# Chapter 14 Capital Structure in a Perfect Market

Size: px
Start display at page:

Transcription

1 Chapter 14 Capital Structure in a Perfect Market 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 for the project is \$100,000, and the project s cost of capital is 20%. The risk-free interest rate is 10%. a. What is the NPV of this project? b. Suppose that to raise the funds for the initial investment, the project is sold to investors as an all-equity firm. The equity holders will receive the cash flows of the project in one year. How much money can be raised in this way that is, what is the initial market value of the unlevered equity? c. Suppose the initial \$100,000 is instead raised by borrowing at the risk-free interest rate. What are the cash flows of the levered equity, and what is its initial value according to MM? 1 a. E C() 1 = ( 130, , 000) = 155, 000, 2 155,000 NPV = 100,000 = 129, ,000 = \$29, , 000 b. Equity value = PV ( C () 1 ) = = 129, c. Debt payments = 100,000, equity receives 20,000 or 70,000. Initial value, by MM, is129, ,000 = \$29, You are an entrepreneur starting a biotechnology firm. If your research is successful, the technology can be sold for \$30 million. If your research is unsuccessful, it will be worth nothing. To fund your research, you need to raise \$2 million. Investors are willing to provide you with \$2 million in initial capital in exchange for 50% of the unlevered equity in the firm. a. What is the total market value of the firm without leverage? b. Suppose you borrow \$1 million. According to MM, what fraction of the firm s equity will you need to sell to raise the additional \$1 million you need? c. What is the value of your share of the firm s equity in cases (a) and (b)? a. Total value of equity = 2 \$2m = \$4m b. MM says total value of firm is still \$4 million. \$1 million of debt implies total value of equity is \$3 million. Therefore, 33% of equity must be sold to raise \$1 million. c. In (a), 50% \$4m = \$2m. In (b), 2/3 \$3m = \$2m. Thus, in a perfect market the choice of capital structure does not affect the value to the entrepreneur.

2 Berk/DeMarzo Corporate Finance, Second Edition Acort Industries owns assets that will have an 80% probability of having a market value of \$50 million in one year. There is a 20% chance that the assets will be worth only \$20 million. The current risk-free rate is 5%, and Acort s assets have a cost of capital of 10%. a. If Acort is unlevered, what is the current market value of its equity? b. Suppose instead that Acort has debt with a face value of \$20 million due in one year. According to MM, what is the value of Acort s equity in this case? c. What is the expected return of Acort s equity without leverage? What is the expected return of Acort s equity with leverage? d. What is the lowest possible realized return of Acort s equity with and without leverage? 44 = + =. E = = \$40m a. E[Value in one year] 0.8( 50) 0.2( 20) 44 b. D = 20 = Therefore, \$20.952m E = = c. Without leverage, r= % 40 =, with leverage, r = = 14.55% d. Without leverage, r= % 40 =, with leverage, r = % = Wolfrum Technology (WT) has no debt. Its assets will be worth \$450 million in one year if the economy is strong, but only \$200 million in one year if the economy is weak. Both events are equally likely. The market value today of its assets is \$250 million. a. What is the expected return of WT stock without leverage? b. Suppose the risk-free interest rate is 5%. If WT borrows \$100 million today at this rate and uses the proceeds to pay an immediate cash dividend, what will be the market value of its equity just after the dividend is paid, according to MM? c. What is the expected return of MM stock after the dividend is paid in part (b)? a. ( )/250 = 1.30 => 30% b. E + D = 250, D = 100 => E = 150 c. (.5 ( ) +.5 ( ))/150 = => 46.67% Suppose there are no taxes. Firm ABC has no debt, and firm XYZ has debt of \$5000 on which it pays interest of 10% each year. Both companies have identical projects that generate free cash flows of \$800 or \$1000 each year. After paying any interest on debt, both companies use all remaining free cash flows to pay dividends each year. a. Fill in the table below showing the payments debt and equity holders of each firm will receive given each of the two possible levels of free cash flows. b. Suppose you hold 10% of the equity of ABC. What is another portfolio you could hold that would provide the same cash flows?

3 186 Berk/DeMarzo Corporate Finance, Second Edition c. Suppose you hold 10% of the equity of XYZ. If you can borrow at 10%, what is an alternative strategy that would provide the same cash flows? a. ABC XYZ FCF Debt Payments Equity Dividends Debt Payments Equity Dividends \$ \$1, b. Unlevered Equity = Debt + Levered Equity. Buy 10% of XYZ debt and 10% of XYZ Equity, get 50 + (30,50) = (80,100) c. Levered Equity = Unlevered Equity + Borrowing. Borrow \$500, buy 10% of ABC, receive (80,100) 50 = (30, 50) Suppose Alpha Industries and Omega Technology have identical assets that generate identical cash flows. Alpha Industries is an all-equity firm, with 10 million shares outstanding that trade for a price of \$22 per share. Omega Technology has 20 million shares outstanding as well as debt of \$60 million. a. According to MM Proposition I, what is the stock price for Omega Technology? b. Suppose Omega Technology stock currently trades for \$11 per share. What arbitrage opportunity is available? What assumptions are necessary to exploit this opportunity? a. V(alpha) = = 220m = V(omega) = D + E E = = 160m p = \$8 per share. b. Omega is overpriced. Sell 20 Omega, buy 10 alpha, and borrow 60. Initial = = 60. Assumes we can trade shares at current prices and that we can borrow at the same terms as Omega (or own Omega debt and can sell at same price) Cisoft is a highly profitable technology firm that currently has \$5 billion in cash. The firm has decided to use this cash to repurchase shares from investors, and it has already announced these plans to investors. Currently, Cisoft is an all-equity firm with 5 billion shares outstanding. These shares currently trade for \$12 per share. Cisoft has issued no other securities except for stock options given to its employees. The current market value of these options is \$8 billion. a. What is the market value of Cisoft s non-cash assets? b. With perfect capital markets, what is the market value of Cisoft s equity after the share repurchase? What is the value per share? a. Assets = cash + non-cash, Liabilities = equity + options, Non-cash assets = equity + options cash = = 63 billion. b. Equity = 60 5 =55. Repurchase 5b = 0.417b shares b shares remain Per share value = = \$ Schwartz Industry is an industrial company with 100 million shares outstanding and a market capitalization (equity value) of \$4 billion. It has \$2 billion of debt outstanding. Management have decided to delever the firm by issuing new equity to repay all outstanding debt. a. How many new shares must the firm issue? b. Suppose you are a shareholder holding 100 shares, and you disagree with this decision. Assuming a perfect capital market, describe what you can do to undo the effect of this decision. a. Share price = 4b/100m = \$40, Issue 2b/40 = 50 million shares

5 188 Berk/DeMarzo Corporate Finance, Second Edition c. Return sensitivity = 145% (-55%) = 200%. This sensitivity is 4x the sensitivity of unlevered equity (50%). Its risk premium is also 4x that of unlevered equity (40% vs. 10%). 750 d. 3x 250 = e. 25%(45%)+75%(5%) = 15% Hardmon Enterprises is currently an all-equity firm with an expected return of 12%. It is considering a leveraged recapitalization in which it would borrow and repurchase existing shares. a. Suppose Hardmon borrows to the point that its debt-equity ratio is With this amount of debt, the debt cost of capital is 6%. What will the expected return of equity be after this transaction? b. Suppose instead Hardmon borrows to the point that its debt-equity ratio is With this amount of debt, Hardmon s debt will be much riskier. As a result, the debt cost of capital will be 8%. What will the expected return of equity be in this case? c. A senior manager argues that it is in the best interest of the shareholders to choose the capital structure that leads to the highest expected return for the stock. How would you respond to this argument? a. r e = r u + d/e(r u r d ) = 12% (12% 6%) = 15% b. r e = 12% (12% 8%) = 18% c. Returns are higher because risk is higher the return fairly compensates for the risk. There is no free lunch Suppose Microsoft has no debt and an equity cost of capital of 9.2%. The average debt-to-value ratio for the software industry is 13%. What would its cost of equity be if it took on the average amount of debt for its industry at a cost of debt of 6%? At a cost of debt of 6%: D re = ru + ( ru rd) E 0.13 re = ( ) 0.87 = = 9.68% Global Pistons (GP) has common stock with a market value of \$200 million and debt with a value of \$100 million. Investors expect a 15% return on the stock and a 6% return on the debt. Assume perfect capital markets. a. Suppose GP issues \$100 million of new stock to buy back the debt. What is the expected return of the stock after this transaction? b. Suppose instead GP issues \$50 million of new debt to repurchase stock. i. If the risk of the debt does not change, what is the expected return of the stock after this transaction? ii. If the risk of the debt increases, would the expected return of the stock be higher or lower than in part (i)?

6 Berk/DeMarzo Corporate Finance, Second Edition 189 a. ( ) 215% 6% wacc = + = 12% = r u. 3 3 b. i. r r d e( r r ) ( ) = + / = 12+ = 18% e u u d 150 ii. if r d is higher, r e is lower. The debt will share some of the risk Hubbard Industries is an all-equity firm whose shares have an expected return of 10%. Hubbard does a leveraged recapitalization, issuing debt and repurchasing stock, until its debt-equity ratio is Due to the increased risk, shareholders now expect a return of 13%. Assuming there are no taxes and Hubbard s debt is risk free, what is the interest rate on the debt? wacc = r = 10% = 13% + x 1.6( 10) 13 = 3 = 0.6x x = 5% u Hartford Mining has 50 million shares that are currently trading for \$4 per share and \$200 million worth of debt. The debt is risk free and has an interest rate of 5%, and the expected return of Hartford stock is 11%. Suppose a mining strike causes the price of Hartford stock to fall 25% to \$3 per share. The value of the risk-free debt is unchanged. Assuming there are no taxes and the risk (unlevered beta) of Hartford s assets is unchanged, what happens to Hartford s equity cost of capital? ru r = 8% + 8% 5% = 12% e 150 = wacc = ( 11) + ( 5) = 8%. ( ) Mercer Corp. is an all equity firm with 10 million shares outstanding and \$100 million worth of debt outstanding. Its current share price is \$75. Mercer s equity cost of capital is 8.5%. Mercer has just announced that it will issue \$350 million worth of debt. It will use the proceeds from this debt to pay off its existing debt, and use the remaining \$250 million to pay an immediate dividend. Assume perfect capital markets. a. Estimate Mercer s share price just after the recapitalization is announced, but before the transaction occurs. b. Estimate Mercer s share price at the conclusion of the transaction. (Hint: use the market value balance sheet.) c. Suppose Mercer s existing debt was risk-free with a 4.25% expected return, and its new debt is risky with a 5% expected return. Estimate Mercer s equity cost of capital after the transaction. a. MM => no change, \$75 b. Initial enterprise value = = 850 million New debt = 350 million E = = 500 Share price = 500/10 = \$50 c. Ru = (750/850) 8.5% + (100/850) 4.25% = 8% Re = 8% + 350/500(8% 5%) = 10.1%

7 190 Berk/DeMarzo Corporate Finance, Second Edition In June 2009, Apple Computer had no debt, total equity capitalization of \$128 billion, and a (equity) beta of 1.7 (as reported on Google Finance). Included in Apple s assets was \$25 billion in cash and risk-free securities. Assume that the risk-free rate of interest is 5% and the market risk premium is 4%. a. What is Apple s enterprise value? b. What is the beta of Apple s business assets? c. What is Apple s WACC? a =103 million E b. Because the debt is risk free, βu = βe E + D 128 = (1.7) 103 = 2.11 c. rwacc rf β ( E RMkt rf ) = + [ ] = = 13.4% alternatively ( ) r = r + β E[ R ] r = = 11.8% E f E Mkt f E D \$128 \$25 r wacc = re + r D = (11.8%) (5%) = 13.4% E + D E + D \$103 \$ Indell stock has a current market value of \$120 million and a beta of Indell currently has risk-free debt as well. The firm decides to change its capital structure by issuing \$30 million in additional risk-free debt, and then using this \$30 million plus another \$10 million in cash to repurchase stock. With perfect capital markets, what will be the beta of Indell stock after this transaction? Indell increases its net debt by \$40 million (\$30 million in new debt + \$10 million in cash paid out). Therefore, the value of its equity decreases to = \$80 million. If the debt is risk-free: ( E+ D) D βu EV β = β 1 e u + = = β, u E E E where D is net debt, and EV is enterprise value. The only change in the equation is the value of equity. Therefore ' E 120 β = β = 1.50 = e e E ' Yerba Industries is an all-equity firm whose stock has a beta of 1.2 and an expected return of 12.5%. Suppose it issues new risk-free debt with a 5% yield and repurchases 40% of its stock. Assume perfect capital markets. a. What is the beta of Yerba stock after this transaction? b. What is the expected return of Yerba stock after this transaction? Suppose that prior to this transaction, Yerba expected earnings per share this coming year of \$1.50, with a forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) of 14.

8 Berk/DeMarzo Corporate Finance, Second Edition 191 c. What is Yerba s expected earnings per share after this transaction? Does this change benefit shareholders? Explain. d. What is Yerba s forward P/E ratio after this transaction? Is this change in the P/E ratio reasonable? Explain. 40 e = 1 + d / e = u + = 60 a. β β ( ) = + = = 6.25 = = 17.5% from the CAPM, or 1.2 b. r r b( r r ) r r r ( ) e f m f m f e ( ) r = r + d / e( r r ) = = 17.5 e u u d 60 c. p = 14( 1.50 ) = \$21. Borrow 40%(21) = 8.4, interest = 5%(8.4) = Earnings = = d , per share = = No benefit; risk is higher. The stock price does not change. 21 PE = = It falls due to higher risk You are CEO of a high-growth technology firm. You plan to raise \$180 million to fund an expansion by issuing either new shares or new debt. With the expansion, you expect earnings next year of \$24 million. The firm currently has 10 million shares outstanding, with a price of \$90 per share. Assume perfect capital markets. a. If you raise the \$180 million by selling new shares, what will the forecast for next year s earnings per share be? b. If you raise the \$180 million by issuing new debt with an interest rate of 5%, what will the forecast for next year s earnings per share be? c. What is the firm s forward P/E ratio (that is, the share price divided by the expected earnings for the coming year) if it issues equity? What is the firm s forward P/E ratio if it issues debt? How can you explain the difference? a. Issue 180 = 2 million new shares 12 million shares outstanding New EPS = = \$2.00 per share. 12 b. Interest on new debt = 180 5% = \$9 million. The interest expense will reduce earnings to = \$15 million. With 10 million shares outstanding, EPS = = \$1.50 per share. 10 c. By MM, share price is \$90 in either case. PE ratio with equity issue is =. PE ratio with debt is \$ =. The higher PE ratio is justified because with leverage, EPS will grow at a faster rate.

9 192 Berk/DeMarzo Corporate Finance, Second Edition Zelnor, Inc., is an all-equity firm with 100 million shares outstanding currently trading for \$8.50 per share. Suppose Zelnor decides to grant a total of 10 million new shares to employees as part of a new compensation plan. The firm argues that this new compensation plan will motivate employees and is a better strategy than giving salary bonuses because it will not cost the firm anything. a. If the new compensation plan has no effect on the value of Zelnor s assets, what will be the share price of the stock once this plan is implemented? b. What is the cost of this plan for Zelnor s investors? Why is issuing equity costly in this case? a. 850 Assets = 850m. New shares = 110. price = = \$ b. Cost = 100( ) = 77 m = 10(7.73). Issuing equity at below market price is costly.

### 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

### 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

### 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

### 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,

### 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

### If 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

### DUKE 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

### 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

### Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012. Part One: Multiple-Choice Questions (45 points)

Finance 2 for IBA (30J201) F. Feriozzi Re-sit exam June 18 th, 2012 Part One: Multiple-Choice Questions (45 points) Question 1 Assume that capital markets are perfect. Which of the following statements

### LECTURE- 4. Valuing stocks Berk, De Marzo Chapter 9

1 LECTURE- 4 Valuing stocks Berk, De Marzo Chapter 9 2 The Dividend Discount Model A One-Year Investor Potential Cash Flows Dividend Sale of Stock Timeline for One-Year Investor Since the cash flows are

### 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

### U + PV(Interest Tax Shield)

CHAPTER 15 Debt and Taxes Chapter Synopsis 15.1 The Interest Tax Deduction A C-Corporation pays taxes on proits ater interest payments are deducted, but it pays dividends rom ater-tax net income. Thus,

### How To Value A Stock

Chapter 9 Valuing Stocks 9-1. Assume Evco, Inc., has a current price of \$50 and will pay a \$2 dividend in one year, and its equity cost of capital is 15%. What price must you expect it to sell for right

### GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE

GESTÃO FINANCEIRA II PROBLEM SET 5 SOLUTIONS (FROM BERK AND DEMARZO S CORPORATE FINANCE ) LICENCIATURA UNDERGRADUATE COURSE 1 ST SEMESTER 2010-2011 Chapter 18 Capital Budgeting and Valuation with Leverage

### MM1 - The value of the firm is independent of its capital structure (the proportion of debt and equity used to finance the firm s operations).

Teaching Note Miller Modigliani Consider an economy for which the Efficient Market Hypothesis holds and in which all financial assets are possibly traded (abusing words we call this The Complete Markets

Chapter 17 Valuation and Capital Budgeting for the Levered Firm 17A-1 Appendix 17A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

FINC 3630: Advanced Business Finance Additional Practice Problems Accounting For Financial Management 1. Calculate free cash flow for Home Depot for the fiscal year-ended February 1, 2015 (the 2014 fiscal

### The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction

Chapter 18 Valuation and Capital Budgeting for the Levered Firm 18A-1 Appendix 18A The Adjusted Present Value Approach to Valuing Leveraged Buyouts 1 Introduction A leveraged buyout (LBO) is the acquisition

### Financial Markets and Valuation - Tutorial 6: SOLUTIONS. Capital Structure and Cost of Funds

Financial Markets and Valuation - Tutorial 6: SOLUTIONS Capital Structure and Cost of Funds (*) denotes those problems to be covered in detail during the tutorial session (*) Problem 1. (Ross, Westerfield

### 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

### 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

### Chapter 16 Financial Distress, Managerial Incentives, and Information

Chapter 16 Financial Distress, Managerial Incentives, and Information 16-1. Gladstone Corporation is about to launch a new product. Depending on the success of the new product, Gladstone may have one of

### 1 Pricing options using the Black Scholes formula

Lecture 9 Pricing options using the Black Scholes formula Exercise. Consider month options with exercise prices of K = 45. The variance of the underlying security is σ 2 = 0.20. The risk free interest

### EMBA in Management & Finance. Corporate Finance. Eric Jondeau

EMBA in Management & Finance Corporate Finance EMBA in Management & Finance Lecture 5: Capital Budgeting For the Levered Firm Prospectus Recall that there are three questions in corporate finance. The

### 1. What is a recapitalization? Why is this considered a pure capital structure change?

CHAPTER 12 CONCEPT REVIEW QUESTIONS 1. What is a recapitalization? Why is this considered a pure capital structure change? Recapitalization is an alteration of a company s capital structure to change the

### 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

### SOLUTIONS. 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

IE Aufgabe 4 The Adjusted-Present-Value Approach to Valuing Leveraged Buyouts 1) Introduction A leveraged buyout (LBO) is the acquisition by a small group of equity investors of a public or private company

### 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

### Corporate 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

### 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

### Primary Market - Place where the sale of new stock first occurs. Initial Public Offering (IPO) - First offering of stock to the general public.

Stock Valuation Primary Market - Place where the sale of new stock first occurs. Initial Public Offering (IPO) - First offering of stock to the general public. Seasoned Issue - Sale of new shares by a

### CHAPTER 20. Financial Options. Chapter Synopsis

CHAPTER 20 Financial Options Chapter Synopsis 20.1 Option Basics A financial option gives its owner the right, but not the obligation, to buy or sell a financial asset at a fixed price on or until a specified

### 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

### The 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

### Chapter 10 Risk and Capital Budgeting

Chapter 10 Risk and Capital Budgeting MULTIPLE CHOICE 1. Operating leverage describes the relationship between... a. EBIT and sales b. taxes and sales c. debt and equity d. fixed costs and variable costs

### Practice 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

### Corporate 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. 1. DayTop Inns is a publicly traded company, with 10 million shares

### VALUATIONS I Financial Metrics, Ratios, & Comparables Analysis. Fall 2015 Comp Week 6

VALUATIONS I Financial Metrics, Ratios, & Comparables Analysis Fall 2015 Comp Week 6 CODE: COMPS Timeline Date Topic 9/10/15 Introduction to Finance 9/17/15 Qualitative Analysis: SWOT and Porter s Five

### The Assumptions and Math Behind WACC and APV Calculations

The Assumptions and Math Behind WACC and APV Calculations Richard Stanton U.C. Berkeley Mark S. Seasholes U.C. Berkeley This Version October 27, 2005 Abstract We outline the math and assumptions behind

### TIP If you do not understand something,

Valuing common stocks Application of the DCF approach TIP If you do not understand something, ask me! The plan of the lecture Review what we have accomplished in the last lecture Some terms about stocks

### Lecture 15: Final Topics on CAPM

Lecture 15: Final Topics on CAPM Final topics on estimating and using beta: the market risk premium putting it all together Final topics on CAPM: Examples of firm and market risk Shorting Stocks and other

### Equity 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

### Exercise. Exam Aid: All calculators are allowed but empty memory. Paper dictionaries are allowed. No other aids allowed in the exam room.

Exercise Exam Aid: All calculators are allowed but empty memory. Paper dictionaries are allowed. No other aids allowed in the exam room. Note: No formula sheets are allowed in the exam. Exercise: 01 Exercise

### Part 9. The Basics of Corporate Finance

Part 9. The Basics of Corporate Finance The essence of business is to raise money from investors to fund projects that will return more money to the investors. To do this, there are three financial questions

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

### ACCOUNTING III Cash Flow Statement & Linking the 3 Financial Statements. Fall 2015 Comp Week 5

ACCOUNTING III Cash Flow Statement & Linking the 3 Financial Statements Fall 2015 Comp Week 5 CODE: CA\$H Administrative Stuff Send an email to trentnelson@college.harvard.edu if you have not been added

### Things 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

### Problem 1 (Issuance and Repurchase in a Modigliani-Miller World)

Problem 1 (Issuance and Repurchase in a Modigliani-Miller World) A rm has outstanding debt with a market value of \$100 million. The rm also has 15 million shares outstanding with a market value of \$10

### CHAPTER 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,

### 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,

### The value of tax shields is NOT equal to the present value of tax shields

The value of tax shields is NOT equal to the present value of tax shields Pablo Fernández * IESE Business School. University of Navarra. Madrid, Spain ABSTRACT We show that the value of tax shields is

### Homework 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

### Finance 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

### 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

### Chapter 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

### 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

### Practice Bulletin No. 2

Practice Bulletin No. 2 INTERNATIONAL GLOSSARY OF BUSINESS VALUATION TERMS To enhance and sustain the quality of business valuations for the benefit of the profession and its clientele, the below identified

### SAMPLE 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.

### Chapter 17: Financial Statement Analysis

FIN 301 Class Notes Chapter 17: Financial Statement Analysis INTRODUCTION Financial ratio: is a relationship between different accounting items that tells something about the firm s activities. Purpose

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

### International Glossary of Business Valuation Terms*

40 Statement on Standards for Valuation Services No. 1 APPENDIX B International Glossary of Business Valuation Terms* To enhance and sustain the quality of business valuations for the benefit of the profession

### Estimating 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

### CHAPTER 22 Options and Corporate Finance

CHAPTER 22 Options and Corporate Finance Multiple Choice Questions: I. DEFINITIONS OPTIONS a 1. A financial contract that gives its owner the right, but not the obligation, to buy or sell a specified asset

### Q3: What is the quarterly equivalent of a continuous rate of 3%?

SESSION 1: Pre-requisites: a reminder Time value of money, annuities Q1: You wish to buy a new house but would need to borrow part of the required amount. In view of your revenues you have been able to

### 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

### Contribution 787 1,368 1,813 983. Taxable cash flow 682 1,253 1,688 858 Tax liabilities (205) (376) (506) (257)

Answers Fundamentals Level Skills Module, Paper F9 Financial Management June 2012 Answers 1 (a) Calculation of net present value (NPV) As nominal after-tax cash flows are to be discounted, the nominal

### 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

### APractitionersToolkitonValuation

APractitionersToolkitonValuation Part I: (Un)Levering the Cost of Equity and Financing Policy with Constant Expected Free Cash Flows: APV, WACC and CFE Frans de Roon, Joy van der Veer 1 Introduction Valuation

### Actuarial Society of India

Actuarial Society of India EXAMINATIONS November 2004 SUBJECT - 108: Finance and Financial Reporting Indicative Solution S-108 Page 1 of 7 1 D 2 C 3 B 4 D 5 D 6 A 7 B 8 C 9 B 10 D 11 Trade credit is short-term

### Diploma in Financial Management Examination Module B Paper DB1 incorporating subject areas: Financial Strategy; Risk Management

Answers Diploma in Financial Management Examination Module B Paper DB1 incorporating subject areas: Financial Strategy; Risk Management June 2005 Answers 1 D Items 2, 3 and 4 are correct. Item 1 relates

### 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

### Forecasting and Valuation of Enterprise Cash Flows 1. Dan Gode and James Ohlson

Forecasting and Valuation of Enterprise Cash Flows 1 1. Overview FORECASTING AND VALUATION OF ENTERPRISE CASH FLOWS Dan Gode and James Ohlson A decision to invest in a stock proceeds in two major steps

Econ 497 Barry W. Ickes Spring 2007 Midterm Exam:Answer Sheet 1. (25%) Consider a portfolio, c, comprised of a risk-free and risky asset, with returns given by r f and E(r p ), respectively. Let y be the

### CHAPTER 18 Dividend and Other Payouts

CHAPTER 18 Dividend and Other Payouts Multiple Choice Questions: I. DEFINITIONS DIVIDENDS a 1. Payments made out of a firm s earnings to its owners in the form of cash or stock are called: a. dividends.

### THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE

IX. THE FINANCING DECISIONS BY FIRMS: IMPACT OF CAPITAL STRUCTURE CHOICE ON VALUE The capital structure of a firm is defined to be the menu of the firm's liabilities (i.e, the "right-hand side" of the

### BA 351 CORPORATE FINANCE. John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD

BA 351 CORPORATE FINANCE John R. Graham Adapted from S. Viswanathan LECTURE 10 THE ADJUSTED NET PRESENT VALUE METHOD FUQUA SCHOOL OF BUSINESS DUKE UNIVERSITY 1 THE ADJUSTED NET PRESENT VALUE METHOD COPING

### DUKE UNIVERSITY Fuqua School of Business. FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof. Simon Gervais Fall 2011 Term 2

DUKE UNIVERSITY Fuqua School of Business FINANCE 351 - CORPORATE FINANCE Problem Set #8 Prof. Simon Gervais Fall 2011 Term 2 Questions 1. Hors d Age Cheeseworks has been paying a regular cash dividend

### Often stock is split to lower the price per share so it is more accessible to investors. The stock split is not taxable.

Reading: Chapter 8 Chapter 8. Stock: Introduction 1. Rights of stockholders 2. Cash dividends 3. Stock dividends 4. The stock split 5. Stock repurchases and liquidations 6. Preferred stock 7. Analysis

### ENTREPRENEURIAL FINANCE: Strategy, Valuation, and Deal Structure

ENTREPRENEURIAL FINANCE: Strategy, Valuation, and Deal Structure Chapter 11. The Entrepreneur s Perspective on Value Questions and Problems 1. A venture that requires an investment of \$5 million is expected

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

### Practice Questions for Midterm II

Finance 333 Investments Practice Questions for Midterm II Winter 2004 Professor Yan 1. The market portfolio has a beta of a. 0. *b. 1. c. -1. d. 0.5. By definition, the beta of the market portfolio is

### Financial ratio analysis

Financial ratio analysis A reading prepared by Pamela Peterson Drake O U T L I N E 1. Introduction 2. Liquidity ratios 3. Profitability ratios and activity ratios 4. Financial leverage ratios 5. Shareholder

### DCF and WACC calculation: Theory meets practice

www.pwc.com DCF and WACC calculation: Theory meets practice Table of contents Section 1. Fair value and company valuation page 3 Section 2. The DCF model: Basic assumptions and the expected cash flows

### 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

### Corporate 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

### MCQ on Financial Management

MCQ on Financial Management 1. "Shareholder wealth" in a firm is represented by: a) the number of people employed in the firm. b) the book value of the firm's assets less the book value of its liabilities

### CIS 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

### INTERVIEWS - FINANCIAL MODELING

420 W. 118th Street, Room 420 New York, NY 10027 P: 212-854-4613 F: 212-854-6190 www.sipa.columbia.edu/ocs INTERVIEWS - FINANCIAL MODELING Basic valuation concepts are among the most popular technical

### 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

### Discounted Cash Flow Valuation: Basics

Discounted Cash Flow Valuation: Basics Aswath Damodaran Aswath Damodaran 1 Discounted Cashflow Valuation: Basis for Approach Value = t=n CF t t =1(1+r) t where CF t is the cash flow in period t, r is the

### 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:

### 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.

### On the Applicability of WACC for Investment Decisions

On the Applicability of WACC for Investment Decisions Jaime Sabal Department of Financial Management and Control ESADE. Universitat Ramon Llull Received: December, 2004 Abstract Although WACC is appropriate

### CHAPTER 17 Does Debt Policy Matter?

CHPTR 17 Does Debt Policy Matter? nswers to Practice Questions 1. a. The two firms have equal value; let represent the total value of the firm. Rosencrantz could buy one percent of Company B s equity and

### Chapter 7. . 1. component of the convertible can be estimated as 1100-796.15 = 303.85.

Chapter 7 7-1 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

### FIN 432 Investment Analysis and Management Review Notes for Midterm Exam

FIN 432 Investment Analysis and Management Review Notes for Midterm Exam Chapter 1 1. Investment vs. investments 2. Real assets vs. financial assets 3. Investment process Investment policy, asset allocation,