Bus 170 exam 4

waac

A firm's Weighted Average Cost of Capital (WACC) represents its blended cost of capital across all sources, including common shares, preferred shares, and debt. The cost of each type of capital is weighted by its percentage of total capital and they are added together. WACC is the average after-tax cost of a company's various capital sources, including common stock, preferred stock, bonds, and any other long-term debt. In other words, WACC is the average rate a company expects to pay to finance its assets.

Firms' actual capital structures change over time, and for two quite different reasons:

Deliberate actions: If a firm is not currently at its target, it may deliberately raise new money in a manner that moves the actual structure toward the target. Market actions: The firm could incur high profits or losses that lead to significant changes in book value equity as shown on its balance sheet and to a decline in its stock price. Similarly, although the book value of its debt would probably not change, interest rate changes due to changes in the general level of rates and/or changes in the firm's default risk could cause significant changes in its debt's market value. Such changes in the market value of the debt and/or equity could result in large changes in its measured capital structure.

Is the debt level that maximizes a firm's expected EPS the same as the debt level that maximizes its stock price? Explain

Expected EPS is generally measured as EPS for the coming years, and we typically do not reflect in this calculation any bankruptcy-related costs.Also, EPS does not reflect the increase in risk and Rs that accompanies an increase in the debt to capital ratio, whereas P0 does reflect these factorsThus, the stock price will be maximized at a debt LOWER than the EPS maximizing debt level

What is the only risk that should matter to a rational, diversified investor?

Market risk

Why should we use Market value of equity, not Book value, in calculating the WACC?

Market value WACC is prefered beacause an investor would be demand required rate of return on the market value of capital and not on the book value of capital

Market value equity

Market value of equity is the total dollar value of a company's equity and is also known as market capitalization. This measure of a company's value is calculated by multiplying the current stock price by the total number of outstanding shares. A company's market value of equity is therefore always changing as these two input variables change. It is used to measure a company's size and helps investors diversify their investments across companies of different sizes and different levels of risk.

What Is Return on Market Value of Equity?

Return on market value of equity (ROME) is a comparative measure typically used by analysts to identify companies that generate positive returns on book value and trade at otherwise low valuations. The market value of equity is generally accepted to be synonymous with a company's market capitalization, and the return on market value of equity is effectively the profit yield on a company's stock price.

What's the difference between Market value and Book value of equity?

The market value of equity is also distinct from the book value of equity. The book value of equity is based on stockholders' equity, which is a line item on the company's balance sheet. A company's market value of equity differs from its book value of equity because the book value of equity focuses on owned assets and owed liabilities. The market value of equity is generally believed to price in some of the company's growth potential beyond its current balance sheet. If the book value is above the market value of equity, however, it may be due to market oversight. This means the company is a potential value buy.

If a firm went from zero debt to successively higher levels of debt, why would you expect its stock price to first rise, then hit a peak, and then begin to decline?

The tax benefits from debt increase linearly, which causes a continuous increase in the firm's value and stock price. However, financial distress costs get higher and higher as more and more debt is employed, and these costs eventually offset and begin to outweigh the benefits of debt.

Why do we need to calculate the After-tax Cost of Debt?

We use the after-tax cost of debt in calculating the WACC because we are interested in maximizing the value of the firm's stock, and the stock price depends on after-tax cash flows. Because we are concerned with after-tax cash flows and because cash flows and rates of return should be calculated on a comparable basis, we adjust the interest rate downward due to debt's preferential tax treatment.*

Systematic Risk Vs. Unsystematic Risk

While systematic risk can be thought of as the probability of a loss that is associated with the entire market or a segment thereof, unsystematic risk refers to the probability of a loss within a specific industry or security.

A cyclical company is

a business whose success is determined by the economy.

Operating leverage is

a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

Diversification is

a great strategy for anyone looking to reduce risk on their investment for the long term. The process of diversification includes investing in more than one type of asset. This means including bonds, shares, commodities, REITs, hybrids, and more in your portfolio.

The security market line (SML)

a line drawn on a chart that serves as a graphical representation of the capital asset pricing model (CAPM)—which shows different levels of systematic, or market risk, of various marketable securities, plotted against the expected return of the entire market at any given time.

Beta is

a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital.

A perpetuity is

a security that pays for an infinite amount of time. In finance, perpetuity is a constant stream of identical cash flows with no end. The formula to calculate the present value of a perpetuity, or security with perpetual cash flows, is as follows:

Modern portfolio theory (MPT) is

a theory on how risk-averse investors can construct portfolios to maximize expected return based on a given level of market risk. Harry Markowitz pioneered this theory in his paper "Portfolio Selection," which was published in the Journal of Finance in 1952.1 He was later awarded a Nobel Prize for his work on modern portfolio theory.2

Discounted cash flow (DCF) is

a valuation method used to estimate the value of an investment based on its expected future cash flows. DCF analysis attempts to figure out the value of an investment today, based on projections of how much money it will generate in the future. This applies to both financial investments for investors and for business owners looking to make changes to their businesses, such as purchasing new equipment.

Relative valuation,

also referred to as comparable valuation, is a very useful and effective tool in valuing an asset. Relative valuation involves the use of similar, comparable assets in valuing another asset. (So you've finally decided to start investing. But what should you put in your portfolio? Find out here. Check out How to Pick a Stock.)

Comparables (comps)

are used in valuations where a recently sold asset is used to determine the value of a similar asset. Comparables, often used in real estate to find the fair value of a home, are a list of recent asset sales that reflect the characteristics of the asset an owner is looking to sell. However, the list of sales is generally limited to within the last year.

average stock's beta

ba= 1.0

Sharpe ratio

compares the asset's realized excess return to its standard deviation over a specified period: (return - risk free rate/ σ). Investments with returns equal to the risk-free rate will have a zero Sharpe ratio. It follows that over a given time period, investments with higher Sharpe ratios performed better, because they generated higher excess returns per unit of risk.

Non-cyclical stocks, or defensive stocks,

comprise businesses that operate in industries that do well regardless of what the overall economy is doing. This is because these businesses offer essential goods, such as utilities. Luxury goods are nice to have. But consumers always need utilities such as water, electricity and gas. They continue buying food, household products and tobacco.

financial leverage

concentrates the firm's business risk on the stockholders.

The Capital Asset Pricing Model (CAPM)

describes the relationship between systematic risk and expected return for assets, particularly stocks. CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.

Diversifiable risk can be eliminated by

holding very large portfolios or by buying shares in a mutual fund.

The standard deviation, σ ,

is a measure of how far the actual return is likely to deviate from the expected return.

Correlation

is a statistic that measures the degree to which two securities move in relation to each other. Correlations are used in advanced portfolio management, computed as the correlation coefficient, which has a value that must fall between -1.0 and +1.0. A perfect negative correlation means that two assets move in opposite directions, while a zero correlation implies no linear relationship at all.

ROIC

measures the after-tax return that the company provides for all of its investors. Because ROIC does not vary with changes in capital structure, the standard deviation of ROIC σ (σROIC) measures the underlying risk of the firm before considering the effects of debt financing, thereby providing a good measure of business risk.*

Why do we NOT need to calculate an after-tax cost for Common or Preferred Stock?

preferred stock may include an option to convert to common stock, which adds another layer of complexity.

after-tax cost of debt,

rd(1-T) , should be used to calculate the weighted average cost of capital. This is the interest rate on new debt, rd , less the tax savings that result because interest is tax deductible:*

Systematic risk

refers to the risk inherent to the entire market or market segment. Systematic risk, also known as "undiversifiable risk," "volatility" or "market risk," affects the overall market, not just a particular stock or industry. This type of risk is both unpredictable and impossible to completely avoid. It cannot be mitigated through diversification, only through hedging or by using the correct asset allocation strategy.

Portfolio risk

reflects the overall risk for a portfolio of investments. The portfolio's risk is generally smaller than the average of the stocks' σs because diversification lowers the portfolio's risk.

The market risk premium, RPM ,

shows the premium that investors require for bearing the risk of an average stock. The size of this premium depends on how risky investors think the stock market is and on their degree of risk aversion. It should be noted that the risk premium of an average stock, rM-rRF , is hard to measure because it is impossible to obtain a precise estimate of the expected future return of the market, rM .*

Financial risk is

the additional risk placed on the common stockholders as a result of the decision to finance with debt.

Financial risk, which is

the additional risk placed on the common stockholders as a result of using debt.

The optimal capital structure of a firm is

the best mix of debt and equity financing that maximizes a company's market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

The cost of debt is

the effective interest rate a company pays on its debts. It's the cost of debt, such as bonds and loans, among others. The cost of debt often refers to before-tax cost of debt, which is the company's cost of debt before taking taxes into account. However, the difference in the cost of debt before and after taxes lies in the fact that interest expenses are deductible.

Cost of capital is

the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. When analysts and investors discuss the cost of capital, they typically mean the weighted average of a firm's cost of debt and cost of equity blended together.

Diversifiable risk is

the risk that is eliminated by adding stocks.Diversifiable risk is caused by such random, unsystematic events as lawsuits, strikes, successful and unsuccessful marketing and R&D programs, the winning or losing of a major contract, and other events that are unique to the particular firm. Because these events are random, their effects on a portfolio can be eliminated by diversification—bad events for one firm will be offset by good events for another.

Market risk

the risk that remains even if the portfolio holds every stock in the market. Market risk, on the other hand, stems from factors that systematically affect most firms: war, inflation, recessions, high interest rates, and other macro factors. Because most stocks are affected by macro factors, market risk cannot be eliminated by diversification.

Business risk, which is

the riskiness of the firm's assets if no debt is used.

Business risk

the single most important determinant of capital structure, and it represents the amount of risk that is inherent in the firm's operations even if it uses no debt financing. A commonly used measure of business risk is the standard deviation of the firm's return on invested capital, or ROIC.

Terminal value (TV) is

the value of a business or project beyond the forecast period when future cash flows can be estimated. Terminal value assumes a business will grow at a set growth rate forever after the forecast period. Terminal value often comprises a large percentage of the total assessed value.

True or False: The greater the difference between the stock's book value and market value, the greater the difference between the alternative WACCs.

true