To value a project, it is important to discount the cash flows using a discount rate that incorporates the debtequity
More informationChapter 9. The Valuation of Common Stock. 1.The Expected Return (Copied from Unit02, slide 36)
Readings Chapters 9 and 10 Chapter 9. The Valuation of Common Stock 1. The investor s expected return 2. Valuation as the Present Value (PV) of dividends and the growth of dividends 3. The investor s required
More informationChoice of Discount Rate
Choice of Discount Rate Discussion Plan Basic Theory and Practice A common practical approach: WACC = Weighted Average Cost of Capital Look ahead: CAPM = Capital Asset Pricing Model Massachusetts Institute
More informationFNCE 301, Financial Management H Guy Williams, 2006
REVIEW We ve used the DCF method to find present value. We also know shortcut methods to solve these problems such as perpetuity present value = C/r. These tools allow us to value any cash flow including
More informationSOLUTIONS. Practice questions. Multiple Choice
Practice questions Multiple Choice 1. XYZ has $25,000 of debt outstanding and a book value of equity of $25,000. The company has 10,000 shares outstanding and a stock price of $10. If the unlevered beta
More informationAnswers to Review Questions
Answers to Review Questions 1. The real rate of interest is the rate that creates an equilibrium between the supply of savings and demand for investment funds. The nominal rate of interest is the actual
More informationIncome Measurement and Profitability Analysis
PROFITABILITY ANALYSIS The following financial statements for Spencer Company will be used to demonstrate the calculation of the various ratios in profitability analysis. Spencer Company Comparative Balance
More informationFinal Exam Practice Set and Solutions
FIN469 Investments Analysis Professor Michel A. Robe Final Exam Practice Set and Solutions What to do with this practice set? To help students prepare for the final exam, three practice sets with solutions
More informationChapter 8. Stock Valuation Process. Stock Valuation
Stock Valuation Process Chapter 8 Stock Valuation: Investors use risk and return concept to determine the worth of a security. In the valuation process: The intrinsic value of any investment equals the
More informationChapter 5 Valuing Stocks
Chapter 5 Valuing Stocks MULTIPLE CHOICE 1. The first public sale of company stock to outside investors is called a/an a. seasoned equity offering. b. shareholders meeting. c. initial public offering.
More informationStudy Guide  Final Exam Accounting I
Study Guide  Final Exam Accounting I True/False Indicate whether the sentence or statement is true or false. 1. Entries in a sales journal affect account balances in both the accounts receivable ledger
More informationTakeHome Problem Set
Georgia State University Department of Finance MBA 8622 Fall 2001 MBA 8622: Corporation Finance TakeHome Problem Set Instructors: Lalitha Naveen, N. Daniel, C.Hodges, A. Mettler, R. Morin, M. Shrikhande,
More informationPaper F9. Financial Management. Friday 7 June 2013. Fundamentals Level Skills Module. The Association of Chartered Certified Accountants.
Fundamentals Level Skills Module Financial Management Friday 7 June 2013 Time allowed Reading and planning: Writing: 15 minutes 3 hours ALL FOUR questions are compulsory and MUST be attempted. Formulae
More informationBUSINESS FINANCE (FIN 312) Spring 2008
BUSINESS FINANCE (FIN 312) Spring 2008 Assignment 3 Instructions: please read carefully You can either do the assignment by yourself or work in a group of no more than two. You should show your work how
More informationPaper F9. Financial Management. Friday 7 December 2012. Fundamentals Level Skills Module. The Association of Chartered Certified Accountants
Fundamentals Level Skills Module Financial Management Friday 7 December 2012 Time allowed Reading and planning: Writing: 15 minutes 3 hours ALL FOUR questions are compulsory and MUST be attempted. Formulae
More informationE22: Identifying Financing, Investing and Operating Transactions?
E22: Identifying Financing, Investing and Operating Transactions? Listed below are eight transactions. In each case, identify whether the transaction is an example of financing, investing or operating
More informationIf you ignore taxes in this problem and there is no debt outstanding: EPS = EBIT/shares outstanding = $14,000/2,500 = $5.60
Problems Relating to Capital Structure and Leverage 1. EBIT and Leverage Money Inc., has no debt outstanding and a total market value of $150,000. Earnings before interest and taxes [EBIT] are projected
More information380.760: Corporate Finance. Financial Decision Making
380.760: Corporate Finance Lecture 2: Time Value of Money and Net Present Value Gordon Bodnar, 2009 Professor Gordon Bodnar 2009 Financial Decision Making Finance decision making is about evaluating costs
More informationPERPETUITIES NARRATIVE SCRIPT 2004 SOUTHWESTERN, A THOMSON BUSINESS
NARRATIVE SCRIPT 2004 SOUTHWESTERN, A THOMSON BUSINESS NARRATIVE SCRIPT: SLIDE 2 A good understanding of the time value of money is crucial for anybody who wants to deal in financial markets. It does
More informationCorporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document)
Corporate Finance, Fall 03 Exam #2 review questions (full solutions at end of document) 1. Portfolio risk & return. Idaho Slopes (IS) and Dakota Steppes (DS) are both seasonal businesses. IS is a downhill
More informationManagement Accounting Financial Strategy
PAPER P9 Management Accounting Financial Strategy The Examiner provides a short study guide, for all candidates revising for this paper, to some first principles of finance and financial management Based
More informationSource of Finance and their Relative Costs F. COST OF CAPITAL
F. COST OF CAPITAL 1. Source of Finance and their Relative Costs 2. Estimating the Cost of Equity 3. Estimating the Cost of Debt and Other Capital Instruments 4. Estimating the Overall Cost of Capital
More informationFinal Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator
University of Stavanger (UiS) Stavanger Masters Program Final Exam MØA 155 Financial Economics Fall 2009 Permitted Material: Calculator The number in brackets is the weight for each problem. The weights
More informationEquity Analysis and Capital Structure. A New Venture s Perspective
Equity Analysis and Capital Structure A New Venture s Perspective 1 Venture s Capital Structure ASSETS Short term Assets Cash A/R Inventories Long term Assets Plant and Equipment Intellectual Property
More informationMost publicly limited companies (PLCs) will use a number of different sources of finance including:
Weighted Average Cost of Capital (WACC) Article by Bernard Vallely, FCCA, MBA, Current Examiner. RELEVANT TO : P1 Managerial Finance P2 Financial Management (Transitional Students) P2 Strategic Corporate
More informationFinancial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Exercises
Financial Reporting & Analysis Chapter 17 Solutions Statement of Cash Flows Exercises Exercises E171. Determining cash flows from operations Using the indirect method, cash flow from operations is computed
More informationHomework Solutions  Lecture 2
Homework Solutions  Lecture 2 1. The value of the S&P 500 index is 1286.12 and the treasury rate is 3.43%. In a typical year, stock repurchases increase the average payout ratio on S&P 500 stocks to over
More informationPaper F9. Financial Management. Friday 6 December 2013. Fundamentals Level Skills Module. The Association of Chartered Certified Accountants
Fundamentals Level Skills Module Financial Management Friday 6 December 2013 Time allowed Reading and planning: Writing: 15 minutes 3 hours ALL FOUR questions are compulsory and MUST be attempted. Formulae
More informationCorporate Finance & Options: MGT 891 Homework #6 Answers
Corporate Finance & Options: MGT 891 Homework #6 Answers Question 1 A. The APV rule states that the present value of the firm equals it all equity value plus the present value of the tax shield. In this
More information1 Present and Future Value
Lecture 8: Asset Markets c 2009 Je rey A. Miron Outline:. Present and Future Value 2. Bonds 3. Taxes 4. Applications Present and Future Value In the discussion of the twoperiod model with borrowing and
More informationCHAPTER 15 Capital Structure: Basic Concepts
Multiple Choice Questions: CHAPTER 15 Capital Structure: Basic Concepts I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an
More informationChapter 5 Financial Forwards and Futures
Chapter 5 Financial Forwards and Futures Question 5.1. Four different ways to sell a share of stock that has a price S(0) at time 0. Question 5.2. Description Get Paid at Lose Ownership of Receive Payment
More informationCIMA F3 Course Notes. Chapter 11. Company valuations
CIMA F3 Course Notes Chapter 11 Company valuations Personal use only  not licensed for use on courses 144 1. Company valuations There are several methods of valuing the equity of a company. The simplest
More information1 (a) Net present value of investment in new machinery Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales income 6,084 6,327 6,580 6,844
Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2013 Answers 1 (a) Net present value of investment in new machinery Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales income 6,084
More informationIt should be noted that as a source of capital, most forms of debt differ in this regard from the normal equity sources of capital.
THE COST OF DEBT AS A SOURCE OF CAPITAL The agribusiness industry is not, of course, unique in its use of various forms of debt as a source of capital. My own research has shown that the agribusiness industry's
More informationChapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.)
Chapter 17 Corporate Capital Structure Foundations (Sections 17.1 and 17.2. Skim section 17.3.) The primary focus of the next two chapters will be to examine the debt/equity choice by firms. In particular,
More informationThe Weighted Average Cost of Capital
The Weighted Average Cost of Capital What Does "Cost of Capital" Mean? "Cost of capital" is defined as "the opportunity cost of all capital invested in an enterprise." Let's dissect this definition: Opportunity
More informationAN OVERVIEW OF FINANCIAL MANAGEMENT
CHAPTER 1 Review Questions AN OVERVIEW OF FINANCIAL MANAGEMENT 1. Management s basic, overriding goal is to create for 2. The same actions that maximize also benefits society 3. If businesses are successful
More informationChapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium ANSWERS TO ENDOFCHAPTER QUESTIONS
Chapter 7 Stocks, Stock Valuation, and Stock Market Equilibrium ANSWERS TO ENDOFCHAPTER QUESTIONS 71 a. A proxy is a document giving one person the authority to act for another, typically the power
More informationDUKE UNIVERSITY Fuqua School of Business. FINANCE 351  CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2.
DUKE UNIVERSITY Fuqua School of Business FINANCE 351  CORPORATE FINANCE Problem Set #7 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Suppose the corporate tax rate is 40%, and investors pay a tax
More information1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises.
1. Solutions to PS 1: 1. a. (iv) b. (ii) [6.75/(1.34) = 10.2] c. (i) Writing a call entails unlimited potential losses as the stock price rises. 7. The bill has a maturity of onehalf year, and an annualized
More information1. What are the three types of business organizations? Define them
Written Exam Ticket 1 1. What is Finance? What do financial managers try to maximize, and what is their second objective? 2. How do you compare cash flows at different points in time? 3. Write the formulas
More informationChapter 6 Interest rates and Bond Valuation. 2012 Pearson Prentice Hall. All rights reserved. 41
Chapter 6 Interest rates and Bond Valuation 2012 Pearson Prentice Hall. All rights reserved. 41 Interest Rates and Required Returns: Interest Rate Fundamentals The interest rate is usually applied to
More informationChapter 11. Stocks and Bonds. How does this distribution work? An example. What form do the distributions to common shareholders take?
Chapter 11. Stocks and Bonds Chapter Objectives To identify basic shareholder rights and the means by which corporations make distributions to shareholders To recognize the investment opportunities in
More informationUnderstanding Cash Flow Statements
Understanding Cash Flow Statements 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam Contents 1. Introduction... 3 2. Components and Format of the Cash Flow Statement... 3 3. The
More informationANALYSIS OF FIXED INCOME SECURITIES
ANALYSIS OF FIXED INCOME SECURITIES Valuation of Fixed Income Securities Page 1 VALUATION Valuation is the process of determining the fair value of a financial asset. The fair value of an asset is its
More information