FIN 3320 Exam 2

Disadvantages of Payback

(1) All dollars received in different years are given equal weight. (2) Cash flows beyond the payback year are ignored. (3) The payback merely indicates when a project's investment will be recovered. There is no necessary relationship between a given payback and investor wealth maximization.

Bond's current yield

calculated as the annual interest payment divided by it's current price. Unlike the yield to maturity or the yield to call, it does not represent the actual return that investors should expect because it does not account for the capital gain or loss that will be realized if the bond is held until it matures or is called.

Yield to maturity (YTM)

The rate of return earned on a bond if it is held to maturity. Calculate YTM using a financial calculator by entering the number of payment periods until maturity for N, the price of the bond for PV, the interest payments for PMT, and the maturity value for FV. Then solve for I/YR = YTM. Remember, you need to make the appropriate adjustments for a semiannual bond and realize that the calculated I/YR is on a periodic basis so you will need to multiply the rate by 2 to obtain the annual rate.

Significance of crossover rate

The significance of the crossover rate is that at any cost of capital greater than the crossover rate, the NPV and IRR methods will provide the same conclusion for evaluating mutually exclusive projects. However, at any cost of capital less than the crossover rate, the NPV and IRR methods' conclusions will conflict. In that situation, the NPV method will always provide the correct project acceptance result.

Coupon interest rate

The stated annual interest rate on the bond

Relationship between fixed-rate bonds and interest rates

The value of the bond has an INVERSE relationship with the level of interest rates

Constant growth stock

There are several conditions that must exist before this equation can be used. First, the required rate of return, rs, must be greater than the long-run growth rate, g. Second, the constant growth model is not appropriate unless a company's growth rate is expected to remain constant in the future. This condition almost never holds for start-up firms, but it does exist for many mature companies.

The Cost of Capital

This cost is equal to the marginal investor's required return on the applicable security. The cost of capital is often referred to as the hurdle rate.

Discounted Payback Period

Unlike regular payback, the discounted payback considers capital costs. However, the discounted payback still disregards cash flows beyond the payback year. In addition, there is no specific payback rule to justify project acceptance. Both methods provide information about liquidity and risk.

5 years ago, Barton Industries issued 25-year noncallable, semiannual bonds with a $1,000 face value and an 11% coupon, semiannual payment ($55 payment every 6 months). The bonds currently sell for $844.87. If the firm's marginal tax rate is 25%, what is the firm's after-tax cost of debt? Do not round intermediate calculations. Round your answer to two decimal places.

Using a financial calculator, enter the following input data: N = 20 × 2 = 40; PV = -844.87; PMT = 0.11/2 × 1,000 = 55; and FV = 1,000. Then, solve for YTM/2 = I/YR = 6.61%. So, YTM = rd = 2 × 6.61% = 13.22%.

NPV

estimates how much a potential project will contribute to shareholders' wealth, and it is the best selection criterion. The larger the NPV, the more value the project adds; and added value means a higher stock price.

A call provision

gives the issuer the right to redeem the bonds under specified terms prior to their normal maturity date, although not all bonds have this provision

Longer maturity bonds

high price risk low reinvestment risk

The value of any financial asset

is the present value of the cash flows you expect to receive from that asset Using a financial calculator is easiest: Simply enter N as years to maturity, I/YR as the going annual interest rate, PMT as the annual coupon payment (calculated as the annual coupon interest rate times the face value of the bond), and FV as the stated maturity value. Once those inputs are entered in your financial calculator, you can solve for PV, the value of the bond.

Par value of a bond

its stated face value or maturity value

Sinking fund provision

require the issuer to systematically retire a portion of the bond issue each year. Because sinking fund provisions facilitate their orderly retirement, bonds with these provisions are regarded as being safer so they will have lower coupon rates than similar bonds without these provisions.

Cost of preferred stock

rp, used in the weighted average cost of capital equation is calculated as the preferred dividend, Dp, divided by the current price of the preferred stock, Pp. No tax adjustment is made when calculating rp because preferred dividends aren't tax deductible; so no tax savings are associated with preferred stock.

Beta coefficient

shows the extent to which a given stock's returns move up and down with the stock market. An average stock's beta is equal to 1 because an average-risk stock is one that tends to move up and down in step with the general market. A stock with a beta greater than 1 is considered to have high-risk, while a stock with beta less than 1 is considered to have low risk.

CAPM (Capital Asset Pricing Model)

states that any stock's required rate of return is equal to the risk-free rate of return plus a risk premium that reflects only the risk remaining after diversification.

Internal Rate of Return (IRR)

the discount rate that forces the PV of its inflows to equal its cost. The IRR is an estimate of the project's rate of return, and it is comparable to the YTM on a bond. The IRR equation is simply the NPV equation solved for the particular discount rate that causes NPV to equal zero.

Differences between Discounted Dividend and Corporate Valuation

the expected cash flow stream and the discount rate used in the models are different. The discounted dividend model calculates the firm's stock price as the present value of the expected future dividends at the firm's required rate of return on equity, while the corporate valuation model calculates the firm's stock price as the present value of the expected free cash flows at the firm's weighted average cost of equity.

Yield to Call (YTC)

the rate of return earned on a bond when it is called before its maturity date. Calculate YTC using a financial calculator by entering the number of payment periods until call for N, the price of the bond for PV, the interest payments for PMT, and the call price for FV. Then you can solve for I/YR = YTC. Again, remember you need to make the appropriate adjustments for a semiannual bond and realize that the calculated I/YR is on a periodic basis so you will need to multiply the rate by 2 to obtain the annual rate.

Expected rate of return

the return expected to be realized from an investment; it is calculated as the weighted average of the probability distribution of possible results

Price risk

the risk of a decline in a bond's value due to an increase in interest rates. This risk is higher on bonds that have long maturities than on bonds that will mature in the near future.

Reinvestment risk

the risk that a decline in interest rates will lead to a decline in income from a bond portfolio. This risk is obviously high on callable bonds. It is also high on short-term bonds because the shorter the bond's maturity, the fewer the years before the relatively high old-coupon bonds will be replaced with new low-coupon issues.

Duration

the weighted average of the time it takes to receive each of the bond's cash flows.

Payback Period

was the earliest capital budgeting selection criterion. The payback is a "break-even" calculation in the sense that if a project's cash flows come in at the expected rate, the project will break even. The shorter a project's payback, the better it is.

Premium bond

a bond that sells above its par value; occurs whenever the going rate of interest is below the coupon rate

What is a Bond?

a long-term contract under which a borrower agrees to make payments of interest and principal on specific dates.

Which of the following would be included in the calculation of total invested capital?

a. Notes payable b. Taxes payable c. Accounts payable d. Responses a and c would be included in the calculation of total invested capital. e. None of the above would be included in the calculation of total invested capital. Answer: a

Which of the following assumptions would cause the constant growth stock valuation model to be invalid?

a. The growth rate is zero. b. The growth rate is negative. c. The required rate of return is greater than the growth rate. d. The required rate of return is more than 50%. e. None of the above assumptions would invalidate the model. Answer: e

Security Market Line (SML)

an equation that shows the relationship between risk as measured by beta and the required rates of return on individual securities. If a stock's expected return plots on or above the SML, then the stock's return is sufficient to compensate the investor for risk. If a stock's expected return plots below the SML, the stock's return is insufficient to compensate the investor for risk.

Original Issue Discount (OID) Bond

any bond originally offered at a price below its par value

When is a bond likely to be called?

A company is more likely to call its bonds if they are able to replace their current high-coupon debt with less expensive financing. A bond is more likely to be called if its price is above par - because this means that the going market interest rate is less than its coupon rate.

nonconstant growth stock

Basically, this equation calculates the present value of dividends received during the nonconstant growth period and the present value of the stock's horizon value, which is the value at the horizon date of all dividends expected thereafter.

After-tax cost of Debt

Because interest is tax deductible, the relevant cost of new debt used to calculate a firm's WACC is the after-tax cost of debt, Rd(1 -T). The after-tax cost of debt is used 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.

Conflicts between NPV and IRR

Because of the IRR reinvestment rate assumption, when mutually exclusive projects are evaluated the IRR approach can lead to conflicting results from the NPV method. Two basic conditions can lead to conflicts between NPV and IRR: timing differences (earlier cash flows in one project vs. later cash flows in the other project) and project size (the cost of one project is larger than the other). When mutually exclusive projects are considered, then the NPV method should be used to evaluate projects.

Sharpe Ratio

Compares the asset's realized excess return to its standard deviation over a specified period of time. investments with returns equal to the risk-free rate will have a ZERO sharpe ratio. Calculated as: (Return - Riskfree rate)/ Standard dev.

Debentures

Debentures are long-term bonds that are not secured by a mortgage. Subordinated debentures are bonds having claims on assets only after senior debt has been paid in full in the event of liquidation.

Investment horizon

Determines which type of risk is more relevant to an investor; the period of time an investor plans to hold a particular investment.

2 models to estimate a stock's intrinsic value

Discounted dividend model - values a common stock as the present value of its expected future cash flows at the firm's required rate of return on equity. Variations of this model are used to value constant growth stocks, zero growth stocks, and nonconstant growth stocks. Corporate valuation model - an alternative model used to value a firm, especially one that does not pay dividends or is privately held. This model calculates the firm's free cash flows, and then finds their present values at the firm's weighted average cost of capital to determine a firm's value.

2 types of Portfolio risk

Diversifiable risk - is that part of a security's risk associated with random events. It can be eliminated by proper diversification and is also known as company-specific risk. Market risk - is the risk that remains in a portfolio after diversification has eliminated all company-specific risk. Standard deviation is not a good measure of risk when a stock is held in a portfolio. A stock's relevant risk is the risk that remains once a stock is in a diversified portfolio. Its contribution to the portfolio's market risk is measured by a stock's beta

Bond Yield Plus Risk Premium approach

Empirical studies suggest that the risk premium on a firm's stock over its own bonds generally ranges from 3 to 5 percentage points. The equation is shown as: rs = Bond yield + Risk premium. Note that this risk premium is different from the risk premium given in the CAPM. This method doesn't produce a precise cost of equity, but does provide a ballpark estimate.

Capital Budgeting

Firms use capital budgeting for their long-term asset investment decisions. Capital budgeting is important because fixed asset investment decisions chart a company's course for the future. Similar to security valuation.

Higher coupon bonds

Higher level of reinvestment risk Lower level of price risk

The firm's primary financial objective

Maximize shareholder value. To do this, companies invest in projects that earn more than their cost of capital

Capital Budgeting methods

Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return Payback period

IRR assumptions

The IRR calculation assumes that cash flows are reinvested at the IRR. If the IRR is greater than the project's risk-adjusted cost of capital, then the project should be accepted; however, if the IRR is less than the project's risk-adjusted cost of capital, then the project should be rejected

The tighter an asset's probability

The LOWER its risk

NPV assumptions

The NPV calculation assumes that cash inflows can be reinvested at the project's risk-adjusted WACC. When the firm is considering independent projects, if the project's NPV exceeds zero the firm should accept the project. When the firm is considering mutually exclusive projects, the firm should accept the project with the highest positive NPV.

Zero growth stocks

The constant growth model is sufficiently general to handle the case of a zero growth stock, where the dividend is expected to remain constant over time. Note that this is the same equation developed in Chapter 5 to value a perpetuity, and it is the same equation used to value a perpetual preferred stock that entitles its owners to regular, fixed dividend payments in perpetuity. The valuation equation is simply the current dividend divided by the required rate of return.

Crossover rate

The cost of capital at which the NPV profiles of two projects cross and, thus, at which the projects' NPVs are equal. The crossover rate can be found by calculating the IRR of the differences in the projects' cash flows (Project Delta).

Flotation Cost Adjustment

The difference between the flotation-adjusted cost of equity and the cost of equity calculated without the flotation adjustment represents the flotation cost adjustment. F = Re - Rs

Mortgage bonds are

backed by Fixed Assets

Cost of common equity (retained earnings)

based on the rate of return that investors require on the company's common stock. New common equity is raised in two ways: (1) by retaining some of the current year's earnings and (2) by issuing new common stock. Equity raised by issuing stock has a(n) higher cost, re, than equity raised from retained earnings, rs, due to flotation costs required to sell new common stock

Investment-grade bonds

bonds are rated triple B or higher, and many banks and other institutional investors are legally limited to only holding these bonds. In contrast, junk bonds are high-risk, high-yield bonds.

Putable Bonds

bonds contain a provision that allows holders to sell them back to the company prior to maturity at a prearranged price.

Convertible bonds

bonds that are exchangeable at the option of the holder for the issuing firm's common stock

Zero coupon bond

bonds that pay no annual interest but are sold at a discount below par, thus compensating investors in the form of capital appreciation

Fixed-rate bonds

bonds with a constant coupon rate over the life of the bond

Floating rate bond

bonds with a coupon rate that varies over time depending on the level of interest rates.

4 main types of issuers

1. Treasury 2. Corporate 3. State/local government 4. Foreign *Each type differs with respect to risk and expected return

Discount bond

A bond that sells below its par value; occurs whenever the going rate of interest is above the coupon rate

NPV profile

A project's NPV profile graph intersects the Y-axis at 0% cost of capital and intersects the X-axis at the project's IRR (where NPV = 0). The Y-axis intersection point represents the project's undiscounted NPV.

Income Bonds

Bonds that pay no interest unless the issuing company is profitable.

Bellinger Industries is considering two projects for inclusion in its capital budget, and you have been asked to do the analysis. Both projects' after-tax cash flows are shown on the time line below. Depreciation, salvage values, net operating working capital requirements, and tax effects are all included in these cash flows. Both projects have 4-year lives, and they have risk characteristics similar to the firm's average project. Bellinger's WACC is 10%.

Calculator solution:Calculate the Project Δ cash flows as Project A CFt - Project B CFt and enter the data into your financial calculator as follows:CF0 = 0; CF1 = 420; CF2 = 55; CF3 = -195; CF4 = -440; and I/YR = 10. Solve for IRR = 11.96%.

3 Procedures to estimate cost of retained earnings

Capital Asset Pricing Model (CAPM) Bond Yield Plus Risk Premium Discounted Cash Flow (DCF)

DCF approach

Investors expect to receive a dividend yield,D1/P0 , plus a capital gain, g, for a total expected return. In equilibrium, this expected return is also equal to the required return. It's easy to calculate the dividend yield; but because stock prices fluctuate, the yield varies from day to day, which leads to fluctuations in the DCF cost of equity.

Capital budgeting analysis

Projects that firms consider are either independent or mutually exclusive. In addition, projects may have normal cash flows or nonnormal cash flows. Whether a project is independent or mutually exclusive will impact the firm's capital budgeting analysis as we will see when we discuss the different decision rules.

Before-tax cost of Debt

Rd, The interest rate the firm must pay on NEW debt.

Common stock

Represents the ownership position in a firm, and is valued as the present value of its expected future dividend stream. Common stock dividends are not specified by contract—they depend on the firm's earnings.

3 measures of stand-alone risk

Standard Deviation Coefficient of Variation Sharpe Ratio

CAPM (cont'd)

The CAPM estimate of rs is equal to the risk-free rate, rRF, plus a risk premium that is equal to the risk premium on an average stock, (rM - rRF), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, bi. This model assumes that a firm's stockholders are well diversified. But if they are not well diversified, then the firm's true investment risk would not be measured by beta and the CAPM estimate would understate the correct value of rs.

WACC

When calculating the weighted average cost of capital (WACC), our concern is with capital that must be provided by investors - interest-bearing debt, preferred stock, and common equity. Accounts payable and accruals, which arise spontaneously from operations when capital budgeting projects are undertaken, are not included as part of investor-supplied capital because they do not come directly from investors.

When does market equilibrium occur?

When the stock's price is equal to its intrinsic value. The actions of the marginal investor determine the equilibrium stock price.