Value-Based Management

Save this PDF as:
 WORD  PNG  TXT  JPG

Size: px
Start display at page:

Download "Value-Based Management"

Transcription

1 Value-Based Management Lecture 5: Calculating the Cost of Capital Prof. Dr. Gunther Friedl Lehrstuhl für Controlling Technische Universität München

2 Overview 1. Value Maximization and Corporate Objectives 2. Measuring Income: Financial Statements 3. Measuring Value Creation: Value-Based Performance Measures 4. Management Compensation: Objectives and Alternatives 5. Calculating the Cost of Capital 6. Accounting Adjustments: Overview 7. Accounting Adjustments: Goal Congruent Performance Measures 8. Valuing and Managing Real Options 9. Identifying the Drivers of Value Creation Value-Based Management: Lecture 5 105

3 Required/suggested readings Required readings: Young, S. David and O Byrne, Stephen F.: EVA and Value-Based Management: A Practical Guide to Implementation, New York et al. 2001, chapter 5. Suggested readings: Brealey, R. A., Myers, S. C., and Marcus, A. J.: Fundamentals of Corporate Finance, 9/e Boston Value-Based Management: Lecture 5 106

4 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 107

5 Measuring the cost of capital is mainly a question of how to measure the cost of equity Cost of capital = opportunity cost that reflects the returns investors expect from other investments of similar risk Different forms of financing (equity, debt) carry different risks for investors and therefore different costs weighted-average cost of capital (WACC) S WACC r S B S B r S B B (1 T C ) S = market value of equity (stock) B = market value of debt (bond) r B = cost of debt T C = corporate tax rate r S = cost of equity Alternative approach: target weightings (target capital structure) instead of marketbased weightings How to get an estimate of the cost of equity? Value-Based Management: Lecture 5 108

6 The Capital Asset Pricing model (CAPM) delivers an estimate of how risky assets like a firm s equity are priced by capital markets The expected return on a risky asset is given by the following equation: E(R ) R i f [E(R i M ) R Market risk premium f ] E(R i ) = expected return on risky asset i R f = return on a risk-free asset E(R M ) = expected return on the stock market β i = measure of risk of asset i (company risk factor) with The CAPM gives the return expected by the capital markets for investing in a risky asset like a company s stock Main assumptions of the CAPM: Either quadratic utility functions of investors or normally distributed returns Investors have a unique planning horizon and homogenous expectations concerning the means, variances and covariances of the asset returns No capital market restrictions like transaction costs or restrictions of short sales cov R i,r i Var R M M Value-Based Management: Lecture 5 109

7 The total risk of a company s equity can be separated into the market risk and the company-specific risk Total risk = market risk + company-specific risk Company-specific risk Also called unsystematic, diversifiable, idiosyncratic risk Market risk Also called systematic, nondiversifiable risk Examples: management errors, production downtimes (only a few (or one) companies are concerned) Examples: GDP, inflation, interest rates (almost the whole market is concerned, to more or less extent) Can be eliminated by diversification Bearing that risk is not paid for by the capital market Cannot be eliminated through diversification Capital market pays investors for bearing that risk β i measures the volatility of a company s stock price with respect to the overall stock market (reflects market risk) β i =1 for companies with a risk identical to the overall market risk, β i > 1 for more risky, β i < 1 for less risky companies Value-Based Management: Lecture 5 110

8 Graphical representation of the security market line Security market line ) E(R i E(R ) R i f [E(R i M ) R f ] E(R M ) R f M 1 i cov R i,r Var R M M Value-Based Management: Lecture 5 111

9 Industry Survey KPMG 2014 Value-Based Management: Lecture 5 112

10 Sample and scope of KPMG (2014): Cost of Capital Study 2014 Data collected between May and September 2014 Survey among 130 companies in Europe (Germany, Austria Switzerland) Main industries of the survey: Automotive Chemicals & Pharmaceuticals Consumer Markets Energy & Natural Resources Financial Services Health Care Industrial Manufacturing Media & Telecommunications Real Estate Technology Transport & Leisure Value-Based Management: Lecture 5 113

11 Average WACC by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 114

12 Average cost of debt by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 115

13 Average cost of equity by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 116

14 Average beta by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 117

15 Average risk free rate and market risk premium by period Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 118

16 Average risk free rate and its determination Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 119

17 WACC estimations for EON, Thyssen & Metro Group (Source: Annual Reports 2013, 2010 & 2008) Company WACC 2013 WACC 2010 WACC 2008 EON 7,5% 8.3% 9.1% Thyssen 9% 8.5% 8.5% METRO Group 9,6% 7.2% 6.5% WACC - Thyssen Business Segments (Source: Annual Reports) Services Elevator Technologies Stainless Steel 7 7,5 8 8,5 9 9,5 10 Value-Based Management: Lecture 5 120

18 WACC estimations for Metro Group (Source: Metro Group Annual Report 2010, p. 087) Value-Based Management: Lecture 5 121

19 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 122

20 Calculating the company s beta some problems to cope for Beta can be calculated by regressing monthly or weekly returns of the company on the returns of the whole stock market Problems of conceptual as well as practical relevance in calculating beta: Choice of the return interval (monthly, weekly, daily etc.) Time period for data (5 years of data, 10 years of data etc.). Attention: Betas may change over time! Choice of market? Which market index is the appropriate proxy? Choice of the risk free rate of return (government bonds etc.) Conceptual problems of the CAPM: CAPM based on expectations of future returns, not on historical returns (model really testable?) CAPM theoretically based on the overall market which isn t observable in reality each index as a proxy will fail in representing the overall market Empirical work shows varying results concerning a confirmation of the model s implications, sometimes depending on the periods employed Value-Based Management: Lecture 5 123

21 Calculating the beta of private firms and divisions without data of observable returns requires a more pragmatic approach The procedure depends on how the divisions are organized: Organized geographically Division funded in the division s home currency Organized by product line Estimate betas from comparable firms in the same or similar industries Add company or product line risk premium to the rate of return of the division s local government bonds Adjust for different capital structure that influences the beta (the more leverage through debt the more risky the equity!) Division not self-financing (financing mainly from parent) Add risk premium to the government bond rate in the parent company s home currency, eventually plus an additional risk premium for undeveloped market economies Choose a target capital structure to calculate the WACC Calculate a fictitious unlevered beta by adjusting the levered beta of the other firm for its debt-to-equity ratio: β other U L 1 other U β other 1 T B other C 1 other L Adjust the fictitious unlevered beta of the other firm for the own division s debt-toequity ratio: own β β S own own 1 T B C S Value-Based Management: Lecture 5 124

22 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 125

23 The Arbitrage Pricing Theory (APT) as an alternative to compute the company s cost of equity Multi-factor model that assumes that returns on securities are generated by a number of industry- and market-wide factors and therefore supposed to explain a greater percentage of stock price movements than the CAPM Return on asset = expected return + unanticipated return (surprise) Example: Using inflation (F INF ), gross domestic product (F GDP ) and interest rate (F RATE ) as possible systematic risk factors influencing asset return, the return on a risky asset is given by: R E(R i ) = expected return on risky asset i ε = unsystematic portion of stock returns = volatility associated with risk factor β i i E(R ) i i,inf F INF i, GDP F GDP i,rate F Problems: Which are the relevant risk factors? Not given in the theory Does not resolve the problem of the use of historical data for beta estimation More difficult to apply in practice (estimation of betas) RATE Value-Based Management: Lecture 5 126

24 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 127

25 A company should choose the appropriate capital structure to minimize the cost of capital Choose the financing alternatives that reduce the firm s cost of capital Financing alternatives Straight debt Short-term debt (bank-loans or money market instruments) Long-term debt (fixed- or floating-rate bonds or bank loans) Straight equity Retained earnings New equity issues (public or private placement) Factors for debt-equity choice Tax shield from interest payments Costs of financial distress Agency costs because of shareholder-debtholder conflicts manager-shareholder conflicts Asymmetric information (capital structure serving as informative signal for the market) Hybrid instruments Convertibles Preferred shares Warrants Value-Based Management: Lecture 5 128

26 Because of the tax-deductibility of interest payments a higher leverage may result in a higher firm value Capital structure does not matter in a world without taxes and bankruptcy costs and with perfect capital markets (Modigliani-Miller) Increase in leverage replaces equity with cheaper debt but also raises the risk and therefore the costs of the remaining equity Sufficient taxable income and tax-deductibility of interest payments: Tax shield = i B T C i B T C V U (V L ) = interest rate = book value of debt = corporate tax rate = value of unlevered (levered) firm Firm value V L Present value of tax shield V U Debt/equity Inclusion of personal tax rates complicates the theory: Personal tax rate (of bondholders) on interest is in general higher than the effective personal tax rate on equity distribution (share buybacks etc.) Personal tax penalties to bondholders (partly) offset the tax benefits of debt at the corporate level (bondholders must be offered higher yields) Problem: How can the tax shield be valued? Value-Based Management: Lecture 5 129

27 The risk of financial distress gives rise to a theory of an optimal capital structure balancing benefits and costs of debt financing Direct costs of financial distress: Payments to lawyers, accountants etc. for reorganization, debt renegotiation and other necessary activities to avoid bankruptcy Firm value Present value of financial distress costs Indirect costs of financial distress: Loss of reputation and confidence in the firm by customers and suppliers Declining sales and disruptions in the supply chain Managerial effort devoted solely to survival Inability to raise necessary capital for new profitable projects V U V L Debt/equity Problem: Quantifying the costs of financial distress Differing opinions about importance of these costs (difference between financial distress and economic distress caused by economic shocks, operating inefficiencies or strategic failure) Value-Based Management: Lecture 5 130

28 Conflicts with managers and bondholders give rise to agency costs for the shareholders depending on the capital structure There are two different types of conflicts concerning the capital structure: Shareholders vs. managers Shareholders vs. bondholders Managers are generally more risk averse than the more diversified shareholders Managers, bearing a high risk in the company tend to have the company underleveraged, since they are not rewarded for that risk by the market (in contrast to the shareholders) Managers might spend the free cash flows for their own purposes A higher debt burden decreases free cash flows due to interest and principal payments Limited liability of the shareholders and limited profit of the bondholders causes a gambling strategy of the shareholders (mainly when in financial distress) at the cost of the bondholders They might invest in high risk projects when there is the chance of a high profit if, in the other case, the shareholders outcome (as residual stake) is worthless even for low risk projects creditors cope with this through higher yields Value-Based Management: Lecture 5 131

29 Asymmetric information between capital markets and the firms or their managers gives capital structure the role of a signal Empirical work supports the hypothesis that announcements of actions that change the company s capital structure have an informational content: Equity issues tend to have a negative effect on stock prices Share buybacks are mainly interpreted as a positive signal by the market Straight debt issues are sometimes interpreted as a positive signal Some reasoning of theoretic research: Managers with private information might issue equity only when they assume that company stock is overpriced (otherwise preferring internal financing in the first place or debt issues: pecking order of financing alternatives) A company that buys back shares might assume its shares undervalued Managers might issue debt (and accept a higher risk of bankruptcy) only when they have reliable information of high future prospects of an investment Disadvantage of these theories: Only descriptive approach, explaining possible capital market reactions Does not give an explicit advise for specific financing decisions Value-Based Management: Lecture 5 132

30 The capital structure choice is an ongoing process a decisionframework of how to achieve a chosen target capital structure Firm overlevered Under threat of bankruptcy? Firm underlevered Under threat of takeover? Yes No Yes No Reduce debt quickly: Sell assets and use proceeds to pay off debt Renegotiate debt terms Debt/equity swaps Reduce debt gradually Positive NPV projects available? Increase debt quickly: Leveraged recap Increase debt gradually Positive NPV projects available? Yes No Finance projects with internally generated cash flows or new equity issue Pay off debt with cash flows Issue new equity and use proceeds to pay off debt Cut dividends Yes Finance projects with debt No Increase regular dividends Special dividend Buy back shares Value-Based Management: Lecture 5 133

Models of Risk and Return

Models of Risk and Return Models of Risk and Return Aswath Damodaran Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for

More information

The Tangent or Efficient Portfolio

The Tangent or Efficient Portfolio The Tangent or Efficient Portfolio 1 2 Identifying the Tangent Portfolio Sharpe Ratio: Measures the ratio of reward-to-volatility provided by a portfolio Sharpe Ratio Portfolio Excess Return E[ RP ] r

More information

BUS303. Study guide 2. Chapter 14

BUS303. Study guide 2. Chapter 14 BUS303 Study guide 2 Chapter 14 1. An efficient capital market is one in which: A. all securities that investors want are offered. B. all transactions are closed within 2 days. C. current prices reflect

More information

t = 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

t = 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 information

Chapter 17 Does Debt Policy Matter?

Chapter 17 Does Debt Policy Matter? Chapter 17 Does Debt Policy Matter? Multiple Choice Questions 1. When a firm has no debt, then such a firm is known as: (I) an unlevered firm (II) a levered firm (III) an all-equity firm D) I and III only

More information

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview

Leverage. FINANCE 350 Global Financial Management. Professor Alon Brav Fuqua School of Business Duke University. Overview Leverage FINANCE 35 Global Financial Management Professor Alon Brav Fuqua School of Business Duke University Overview Capital Structure does not matter! Modigliani & Miller propositions Implications for

More information

Use the table for the questions 18 and 19 below.

Use the table for the questions 18 and 19 below. Use the table for the questions 18 and 19 below. The following table summarizes prices of various default-free zero-coupon bonds (expressed as a percentage of face value): Maturity (years) 1 3 4 5 Price

More information

University of Pennsylvania The Wharton School

University of Pennsylvania The Wharton School University of Pennsylvania The Wharton School FNCE 100 PROBLEM SET #6 Fall Term 2005 A. Craig MacKinlay Capital Structure 1. The XYZ Co. is assessing its current capital structure and its implications

More information

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III

TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II + III TPPE17 Corporate Finance 1(5) SOLUTIONS RE-EXAMS 2014 II III Instructions 1. Only one problem should be treated on each sheet of paper and only one side of the sheet should be used. 2. The solutions folder

More information

Capital Structure. Corporate Finance. Prof. Ian Giddy New York University CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO

Capital Structure. Corporate Finance. Prof. Ian Giddy New York University CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO Capital Structure-1 Capital Structure Prof. Ian Giddy New York University Corporate Finance CORPORATE FINANCE DECISONS INVESTMENT FINANCING RISK MGT MGT PORTFOLIO CAPITAL M&A DEBT EQUITY MEASUREMENT TOOLS

More information

Capital Structure: Informational and Agency Considerations

Capital Structure: Informational and Agency Considerations Capital Structure: Informational and Agency Considerations The Big Picture: Part I - Financing A. Identifying Funding Needs Feb 6 Feb 11 Case: Wilson Lumber 1 Case: Wilson Lumber 2 B. Optimal Capital Structure:

More information

15 Solution 1.4: The dividend growth model says that! DIV1 = $6.00! k = 12.0%! g = 4.0% The expected stock price = P0 = $6 / (12% 4%) = $75.

15 Solution 1.4: The dividend growth model says that! DIV1 = $6.00! k = 12.0%! g = 4.0% The expected stock price = P0 = $6 / (12% 4%) = $75. 1 The present value of the exercise price does not change in one hour if the risk-free rate does not change, so the change in call put is the change in the stock price. The change in call put is $4, so

More information

Chapter 7: Capital Structure: An Overview of the Financing Decision

Chapter 7: Capital Structure: An Overview of the Financing Decision Chapter 7: Capital Structure: An Overview of the Financing Decision 1. Income bonds are similar to preferred stock in several ways. Payment of interest on income bonds depends on the availability of sufficient

More information

Chapter 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.) 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 information

Chapter 15. Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory

Chapter 15. Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory Chapter 15 Capital Structure Policy Agenda Learning Objectives Principles Used in This Chapter 1.A Glance at Capital Structure Choices in Practice 2.Capital Structure Theory 3.Why Do Capital Structures

More information

CAPITAL STRUCTURE [Chapter 15 and Chapter 16]

CAPITAL STRUCTURE [Chapter 15 and Chapter 16] Capital Structure [CHAP. 15 & 16] -1 CAPITAL STRUCTURE [Chapter 15 and Chapter 16] CONTENTS I. Introduction II. Capital Structure & Firm Value WITHOUT Taxes III. Capital Structure & Firm Value WITH Corporate

More information

FN2 Ron Muller 2007-08 MODULE 4: CAPITAL STRUCTURE QUESTION 1

FN2 Ron Muller 2007-08 MODULE 4: CAPITAL STRUCTURE QUESTION 1 MODULE 4: CAPITAL STRUCTURE QUESTION 1 Gadget Corp. manufactures gadgets. The average selling price of this finished product is $200 per unit. The variable cost for these units is $125. Gadget Corp. incurs

More information

The CAPM (Capital Asset Pricing Model) NPV Dependent on Discount Rate Schedule

The CAPM (Capital Asset Pricing Model) NPV Dependent on Discount Rate Schedule The CAPM (Capital Asset Pricing Model) Massachusetts Institute of Technology CAPM Slide 1 of NPV Dependent on Discount Rate Schedule Discussed NPV and time value of money Choice of discount rate influences

More information

Review for Exam 2. Instructions: Please read carefully

Review for Exam 2. Instructions: Please read carefully Review for Exam Instructions: Please read carefully The exam will have 1 multiple choice questions and 5 work problems. Questions in the multiple choice section will be either concept or calculation questions.

More information

Ch. 18: Taxes + Bankruptcy cost

Ch. 18: Taxes + Bankruptcy cost Ch. 18: Taxes + Bankruptcy cost If MM1 holds, then Financial Management has little (if any) impact on value of the firm: If markets are perfect, transaction cost (TAC) and bankruptcy cost are zero, no

More information

Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust.

Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust. Cost of Capital Presentation for ERRA Tariff Committee Dr. Konstantin Petrov / Waisum Cheng / Dr. Daniel Grote April 2009 Experience you can trust. Agenda 1.Definition of Cost of Capital a) Concept and

More information

Source of Finance and their Relative Costs F. COST OF CAPITAL

Source 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 information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2008 Answers 1 (a) Rights issue price = 2 5 x 0 8 = $2 00 per share Theoretical ex rights price = ((2 50 x 4) + (1 x 2 00)/5=$2

More information

AFM 372 Fall 2007 Midterm Examination Friday, October 26. This exam has 11 pages including this page. A separate formula sheet will be provided.

AFM 372 Fall 2007 Midterm Examination Friday, October 26. This exam has 11 pages including this page. A separate formula sheet will be provided. Student name: Student number: Instructor: Alan Huang Duration: 2 hours AFM 372 Fall 2007 Midterm Examination Friday, October 26 This exam has 11 pages including this page. A separate formula sheet will

More information

EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance. Corporate Finance. Eric Jondeau EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 4: Capital Structure Limits to the Use of Debt Outline 1. Costs of Financial Distress 2. Description of Costs 3. Can

More information

CORPORATE FINANCE REVIEW FOR THIRD QUIZ. Aswath Damodaran

CORPORATE FINANCE REVIEW FOR THIRD QUIZ. Aswath Damodaran CORPORATE FINANCE REVIEW FOR THIRD QUIZ Aswath Damodaran Basic Skills Needed What is the trade off involved in the capital structure choice? Can you estimate the optimal debt ratio for a firm using the

More information

How to Estimate the Effect of a Stock Repurchase on Share Price

How to Estimate the Effect of a Stock Repurchase on Share Price How to Estimate the Effect of a Stock Repurchase on Share Price By Dilip D. Kare and C. Don Wiggins Management Accounting May 1987 What is the smallest amount of stock you need to repurchase in order to

More information

More Tutorial at Corporate Finance

More Tutorial at  Corporate Finance Corporate Finance Question 1. The cost of capital (8 points) St. Claire Enterprises is a levered firm. The equity cost of capital for St. Claire is 7%. The debt cost of capital for St. Claire is 2%. Assume

More information

Chapter 11, Risk and Return

Chapter 11, Risk and Return Chapter 11, Risk and Return 1. A portfolio is. A) a group of assets, such as stocks and bonds, held as a collective unit by an investor B) the expected return on a risky asset C) the expected return on

More information

Fundamentals Level Skills Module, Paper F9

Fundamentals Level Skills Module, Paper F9 Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2008 Answers 1 (a) Calculation of weighted average cost of capital (WACC) Cost of equity Cost of equity using capital asset

More information

SOLUTIONS EXAM 2013-10-25 WRITE AS CLEARLY AND DISTINCTLY AS POSSIBLE!

SOLUTIONS EXAM 2013-10-25 WRITE AS CLEARLY AND DISTINCTLY AS POSSIBLE! SOLUTIONS EXAM 2013-10-25 Instructions 1. Only one problem should be treated on each sheet of paper and only one side of the sheet should be used. 2. The solutions folder must be handed in before you leave

More information

2. How does an indirect cost of financial distress differ from a direct cost of bankruptcy?

2. How does an indirect cost of financial distress differ from a direct cost of bankruptcy? Short-Answer 1. What type of conflict of interest do covenants attempt to address? Stockholder-bondholder conflict 2. How does an indirect cost of financial distress differ from a direct cost of bankruptcy?

More information

This paper is not to be removed from the Examination Halls

This paper is not to be removed from the Examination Halls ~~FN3023 ZA d0 This paper is not to be removed from the Examination Halls UNIVERSITY OF LONDON FN3023 ZA BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the Social Sciences,

More information

Principles of Corporate Finance

Principles of Corporate Finance Principles of Corporate Finance Chapter 18. Does debt policy matter? Ciclo Profissional 2 o Semestre / 2009 Graduaccão em Ciências Econômicas V. Filipe Martins-da-Rocha (FGV) Principles of Corporate Finance

More information

CHAPTER 15 Capital Structure: Basic Concepts

CHAPTER 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 information

YieldCo Cost of Capital

YieldCo Cost of Capital by Josh Lutton and Shirley You Large renewable energy project developers often use a type of financing vehicle colloquially known as a YieldCo to finance portfolios of assets that are expected to have

More information

A Basic Introduction to the Methodology Used to Determine a Discount Rate

A 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 information

Chapter 14 Capital Structure in a Perfect Market

Chapter 14 Capital Structure in a Perfect Market Chapter 14 Capital Structure in a Perfect Market 14-1. Consider a project with free cash flows in one year of $130,000 or $180,000, with each outcome being equally likely. The initial investment required

More information

Taxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) CA tax benefits

Taxable cash flow 556 1,485 1,530 2,308 Taxation (167) (446) (459) (692) CA tax benefits Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2011 Answers 1 (a) Net present value evaluation of new confectionery investment Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales

More information

5Capital Structure II: Stockholder & Bondholder Conflicts

5Capital Structure II: Stockholder & Bondholder Conflicts 5Capital Structure II: Stockholder & Bondholder Conflicts Modigliani-Miller (MM I) theorem If There are no taxes There are no bankruptcy costs The firm s investment policy is fixed Then The value of the

More information

Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011. Part One: Multiple-Choice Questions (45 points)

Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011. Part One: Multiple-Choice Questions (45 points) Question 1 Finance 2 for IBA (30J201) F.Feriozzi Resit exam June 14 th, 2011 Part One: Multiple-Choice Questions (45 points) Assume that financial markets are perfect and that the market value of a levered

More information

CHAPTER 10. Capital Markets and the Pricing of Risk. Chapter Synopsis

CHAPTER 10. Capital Markets and the Pricing of Risk. Chapter Synopsis CHAPE 0 Capital Markets and the Pricing of isk Chapter Synopsis 0. A First Look at isk and eturn Historically there has been a large difference in the returns and variability from investing in different

More information

CHAPTER 13 Capital Structure and Leverage

CHAPTER 13 Capital Structure and Leverage CHAPTER 13 Capital Structure and Leverage Business and financial risk Optimal capital structure Operating Leverage Capital structure theory 1 What s business risk? Uncertainty about future operating income

More information

Copyright 2009 Pearson Education Canada

Copyright 2009 Pearson Education Canada d) If Dorval calls in the outstanding bonds, a bondholder who currently owns bonds with $100,000 of face value will have to sell them back to the firm at face value. The bonds would be more valuable than

More information

Swaps: Debt-equity swap

Swaps: Debt-equity swap Swaps: Debt-equity swap INTRODUCTION Debt-equity (respectively equity-debt) swap allows a company, government, or municipality to swap debt for equity (respectively equity for debt). Debt and equity are

More information

Cost of Capital, Valuation and Strategic Financial Decision Making

Cost of Capital, Valuation and Strategic Financial Decision Making Cost of Capital, Valuation and Strategic Financial Decision Making By Dr. Valerio Poti, - Examiner in Professional 2 Stage Strategic Corporate Finance The financial crisis that hit financial markets in

More information

Capital Structure: Part 1

Capital Structure: Part 1 Capital tructure: Part 1 For 9.220, Term 1, 2002/03 02_Lecture19.ppt tudent Version Outline 1. Introduction 2. Theories of Capital tructure a Modigliani and Miller No tax b M&M with Corporate Tax 3. ummary

More information

Capital Structure II

Capital Structure II Capital Structure II Introduction In the previous lecture we introduced the subject of capital gearing. Gearing occurs when a company is financed partly through fixed return finance (e.g. loans, loan stock

More information

University of Waterloo Midterm Examination

University of Waterloo Midterm Examination Student number: Student name: ANONYMOUS Instructor: Dr. Hongping Tan Duration: 1.5 hours AFM 371/2 Winter 2011 4:30-6:00 Tuesday, March 1 This exam has 12 pages including this page. Important Information:

More information

Review for Exam 2. Instructions: Please read carefully

Review for Exam 2. Instructions: Please read carefully Review for Exam 2 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems You are not responsible for any topics that are not covered in the lecture note

More information

Industrial and investment analysis as a tool for regulation

Industrial and investment analysis as a tool for regulation Industrial and investment analysis as a tool for regulation Marina Di Giacomo, Università di Torino Turin School of Local Regulation International Summer School on Regulation of Local Public Services 1

More information

Risk and Return Models: Equity and Debt. Aswath Damodaran 1

Risk and Return Models: Equity and Debt. Aswath Damodaran 1 Risk and Return Models: Equity and Debt Aswath Damodaran 1 First Principles Invest in projects that yield a return greater than the minimum acceptable hurdle rate. The hurdle rate should be higher for

More information

LECTURE 07. Cost of Capital Berk, De Marzo Chapter 14 and 15

LECTURE 07. Cost of Capital Berk, De Marzo Chapter 14 and 15 1 LECTURE 07 Cost of Capital Berk, De Marzo Chapter 14 and 15 2 Equity Versus Debt Financing Capital Structure: The relative proportions of debt, equity, and other securities that a firm has outstanding.

More information

Corporate Finance. Slide 1 咨询热线 : 学习平台 : lms.finance365.com

Corporate Finance. Slide 1 咨询热线 : 学习平台 : lms.finance365.com Corporate Finance Capital Budgeting Cost of Capital Measures of Leverage Dividends and Share Repurchases Working capital management Corporate Governance of Listed Companies Slide 1 Capital Budgeting Slide

More information

CHAPTER 8. Problems and Questions

CHAPTER 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 information

Risk (beta), Return & Capital Budgeting Chpt. 12: problems 2,6,9,13,15. I. Applications of CAPM. 1) risk premium

Risk (beta), Return & Capital Budgeting Chpt. 12: problems 2,6,9,13,15. I. Applications of CAPM. 1) risk premium Risk (beta), Return & Capital Budgeting Chpt. 12: problems 2,6,9,13,15 I. Applications of CAPM 1) risk premium estimate from historical data (Ibbotson) 2) risk free rate Tbill vs. Tbond, consistent with

More information

Module 7 Asset pricing models

Module 7 Asset pricing models 1. Overview Module 7 Asset pricing models Prepared by Pamela Peterson Drake, Ph.D., CFA Asset pricing models are different ways of interpreting how investors value investments. Most models are based on

More information

Chapter 14: Capital Structure in a Perfect Market

Chapter 14: Capital Structure in a Perfect Market Chapter 14: Capital Structure in a Perfect Market-1 Chapter 14: Capital Structure in a Perfect Market I. Overview 1. Capital structure: mix of debt and equity issued by the firm to fund its assets Leverage:

More information

GESTÃO FINANCEIRA II PROBLEM SET 4 - SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE

GESTÃO FINANCEIRA II PROBLEM SET 4 - SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE GESTÃO FINANCEIRA II PROBLEM SET 4 - SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 2010-2011 Chapter 12 Estimating the Cost of Capital 12-1. Suppose

More information

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis

CHAPTER 16. Financial Distress, Managerial Incentives, and Information. Chapter Synopsis CHAPTER 16 Financial Distress, Managerial Incentives, and Information Chapter Synopsis In the previous two chapters it was shown that, in an otherwise perfect capital market in which firms pay taxes, the

More information

DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #4 Prof. Simon Gervais Fall 2011 Term 2.

DUKE 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 information

Paper F9. Financial Management. Friday 6 June 2014. Fundamentals Level Skills Module. The Association of Chartered Certified Accountants.

Paper F9. Financial Management. Friday 6 June 2014. Fundamentals Level Skills Module. The Association of Chartered Certified Accountants. Fundamentals Level Skills Module Financial Management Friday 6 June 2014 Time allowed Reading and planning: Writing: 15 minutes 3 hours ALL FOUR questions are compulsory and MUST be attempted. Formulae

More information

Chapter 7 Risk, Return, and the Capital Asset Pricing Model

Chapter 7 Risk, Return, and the Capital Asset Pricing Model Chapter 7 Risk, Return, and the Capital Asset Pricing Model MULTIPLE CHOICE 1. Suppose Sarah can borrow and lend at the risk free-rate of 3%. Which of the following four risky portfolios should she hold

More information

17.10 SUMMARY AND CONCLUSIONS. Chapter Review and Self-Test Problems

17.10 SUMMARY AND CONCLUSIONS. Chapter Review and Self-Test Problems 598 PART SIX Cost of Capital and Long-Term Financial Policy CONCEPT QUESTIONS 17.9a What is the APR? 17.9b What is the difference between liquidation and reorganization? 17.10 SUMMARY AND CONCLUSIONS The

More information

Module 1: Corporate Finance and the Role of Venture Capital Financing TABLE OF CONTENTS

Module 1: Corporate Finance and the Role of Venture Capital Financing TABLE OF CONTENTS 1.0 FINANCING PRINCIPLES Module 1: Corporate Finance and the Role of Venture Capital Financing Financing Principles 1.01 Introduction to Financing Principles 1.02 Capitalization of a Business 1.03 Capital

More information

Direccio Financiera II

Direccio Financiera II Direccio Financiera II Year 2014-15 Degree/study: 2013-14- GRAU EMPRESARIAL Course: 3-4 Term: Third Number of ECTS credits: 5 Hours of student s dedication: 125 Language or languages of instruction: English

More information

MGT201 Solved MCQs(500) By

MGT201 Solved MCQs(500) By MGT201 Solved MCQs(500) By http://www.vustudents.net Why companies invest in projects with negative NPV? Because there is hidden value in each project Because there may be chance of rapid growth Because

More information

Napoli Pizza wants to determine its optimal capital structure

Napoli Pizza wants to determine its optimal capital structure Napoli Pizza wants to determine its optimal capital structure ABSTRACT Brad Stevenson Daniel Bauer David Collins Keith Richardson This case is based on an actual business decision that was made by a small,

More information

Value-Based Management

Value-Based Management Value-Based Management Handout Problem Set 3 Management Compensation - Bonus Banks Lehrstuhl für BWL Controlling Prof. Dr. Gunther Friedl Email for questions and comments: peter.schaefer@tum.de Value-Based

More information

DESCRIPTION OF FINANCIAL INSTRUMENTS AND INVESTMENT RISKS

DESCRIPTION OF FINANCIAL INSTRUMENTS AND INVESTMENT RISKS DESCRIPTION OF FINANCIAL INSTRUMENTS AND INVESTMENT RISKS A. General The services offered by Prochoice Stockbrokers cover a wide range of Financial Instruments. Every type of financial instrument carries

More information

ENTREPRENEURIAL FINANCE: Strategy Valuation and Deal Structure

ENTREPRENEURIAL 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 information

Cash flow before tax 1,587 1,915 1,442 2,027 Tax at 28% (444) (536) (404) (568)

Cash flow before tax 1,587 1,915 1,442 2,027 Tax at 28% (444) (536) (404) (568) Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2014 Answers 1 (a) Calculation of NPV Year 1 2 3 4 5 $000 $000 $000 $000 $000 Sales income 5,670 6,808 5,788 6,928 Variable

More information

Discuss the potential impact of the recent financial crisis on the capital structure of UK companies. Samuel Jones

Discuss the potential impact of the recent financial crisis on the capital structure of UK companies. Samuel Jones Discuss the potential impact of the recent financial crisis on the capital structure of UK companies Samuel Jones I. Introduction The topic of how firms finance themselves is highly important because poor

More information

Jeffrey F. Jaffe Spring Semester 2016 Corporate Finance FNCE 100 Syllabus, page 1. Spring 2016 Corporate Finance FNCE 100 Wharton School of Business

Jeffrey F. Jaffe Spring Semester 2016 Corporate Finance FNCE 100 Syllabus, page 1. Spring 2016 Corporate Finance FNCE 100 Wharton School of Business Corporate Finance FNCE 100 Syllabus, page 1 Spring 2016 Corporate Finance FNCE 100 Wharton School of Business Syllabus Course Description: This course provides an introduction to the theory, the methods,

More information

1. CFI Holdings is a conglomerate listed on the Zimbabwe Stock Exchange (ZSE) and has three operating divisions as follows:

1. CFI Holdings is a conglomerate listed on the Zimbabwe Stock Exchange (ZSE) and has three operating divisions as follows: NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY FACULTY OF COMMERCE DEPARTMENT OF FINANCE BACHELOR OF COMMERCE HONOURS DEGREE IN FINANCE PART II 2 ND SEMESTER FINAL EXAMINATION MAY 2005 CORPORATE FINANCE

More information

Chapter 15: Debt Policy

Chapter 15: Debt Policy FIN 302 Class Notes Chapter 15: Debt Policy Two Cases: Case one: NO TAX All Equity Half Debt Number of shares 100,000 50,000 Price per share $10 $10 Equity Value $1,000,000 $500,000 Debt Value $0 $500,000

More information

Discounted Cash Flow. Alessandro Macrì. Legal Counsel, GMAC Financial Services

Discounted Cash Flow. Alessandro Macrì. Legal Counsel, GMAC Financial Services Discounted Cash Flow Alessandro Macrì Legal Counsel, GMAC Financial Services History The idea that the value of an asset is the present value of the cash flows that you expect to generate by holding it

More information

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15

Test3. Pessimistic Most Likely Optimistic Total Revenues 30 50 65 Total Costs -25-20 -15 Test3 1. The market value of Charcoal Corporation's common stock is $20 million, and the market value of its riskfree debt is $5 million. The beta of the company's common stock is 1.25, and the market

More information

Chapter 17 Capital Structure Limits to the Use of Debt

Chapter 17 Capital Structure Limits to the Use of Debt University of Science and Technology Beijing Dongling School of Economics and management Chapter 17 Capital Structure Limits to the Use of Debt Dec. 2012 Dr. Xiao Ming USTB 1 Key Concepts and Skills Define

More information

Net revenue 785 25 1,721 05 5,038 54 3,340 65 Tax payable (235 58) (516 32) (1,511 56) (1,002 20)

Net revenue 785 25 1,721 05 5,038 54 3,340 65 Tax payable (235 58) (516 32) (1,511 56) (1,002 20) Answers Fundamentals Level Skills Module, Paper F9 Financial Management December 2013 Answers 1 (a) Calculating the net present value of the investment project using a nominal terms approach requires the

More information

Midterm exam financiering/finance. <Front page>

Midterm exam financiering/finance. <Front page> Midterm exam financiering/finance Question 1 An agency problem can be alleviated by: A) requiring all organizations to be sole proprietorships. B) compensating managers in such a way that

More information

CAPITAL STRUCTURE AND DIVIDEND POLICY

CAPITAL STRUCTURE AND DIVIDEND POLICY CAPITAL STRUCTURE AND DIVIDEND POLICY Capital Structure In the section of the notes titled Cost of Capital, we examined how the cost of capital is determined. From those notes, you should have discovered

More information

ENERGY ADVISORY COMMITTEE. Electricity Market Review: Return on Investment

ENERGY ADVISORY COMMITTEE. Electricity Market Review: Return on Investment ENERGY ADVISORY COMMITTEE Electricity Market Review: Return on Investment The Issue To review the different approaches in determining the return on investment in the electricity supply industry, and to

More information

I. Estimating Discount Rates

I. Estimating Discount Rates I. Estimating Discount Rates DCF Valuation Aswath Damodaran 1 Estimating Inputs: Discount Rates Critical ingredient in discounted cashflow valuation. Errors in estimating the discount rate or mismatching

More information

CFA Examination PORTFOLIO MANAGEMENT Page 1 of 6

CFA Examination PORTFOLIO MANAGEMENT Page 1 of 6 PORTFOLIO MANAGEMENT A. INTRODUCTION RETURN AS A RANDOM VARIABLE E(R) = the return around which the probability distribution is centered: the expected value or mean of the probability distribution of possible

More information

Question 1. Marking scheme. F9 ACCA June 2013 Exam: BPP Answers

Question 1. Marking scheme. F9 ACCA June 2013 Exam: BPP Answers Question 1 Text references. NPV is covered in Chapter 8 and real or nominal terms in Chapter 9. Financial objectives are covered in Chapter 1. Top tips. Part (b) requires you to explain the different approaches.

More information

CHAPTER 18. Capital Budgeting and Valuation with Leverage. Chapter Synopsis

CHAPTER 18. Capital Budgeting and Valuation with Leverage. Chapter Synopsis CHAPTER 18 Capital Budgeting and Valuation with everage Chapter Synopsis 18.1 Overview of Key Concepts There are three discounted cash flow valuation methods: the weighted average cost of capital (WACC)

More information

Copyright 2009 Pearson Education Canada

Copyright 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 high-risk projects, which usually have higher IRR due to their high-risk nature, and

More information

CHAPTER 12 RISK, COST OF CAPITAL, AND CAPITAL BUDGETING

CHAPTER 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 information

MBA 8230 Corporation Finance (Part II) Practice Final Exam #2

MBA 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 information

Estimating Beta. Aswath Damodaran

Estimating Beta. Aswath Damodaran Estimating Beta The standard procedure for estimating betas is to regress stock returns (R j ) against market returns (R m ) - R j = a + b R m where a is the intercept and b is the slope of the regression.

More information

Cost of Capital and Project Valuation

Cost 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 information

Actuarial Society of India

Actuarial Society of India Actuarial Society of India Examination November 2006 CT2: Finance and Financial Reporting Indicative Solutions Page 1 of 7 Solution 1-10 Sol 1 Sol 2 Sol 3 Sol 4 Sol 5 Sol 6 Sol 7 Sol 8 Sol 9 Sol 10 E E

More information

E. V. Bulyatkin CAPITAL STRUCTURE

E. V. Bulyatkin CAPITAL STRUCTURE E. V. Bulyatkin Graduate Student Edinburgh University Business School CAPITAL STRUCTURE Abstract. This paper aims to analyze the current capital structure of Lufthansa in order to increase market value

More information

Harvard Business School Leveraged Betas and the Cost of Equity

Harvard Business School Leveraged Betas and the Cost of Equity Harvard Business School 9-288-036 Rev. June 25, 1993 everaged Betas and the Cost of quity O NOT COPY A stock s expected return, its dividend yield plus expected price appreciation, is related to risk.

More information

Sample Exam Questions and Answers

Sample Exam Questions and Answers 1 Sample Exam Questions and Answers 1. Which of the following statements is most correct? a. Proprietorship is generally not easily and inexpensively formed. b. Partnership has limited liability and limited

More information

Leverage and Capital Structure

Leverage and Capital Structure Leverage and Capital Structure Ross Chapter 16 Spring 2005 10.1 Leverage Financial Leverage Financial leverage is the use of fixed financial costs to magnify the effect of changes in EBIT on EPS. Fixed

More information

CHAPTER 20. Hybrid Financing: Preferred Stock, Warrants, and Convertibles

CHAPTER 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 information

Topics CHAPTER 9. What types of long-term capital do firms use? Capital Components. Before-tax vs. After-tax Capital Costs

Topics CHAPTER 9. What types of long-term capital do firms use? Capital Components. Before-tax vs. After-tax Capital Costs Topics CHAPTER 9 The Cost of Capital Cost of Capital Components Debt Preferred Common Equity WACC 1 2 What types of long-term capital do firms use? Long-term debt Preferred stock Common equity Capital

More information

MBA Financial Management and Markets Spring 2011 Dr. A. Frank Thompson Due: February 28, 2011 Competency Exam 1 Directions: Please answer the

MBA Financial Management and Markets Spring 2011 Dr. A. Frank Thompson Due: February 28, 2011 Competency Exam 1 Directions: Please answer the MBA Financial Management and Markets Spring 2011 Dr. A. Frank Thompson Due: February 28, 2011 Competency Exam 1 Directions: Please answer the following 33 questions designed to test your knowledge of the

More information