EZC1 - Principles of Finance

Value of Preferred Stock

You decide you want to issue preferred stock to finance a new cardio deck. You decide on issuing 5,000 shares at $20 per share. All of the flotation costs together will be $3 per share. You have agreed to an annual dividend of $2 per share. What is your cost of preferred stock? HoP Gym Preferred Example Note that the denominator $17 = $20 - $3, which is the price per share minus flotation costs, which equals the net price.

Plug Figure

The account that makes the pro forma balance sheet balance. **The plug is the DFN and is always the last computation in our projections

Multi-stage Growth Models

The advantage of these models and the reason that they are so widely used as a primary valuation tool by analysts today is that they can be adjusted to value whatever pattern of future cash flows the analyst may hypothesize.

Describe the purposes of the three major financial statements: Income Statement, Balance Sheet, and Statement of Cash Flows.

The balance sheet is a snapshot of the firm's assets and the financing of those assets at a given point in time (that's why it's dated "as of" a particular date). It is a listing of all the assets, liabilities, and equity of the firm and is based on the following equation (known as the balance sheet equation): The Income Statement describes the revenues and expenses associated with a company's operations for a given period of time (that is why it is dated "for the period ended"). The cash flow statement explains the sources and uses of cash for the company—it shows cash in and cash out of the company for a given year. All cash flows are divided into three groups: cash flows from operations (CFO), cash flows from investing (CFI), and cash flows from financing (CFF). The sum of all of these cash flow sources should equal the company's change in cash for the year.

Indenture - Bonds

The bond contract between the bond issuer (the corporation) and the bondholder (investor) and describes all of the bond's features: coupon rate, par value, maturity, etc. It also lists the covenants associated with the bond.

Tax on Equipment Sale - Example II Original equipment cost: $1,000 Accumulated depreciation: $400 Tax rate: 40% Sale price: $800

The book value of the equipment is $1,000 - $400 = $600. It sold for $800 so taxable gain is $800 - $600 = $200. •the $200 is a taxable gain and is treated as ordinary taxable income (unless it is real estate). The tax liability of $200 × .40 = $80 created by this gain represents a real cash outflow for the company. The net cash flow from this sale is then the $800 inflow from the sale minus $80 in taxes on the $200 gain, or $800 - $80 = $720. This is selling an asset for more than book value.

there are three cost components to consider when calculating the cost of debt.

The borrowing cost. This is the explicit interest rate that you pay on the debt. For example, on a 10%, $1,000 loan the borrowing cost is simply the 10% interest rate. On a bond, the borrowing cost would be the yield to maturity (including both coupon and final payments) that you learned to calculate in the bond pricing topic. Flotation costs. There are many costs associated with obtaining new debt. An example of a flotation cost is the transaction fees. When a company wants to issue new debt through selling bonds, it hires investment banking firms to help in the placement of those bonds. The same is true in personal debt. When a home buyer applies to get a 10%, $100,000 mortgage loan, not only does he pay the 10% interest throughout the life of the loan (the borrowing cost), but he also pays additional closing fees, loan origination fees, and various other transaction fees. In either case, corporate or private borrowing, the effect of these fees is to raise the cost of obtaining debt. Taxes. How do taxes affect the cost of borrowing? They lower borrowing costs by creating a tax shield. To illustrate this concept, we will use the following example.

Corporate Governance

The control issues involved in running a company.

Coupon Rate

The coupon rate is the interest rate of the bond and is also known as the coupon yield.

Tax on Equipment Sale - Example Original equipment cost: $1,000 Accumulated depreciation: $400 Tax rate: 40% Sale price: $100

The current book value of this equipment is the cost minus the accumulated depreciation: $1,000 - $400 = $600. Minus the $100 sales price = $500. $500 × .40 = $200. This $200 tax savings represents money that the company now does not have to send to the IRS and can invest in other opportunities; it is real savings to the company. Hence, the cash impact of the sale of the equipment is the $100 sales price plus the $200 tax savings, or a total cash inflow of $300.

After Tax Cost of Debt - Example A bond has a $1,000 face value and a coupon rate of 6.2% paid annually. A new issue would have a flotation cost of 12.3% and a market value of $1,135.22. The bond matures in 15 years. The firm's marginal tax rate is 35%. What is the after-tax cost of debt?

The firm has to pay 12.3% of its price as a flotation cost, so the money the firm will receive is: 1,135.22 x (1 - 0.123) = 995.59, which is the PV to plug-in your calculator. We can then solve for the I button. PV -995.59 FV -1000 N 15 PMT 62 I 6.25% Since debt creates a tax shield, the after-tax cost of capital for the bond is: 6.25% x (1 - 0.35) = 4.06%

Debt PRIOR to Tax - Example (Calculator) AlterU has the option to issue 15-year bonds at $1,180 with a flotation cost of 7%, tax rate of 34%, and a coupon rate of 6% (paid annually). What is AlterU firm's cost of debt PRIOR to tax?

The firm has to pay 7% of its price as a flotation cost, so the funds the firm will receive are: 1,180 x (1 - 0.07) = 1,097.40 which is your PV on your calculator. PV -1,097.40 FV 1,000 N 15 PMT 60 I 5.06%** **this is the answer since you are looking for the "before-tax" cost of debt.

Personal Savings

The first problem is to calculate the required monthly savings for Mary to reach her nest-egg goal. Without looking, how much do you think Mary needs to save each month to accumulate $2,000,000 by the time she retires? This is a fairly straightforward application of the future value of an annuity. Keystrokes: Mini-Case 516 N 2,000,000 FV 12 ÷ 12 = 1 I/YR Solve: Pmt = -$118.51

Coupon Rate - Bonds

The interest rate of the bond and is also known as the coupon yield. • Multiplying the coupon rate by the par value gives the amount of the bond's yearly coupon, or interest payment. For example, a $1,000 par value bond with a 9% coupon rate will pay $1,000 × .09 = $90 in interest annually.

Borrowing Cost

The interest rate you pay on debts • On a loan it's the interest rate • On a bond, it's the yield to maturity (YTM) coupon + final payments

Depreciation Expense II

The method by which capital expenses are allocated to the cost of operations over time. • Depreciation expense impacts the amount and timing of tax payments. Hence, even though depreciation itself is a non-cash expense, it does impact cash flows through its impact on taxes.

Maturity - Bonds

The number of years from when the bond is issued to when it expires is its maturity. Bond maturities may be as short as 3 months or as long as 30 years

Discounting

The opposite, moving a sum from the future back toward the present (or right to left on the timeline).

Value of Bond

The present value of its cash flows.

Intrinsic Value of an Asset

The present value of the stream of expected cash flows discounted at an appropriate required rate of return.

A firm can raise capital from three basic sources:

borrowing (debt), common stock (equity), or preferred stock (hybrid).

Interest Rate/Discount Rate

The rate (or price) of moving consumption through time. Rate = risk free rate + risk premium = Rf + risk premium

Beta Risk

The relationship (correlation) that Company C has with the overall market. Beta risk is also termed systematic risk, nondiversifiable risk, and market risk. • Beta captures how the stock returns of a firm (Company C here) relate to contemporaneous (big word) market returns • Considering that the risk free rate and market risk premium are the same for all companies (i.e., they are determined by the economy and the general market, not by any specific company), the cost of equity for an individual company is in large part determined by a single risk factor: beta risk.

Solutions to the Unequal Lives Problem

The replacement chain approach The Equivalent Annual Annuity (EAA) approach

Tax Shield

The tax savings that result from offsetting positive earnings with negative income.

Stage 2, which begins after the super-normal Stage 1 period, assumes that the company has now matured and stabilized and will continue to grow at the industry average rate from the beginning of Stage 2 through infinity.

The value of Stage 2 is the present value of this infinite stream of dividends that grow at a constant rate forever—it is a growing perpetuity. We have already learned to value a perpetuity that grows at a constant rate forever using the Gordon Model.

Firm Valuation

The value of a firm is the sum of the discounted value of its future cash flows. There are only two main ways to increase company value. 1. Increasing sales or lowering expenses. 2. Decrease the denominator of the discounted cash flow (DCF) model, or the cost of capital, that the firm uses to discount future cash flows by coming up with an optimal mix of financing vehicles—debt, common stock, and preferred stock—that management lowers company cost of capital and increases company value.

Terminal Value

The value of all future cash flows from a point in time.

Security Violation

The value of an asset = the present value of the stream of expected cash flows discounted at the required rate of return.

This discount rate has a specific name when dealing with bonds. It is known as the yield to maturity, abbreviated YTM.

The yield to maturity is also known as the promised yield, meaning that it is the return we are promised if we buy a bond today and hold it to maturity The yield to maturity is the rate of return, or discount rate, of the bond. It is calculated as shown previously. Using the current price, par value, maturity, and coupon rate, we solve for the appropriate annual discount rate.

Flotation costs.

There are many costs associated with obtaining new debt. An example of a flotation cost is the transaction fees. When a company wants to issue new debt through selling bonds, it hires investment banking firms to help in the placement of those bonds. The same is true in personal debt. When a home buyer applies to get a 10%, $100,000 mortgage loan, not only does he pay the 10% interest throughout the life of the loan (the borrowing cost), but he also pays additional closing fees, loan origination fees, and various other transaction fees. In either case, corporate or private borrowing, the effect of these fees is to raise the cost of obtaining debt.

Projected A/P

(Current Accounts Payable / Current Sales) x Projected Sales

Quick Ratio(ACID TEST)

(Current Assets - Inventory) / Current Liabilities

Quick Ratio/Acid Test Ratio

(Current Assets - Inventory) / Current Liabilities • More stringent test of liquidity as compared to Current Ratio • Since Inventory is the least liquid asset it is subtracted from current assets leaving - cash, marketable securities and A/R. ***Higher quick ratio better***

Projected Current Assets

(Current Assets / Current Sales) x Projected Sales

Projected Fixed Assets

(Current Fixed Assets / Current Sales) x Projected Sales

Pro Forma Balance Sheet Equation

(Projected Item [Inventory, A/R, A/P, etc.] / Previous Year's Sales) x Projected Sales **ONLY Calculate on Spontaneous Accounts

Unlike bonds, the future cash flows pertaining to a share of stock are highly uncertain and vary from year to year.

(Remember, stocks are variable-return securities; bonds are fixed-return securities.)

Retention/ Plowback Ratio

1 - Payout Ratio

WACC Mistakes Common

1) Forget to adjust it for taxes 2) they apply the tax benefit to all terms (including preferred and common). If you remember the intuition, you won't mess it up. When a firm is financed by debt, the interest expense is tax deductible—so include the tax shield to debt. Common and preferred stock dividends are paid on after-tax dollars—so they don't get a tax shield.

Ratio Analysis

1) you cannot assess the firm's liquidity with only two ratios. 2) eBuy has a higher current ratio but a lower quick ratio when compared to the industry. 3) is not correct since the relationship between the current and quick ratio doesn't address the liquidity of accounts receivable. 4) is the most reasonable statement since a higher current ratio and lower quick ratio (as compared to the industry) indicates that eBuy has lots of inventory. The inventory build-up may be due to illiquid/non-salable inventory holdings. For eBuy, gross margin is 64.82% (= sales-COGS/sales = [2877-1012]/2877) and operating margin is 23.64% (= EBIT/Sales = 680/2877). If you take Gross Margin - Operating Margin, you get Operating Expense/Sales. For example, for Amazona 67.21-24.75 = 42.46%. This means that operating expenses at Amazona consume 42.46% of sales. For eBuy, this is only 41.18%. Hence, relative to sales, eBuy has lower operating expenses. eBuy's gross margin is lower than Amazona indicating that ebuy has higher cost of goods. Since, eBuy has lower gross and operating margin the data do not support the conclusion that eBuy is more profitable than Amazona.

Cost of Debt Components

1. Borrowing Cost 2. Flotation Costs 3. Taxes

Cost of Common Stock Methods

1. Capital Asset Pricing Model (CAPM) 2. Build Up Method 3. Gordon Model

Stock/Equity Types

1. Common Stock 2. Preferred Stock • Stock has no maturity or expiration date.

Claim Hierarchy (Lowest to Highest)

1. Common Stock (no fixed maturity) 2. Preferred Stock 3. Debt Holders

Cash Flows - Bonds (Two Types)

1. Coupon payment stream (an annuity) 2. Par (face) value repayment (a lump sum)

Capital Budgeting - 3 Step Process

1. Evaluate the Cash Flows 2. Assess Project Risk (Cost of capital is RRR) 3. Accept or Reject the Project (NPV + ok, - nope!)

Discounted Cash Flows (DCF)

1. Forecast as far into the future as you reasonably can (usually 3-5 years is the max you can forecast), and construct pro forma statements. 2. Compute the free cash flow for each of these forecasted years. 3. In the last year of the forecast, estimate a terminal value and add it to the last year's free cash flow from step 2. 4. Compute an appropriate discount rate. 5. Use time value of money to discount back the cash flows to the present value.

IRR Drawbacks

1. IRRs cannot be directly compared across projects. This also means that we can't use the IRR method to help choose between mutually exclusive projects. 2. IRR works well only when project cash flows are conventional.

Ratio Types (studied within text)

1. Liquidity 2. Asset Use Efficiency 3. Financing 4. Profitability

Capital Budgeting Method Attributes

1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) Each of these decision-making criteria: Examines all net cash flows, Considers the time value of money, and Considers risk using the required rate of return.

Capital Budgeting Evaluation Methods

1. Payback period 2. Net present value 3. Internal rate of return

ROE Parts

1. Profitability 2. Asset Utilization 3. Leverage

Percent of Sales Forecasting Method

1. Project sales revenues and expenses 2. Forecast change in spontaneous balance sheet accounts 3. Deal with discretionary accounts 4. Calculate retained earnings 5. Determine total financing needs/assets 6. Calculate DFN This technique includes a number of assumptions about the future increase in sales, the current relationship between sales and assets, and the firm's profitability. • Historical relationships are key!!

Valuation Firm

1. Replacement Cost 2. Discounted Cash Flows (DCF) 3. Comparable Multiples

Pro Forma Balance Sheet Linked to Balance Sheet in 3 Ways

1. Retained earnings from the forecasted income statement increase the forecasted equity account on the balance sheet. 2. The depreciation from the forecasted income statement decreases the forecasted fixed assets on the balance sheet. The new net fixed assets (think: PP&E) equals the prior net fixed assets from the balance sheet minus the forecasted depreciation from the income statement plus forecasted CAPEX. (Recall CAPEX is the net capital expenditures like when we did free cash flows earlier in the text.) 3. The forecasted interest expense on the income statement depends on the interest-bearing liabilities on the forecasted balance sheet.

Stock Shares - Estimating Value Models

1. Single Holding Period Model 2. Constant Growth Model (Gordon Growth) for mature companies 3. Two-Stage Model for younger or growth companies

Slowing DFN

1. Slow Sales Growth 2. Examine Capacity Constraints 3. Lower Dividend Payout 4. Increase Net Margin

Floatation cost

costs of business, ususally subtracted from Par under PV

Tax Example 2 - Hard (Use Calculator) Prescott Corporation issues a $1,000 par, 20-year bond paying the market rate of 10%. Coupons are annual. The bond will sell for par since it pays the market rate, but flotation costs amount to $50 per bond. Prescott's marginal tax rate is 34%. What are the pre-tax and after-tax costs of debt for Prescott Corporation?

1. The explicit borrowing cost is simply the 10% interest rate on the loan. 2. To calculate the pre-tax cost of debt, we must consider flotation costs, which raise the borrowing cost. Flotation costs are $50 for every $1,000 bond, meaning that Prescott today will receive only $950. But in 20 years when the bonds mature, they still have to pay back the full $1,000 to investors. Additionally, each year until the end of the life of the bond Prescott will also have to pay the annual 10% coupon payments, which equal .10 × $1,000 = $100. Just as we did in the bond pricing topic, we can use this information to find the YTM for this bond. That rate will not only be the bond's yield to maturity, but will also be the required return, or pre-tax cost of the bond. 3. Given a PV of $950, annual coupon payments of -$100 (negative because it's an outflow), 20 periods, and a FV of -$1,000, we find (using a financial calculator) that the pre-tax cost of borrowing is kd = 10.61%. As predicted, flotation costs raised the cost of borrowing from 10% to 10.61%. Note the Notation: kd = pre-tax cost of debt kd (1 - t) = after-tax cost of debt To convert the pre-tax borrowing cost to an after-tax cost, we must add in the effect of taxes. Remember that because of the tax shield created by interest payments, the effect of taxes is to lower the cost of borrowing. We calculate the after-tax borrowing cost of kd (1 - t) = 10.61% × (1 - .34) = 7.0%. In summary, Prescott Corporation issued 10% nominal interest rate bonds. Flotation costs drove that rate up to 10.61% pre-tax, after which tax effects lowered it to a 7.0% after-tax cost of borrowing.

Years to Payoff (solve for N)

10,000,000 PV 8 ÷ 4 = 2 I/Yr (remember, there are 4 quarters in a year) -365,557.48 PMT Solve: N = 40 Interpret: 10 years until loan is repaid.

Expected Rate of Return - Example Enrique Co. common stock is selling for $35.36 per share. It EXPECTS to pay a $3.78 dollar dividend next year and grow at 3%. What is the expected rate of return?

kcs = (D1 / Vcs ) + g = (3.78 / 35.36) + 0.03 = 13.69%

CAPM Required Return

kcs = Rrf + β(Rm - Rrf)where: kcs = required return, or cost of a company's internal equity Rrf = risk free rate β = beta Rm = return on the market (Rm - Rrf) = risk premium

Non-Spontaneous/Discretionary Accounts

These accounts do not increase automatically with sales but are left to the discretion of management. • Long-term debt, notes payable, and common stock accounts. • Most of the time, fixed assets are discretionary and not spontaneous accounts.

Foreign Bonds

These are bonds that are issued in a domestic market by a foreign firm, but in the domestic currency. So, if a Chinese firm floats debt in the US and the debt is payable in dollars, then China has floated a foreign bond.

Eurobonds

A Eurobond is payable in a currency not native to the country in which it is issued.

Comparative Balance Sheet

A balance sheet with two or more years of data.

Gordon Growth Model

A closed-form solution meaning that an infinite series is expressed with a non-infinite equation. Simplified assumptions: • Assumed that dividends in that case would be constant forever • Assume that instead of being constant themselves, dividends are going to grow at a constant rate each year

Why Do Ratio Analysis?

They are divided into four types that answer questions about a firm's liquidity asset use efficiency financing profitability

The borrowing cost.

This is the explicit interest rate that you pay on the debt. For example, on a 10%, $1,000 loan the borrowing cost is simply the 10% interest rate. On a bond, the borrowing cost would be the yield to maturity (including both coupon and final payments) that you learned to calculate in the bond pricing topic.

Cost of Capital

This refers to the weighted average cost of capital (WACC)—a weighted average cost of all financing resources. You can think of it as, "On average, how much does it cost this firm to keep $1 of capital for one year?"

Decreasing the discount rate always increases the value of any cash flow today.

Thus the lower the discount rate, the greater the value of the bond.

What are the three pitfalls of time value of money

risk, opportunity, and inflation

Total Asset turnover

sales / total assets

Progress Measurement

To measure progress and achieve goals.

Duration - Bonds

A measure that captures the volatility of a bond's price based on interest rate movements.

Mortgage Bonds

A mortgage bond is a bond that has specific collateral, such as a piece of real estate, behind it.

Dividends in Arrears

A preferred stock characteristic where common stock dividends cannot be paid until the preferred dividends are paid.

Conventional Cash Flows

A project that does not have multiple sign changes in its cash flow stream

Effective Yield

A rate that includes non-annual compounding = (1 + stated rate/m) - 1

Current Yield

A separate yield measure calculated by dividing the annual coupon payment by the current price of the bond. Annual Coupon PMT / Market Price • Ignores time value of money

Risk Free Rate (Rrf)

A theoretical concept that we won't go into too deeply. In real life, we use a government t-bill to proxy for the risk free rate. When we use a US government bond, we are assuming the government will always be able to pay its debts.

Average Collection Period

AR / Daily Credit Sales ***If financial statements don't differentiate between cash/credit sales it is generally assumed it is a credit sale***

Projects Free Cash Flow II Wick Inc. is introducing a new product that has an expected change in EBIT of $450,000. Wick has a 40 percent marginal tax rate. This project will also produce $250,000 of depreciation per year. In addition, this project will also cause the following changes: · Increase of $8,000 in A/R · Increase of $15,000 in Inventory · Increase of $30,000 in A/P What is the project's free cash flow?

ATCF = EBIT - Taxes + Depreciation - Change in Net Working Capital = 450,000 - (450,000 X 0.40) + 250,000 - (8,000 + 15,000 - 30,000) = $527,000

Liquidity

Ability of firm to meet its short-term (30-day debt) obligations • Current Ratio • Quick Ratio • Average Collection Period • A/R Turnover • Inventory Turnover

Ratios You Need to Know: Efficiency

Total Asset turnover = sales / total assets Fixed Asset turnover = sales / fixed assets OIROI = operating income / total assets (also used as a profitability ratio)

Debt Ratio

Total Debt / Total Assets • lower debt ratios better

Total Assets

Total of Current and Fixed Assets

Cash Tax Payments

Total tax payments from the Income Statement

Treasury Bonds

Treasuries are bonds issued by the US federal government to support deficit spending. Treasuries range from short-term, 3-month T-bills to long-term, 30-year T-bonds. Because treasuries are backed by the full faith/allegiance and, more importantly, the taxing power of the US federal government, treasuries are often used as risk-free investment vehicles in financial models.

Ways to Use Ratios

Trend analysis Cross-sectional analysis Progress measurement

Addition to R/E (Retained Earnings)

Addition to R/E = New R/E - Old R/E

Tax Example 1 - Easy A firm pays its lenders 10% in interest and is in the 34% tax bracket. What is its after-tax cost of debt (on a percentage basis)?

After-tax cost of debt = 10% × (1 - 34%) = 6.6%. Tax shield savings can significantly lower the cost of debt!

Indenture

All bonds are described in a document known as the bond indenture. This is essentially the bond contract between the bond issuer (the corporation) and the bondholder (investor) and describes all of the bond's features: coupon rate, par value, maturity, etc. It also lists the covenants associated with the bond.

Operating Expenses

All costs incurred through the company's operations that are not directly associated with the production process.

CFO Operations - Cash Flows

All flows related to producing and selling the firm's product - customer cash, raw materials, operating expenses, taxes. Methods of Calculation (2): 1. Indirect 2. Direct Start with net income, add back the non-cash expenses from the income statement and then adjust for changes in the operating accounts on the comparative balance sheet. For convenience, we repeat it in Table 2-3.

Junk Bonds

All publicly traded bonds have a rating that measures the level of risk of the bond. These ratings are given by professional rating agencies that evaluate the credit worthiness of the company that issued the bond (like S&P, Moody's, and Fitch). Bonds with a rating of BB or below are known as junk bonds. They are seen as too risky to be considered investment grade.

Differential Cash Flows/Annual Cash Flows

Also known as annual cash flows, these are the cash flows resulting from the operations of the project each year and need to be large enough on a discounted basis to justify our investment in the project.

Par Value

Also known as the face value of the bond, the par value is the sum of money that the corporation promises to pay at the bond's expiration.

Par/Face Value - Bonds

Also known as the face value of the bond, the par value is the sum of money that the corporation promises to pay at the bond's expiration.

Zeros

Alternatively known as zero coupon bonds, zeros pay no coupon payments—their coupon rate is 0%.

Annuities Due BEG MODE

An annuity whose payments occur at the beginning of the period. First payment is due at time 0 not 1. VALUE is GREATER than ordinary annuity because you get your payments earlier!

If the WACC of eBuy is 10%, what is the EVA for eBuy in 20x1?

Answer: $-60.5 EVA = NOPAT - (WACC X Costly Capital) = (680 - 140) - (10% X 6005) = -$60.5 · WACC is given as 10% · NOPAT (net operating profit after taxes) =EBIT - taxes = 680-140 = 540 · Costly capital = equity + interest-bearing debt = 6005 o Note: Interest-bearing debt does NOT include accounts payable (all other liabilities are included) Note: a negative value for EVA indicates that the management team destroyed value during the period.

Monthly Payment on Small Business Loan (Annualize!!) A new start-up company is attempting to raise capital to grow to a level that is self sustaining. The company recently received a small business loan of $7 million. The interest rate on the 8-year loan is 9.4% annually. The company's marginal tax rate is 34%. Given this information, the monthly payment on the small business loan is ____________ and the after-tax cost of debt is _____________.

Answer: $104,010; 6.2% PV 7000000 FV 0 PMT SOLVE FOR ($104,009.80) N 96 (8 years X 12 months) I 0.78% (9.4 / 12 months) WACC = 9.4% X (1 - 0.34) = 6.2%

Alex just started his junior year in high school (2 years until he graduates). His mom is worried about his grades and if he will be able to be accepted at the local college. His mom decides that if Alex is accepted two years from now, she will give him $5,000 a year during college to help out with his expenses during his 4-year degree. What is the present value of Alex's annuity if the payments are made at the beginning of each school year in school? Use a 12% discount rate.

Answer: $13,559.60 First, we will find the present value of the 4 year annuity at the beginning of college. Because the payments are at the beginning of the year, we use Beginning Mode. Beginning Mode PMT = 5,000 N = 4 years I = 12 Solve for PV = (17,009.16) Now, we have to discount this number back 2 years to present value. Remember to clear your calculator. Since Alex's mom wants the lump sum of 17,009.16 at the END of two years, she can think of this as the future value in END mode. FV = 17,009.16 N = 2 I = 12% PV = (13,559.60)

AXE Inc. is planning to issue a $1,000 face-value bond with an annual coupon rate of 7.5% that matures in 5 years. AXE is planning to pay quarterly interest payments. Similar AXE bonds are quoting at 95% of par. What is the amount of a single interest payment that AXE will make?

Answer: $18.75 Coupon PMT = 1000 X 0.075/4 = $18.75

What is the present value of a 20-year annuity due of $2,500 given an 8% discount rate?

Answer: $26,509.00 PV FV N (year) I (annual) PMT Mode ($26,509.00) 0 20 8.00% $2,500 BEG Being an annuity due, the payments are paid at the beginning of each year. (Use Beg. mode)

A firm has projected current assets to be $32 million, fixed assets to be $55 million, total liabilities to be $49 million, and owner's equity to be $7 million. Given this information, what is the discretionary financing need?

Answer: $31 million DFN = Assets - Liabilities - Equities = (32m + 55m) - 49m - 7m = $31m

If you are going to receive $70,000 for 20 years starting 5 years from now, what is the present value of the cash flows discounted at 12%?

Answer: $332,288 Step 1: End Mode N = 20 I = 12% PMT = $70000 FV = 0 PV = ? = $522,861.05 N is 20 since you have 20 payments, I is 12% which is the discount rate, PMT is $70,000 since that is the annuity, FV is 0 since there is no lump sum. Then solve for PV which is $522,861.05. Now if you use End mode, then PV you calculate on your calculator is one year before the first payment of the annuity is given. Since the annuity starts in 5 years, PV you calculate is in 4 years; thus you have to discount 4 more years with the PV you calculated as the FV. Step 2: FV = $522,861.05 N = 4 I = 12% PMT = 0 PV = ? = $332,287.65

What is the Retained Earnings for Mula Inc.? $58,400 $36,290 $65,700 $37,750 0 / 1 (0.0%)

Answer: $58,400 The Retained Earnings for Mula Inc is $58,400. Current Assets Current Liab Cash 25,550 A/P 30,000 A/R 33,750 Notes Pay. 35,000 Inv. 45,000 Total CL 65,000 Total CA 104,300 LT Debt 75,000 Fixed Assets PP&E 270,000 Owner's Equity less: AccDepr $(75,900) Com. Stock 100,000 Total FA 194,100 Ret. Earn. 58,400 Total Equity 158,400 Total Assets 298,400 Total L & OE 298,400

One year ago, you bought a 15-year $1,000 face-value bond that has an annual coupon rate of 7% and interest payments are paid semi-annually. If the yield to maturity was 9.1% when you bought the bond, but the yield to maturity is 8.2% today, then the price of the bond has increased ___________.

Answer: $71.19 PV ($829.97) ($901.16) FV 1000 1000 PMT 35 35 N 14 x 2 = 28 15 x 2 = 30 I 4.10% 9.1 / 2 = 4.55 901.16 - 829.97 = $71.19 $71.19

Project's Free Cash Flows ATCF Motris Inc. is introducing a new product and has an expected change in EBIT of $870,000. This project will also produce $150,000 of depreciation per year. In addition, the project will cause changes to the following accounts: · Increase of $20,000 in A/R · Increase of $19,000 in Inventory · Increase of $30,000 in A/P Assuming a tax rate of 34 percent, calculate the project's free cash flows.

Answer: $715,200 ATCF = EBIT - Taxes + Depreciation - Change in Net Working Capital = 870,000 - (870,000 X 0.34) + 150,000 - (20,000 + 19,000 - 30,000) = $715,200 *Taxes = EBIT X Tax Rate **Remember that NWC is the change in current assets - current liabilities *** Also remember that EBIT is after depreciation has been taken out

Initial Outlay Book Value 0 - Example A company in looking to invest in a new asset. The cost of the asset, including shipping and installation costs, is $8.4 million. The company has a buyer for the old asset who is willing to pay $1.2 million. Currently the book value of the old asset is zero. The company will also invest working capital in additional inventory in order to sustain the higher levels of efficiency that come with the new machinery. The total investment in net working capital will be $1.5 million. If the company's marginal tax rate is 39%, what is the initial outlay?

Answer: $9.17 million Book value of old machinery = 0 Sale price of old machinery = $1.2 million *Note: since the book value is lower than the sales price, the firm will record a gain on the machinery. This will generate a tax liability for them gain = $1.2 million - 0 = $1.2 million Tax liability = $1.2 million * .39 = .468 million (or 468,000) Cash flow from the sale = $1.2 million - $.468 = $.732 million * Why did we subtract the .468 million? Because it is a tax liability. It is money that the firm would not have had to pay but, because of the gain, it now has to pay to the IRS. We count that liability as a cash outflow. Initial outlay (IO) = 8.4 + 1.5 - 0.732 = $9.168m

What is the cash flow from investing in millions?

Answer: -$1,304 - Change in Gross PP&E = - ($6,428 - $5,124) = -$1,304

A company is looking to invest in a marketing campaign. The financing of the marketing campaign is expected to come from the issuing of common equity and new debt. Currently, the company has total assets of $506 million and total liabilities of $321 million. Further, the new debt issue will consist of 15-year $1,000 face-value bonds that will pay semi-annual interest payments based on an annual coupon rate of 7%. Prices of similar bonds are quoted at 95.4% of par. Further, the company has a beta of 1.3. The expected return on the market is expected to be 14.5% while the risk free rate is 2.3%. Further, flotation costs for the new debt issues are $24 per bond while flotation costs for the new equity issue are 5%. Given this information what is the Weighted Average Cost of Capital for this company if the marginal tax rate is 34%?

Answer: 10.24% We can find the cost of equity using the CAPM equation: Ke= 2.3% +1.3(14.5% - 2.3%) = 18.16% Note: this is the cost of equity before flotation costs. To adjust for flotation costs = Ke *(1+flotation cost) = .1816*(1.05) = 19.07% Cost of Debt (Before Tax) PV FV PMT N I -930* 1000 35 30 3.90% *954 - 24 7.80%** **3.90% X 2 Cost of Equity 19.07%*** ***(2.3%+1.3X(14.5%-2.3%))*1.05 Value Weight After Tax Weighted Cost Debt 321 63.44% 5.15% 3.27% Equity 185 36.56% 19.07% 6.97% Total 506 WACC 10.24% *The after tax cost of debt = Kd *(1-t) = .078*(1-.34) = 5.15%

GoFigure Inc. is looking to acquire a small competitor. The market value of GoFigure's common stock is $150 million and the market value of their debt is $351 million. Analysts have calculated the cost of common equity to be 18.2% and the cost of debt to be 10.7%. If the marginal tax rate of GoFigure Inc. is 34%, then what is the weighted average cost of capital?

Answer: 10.40% Value Debt Common Mkt Val. 351 150 Weight 70.06% 29.94% After Tax 10.7% 18.2% Total Value = 351+150 = 501 WACC 10.4% WACC = Kd * Wd * (1-t) + Ke * We = .107 *.7006 * (1-.34) + .182 * .2994 = 10.40%

Tonic Juice Corp.'s 15-year, $1,000 par value bonds pay 12% interest annually. The market price of the bonds is $1,062.20 and your required rate of return is 10%. Compute the bond's market expected rate of return.

Answer: 11.13% PV $(1,062.20) FV $1,000.00 PMT 120 N 15 I 11.13%

A company is looking to invest in new machinery. The current financing is 30% debt, 45% common stock, and 25% preferred stock. The company anticipates the new debt issue will consist of 10-year $1,000 face-value bonds that will be priced at par. The bonds will pay an annual coupon of $80. Flotation costs for this new bond issue will be $35 per bond. The company has recently paid a dividend to common shareholders of $2.30 and is expecting to increase the dividend by 5% per year, indefinitely. The current share price for the company's common stock is $29.76. The company also plans to issue preferred stock that will pay a dividend per share of $3.50 per year in perpetuity. The market price of the preferred stock will be $32. The flotation costs of both the common stock issue and preferred stock issue will be $4.50 per share. If the company's marginal tax rate is 39%, then what is the Weighted Average Cost of Capital for this company?

Answer: 11.30% Common stock cost of capital: R= D1/Ps + g The price of the stock must be adjust for the flotation costs. P=29.76-4.5 = $25.26 R= 2.30*(1.05)/25.26 + .05 = 14.56% Preferred stock cost of capital: R = D/P Remember to adjust for flotation costs. P = 32-4.5 = $27.50 R= 3.50/27.50 = 12.73% Cost of Debt (Before Tax) PV FV PMT N I -965 1000 80 10 8.53% Common Stock 14.56% Preferred Stock 12.73% Weight After Tax Weighted Cost Debt 30.00% 5.21% 1.56% Common 45.00% 14.56% 6.55% Preferred 25.00% 12.73% 3.18% WACC 11.30% *Cost of debt after taxes = Kd *(1-t) = .0853*(1-.39)=5.2%

A company has a capital structure of 30% debt and 70% common equity (with no preferred equity). The company has calculated the before-tax cost of debt to be 7.5% and the cost of equity of 14.5%. If the marginal tax rate is 35%, what is the Weighted Average Cost of Capital for this company (as a percentage)?

Answer: 11.61% Given the information in the problem, we can solve for WACC: WACC = .70 x 14.5% + .30 x 7.5% x (1 - .35) = 10.15% + 1.463% = 11.613% Notice that the weights are just the capital structure percentages.

Jobby McJobberton's Inc. is selling bonds for $700. It has an 8% coupon rate and makes payments semi-annually. The bond matures in 25 years. What is the bond's expected rate of return?

Answer: 11.74% PV ($700.00) FV $1,000.00 PMT 80 / 2 = 40 N 25 x 2 = 50 I Answer: 5.87% X 2 = 11.74%

Cost of Equity Gordon Growth Model YIPE Inc. is expecting to pay a dividend of $2.98 in the upcoming year and further anticipates growing the dividend at a constant rate of 5% per year, indefinitely. If the current share price is $39.87, then what is the cost of equity according to the Gordon Growth Model?

Answer: 12.47% Ke = D1/P + g = 2.98/39.87 + 5% = 12.47%

A 7.5 percent semi-annual coupon bond is priced at $1,055.33. The bond has a $1,000 face value and an annual yield to maturity of 6.5 percent. How many years until this bond's maturity?

Answer: 13.94 / 2 = 6.97 years FV = $1,000 PMT = $75 / 2 = $37.50 PV = -$1,055.33 I = 6.5% / 2 = 3.25% Compute N = 13.94 (this is in semi-annual time periods) = 13.94/2 = 6.97 years

Cost of Equity - CAPM with FLOAT Blackstone Technology is planning to invest in some project using external equity. The company has a beta of 1.1. The return on the market is expected to be 14% while the risk free rate is expected to be 3%. If flotation costs are 4%, then what is the cost of equity?

Answer: 15.70% CAPM = 3% + (1.1 * (14% - 3%)) = 3% + 12.1% = 15.1% Kcs = CAPM (1 +%F) = 15.1% X 1.04 = 15.70% or kcs = Rrf + βc (Rm - Rrf)

Return Required of Shareholders NO FLOAT NEXTOLL has a beta of 1.4. The expected return on the market is 15% while the risk free rate is 3.1%. Given this information, what is the return required by the shareholders?

Answer: 19.76% Rp = 3.1% + 1.4 (15% - 3.1%) = 19.76%

Cost of Equity - Build Up Method Example NO FLOAT A recent start-up technology company that has a very low market cap is looking to calculate the return required by share holders using the build-up method. Historically long-term government bonds have been 5.8% and the equity risk premium is approximately 6%. Further, the start-up premium and the micro-cap premium are each 4%. Given this information, what is the return required by shareholders?

Answer: 19.8% Recall that the build-up method adds a premium for each element of risk, beginning with the risk-free rate of return Rp = 5.8% + 6% + 4% + 4% = 19.8%

Current Government Treasury bills (i.e. short-term bonds) are priced at 96.8% of par, where par is $1,000. If these bonds do not pay a coupon and mature in one year from today, then what is the yield to maturity on these bonds?

Answer: 3.3% PV FV PMT N I -968 1000 0 1 3.31%

New York Pizza Kitchen has a leverage multiplier of 2.00, total asset turnover of 1.50 and an ROE 18.00%. What is New York Pizza Kitchen's net profit margin? 7.20% 5.60% 8.00% 6.00%

Answer: 6.00% Solution: ROE = Net Margin X TAT X Leverage Multiplier, so Net Margin = ROE/(TAT X Leverage Multiplier). Hence: net margin = .18/(1.5x2) = 6%

BHB has an opportunity to invest capital in a large expansion of manufacturing facilities. The market value of common stock is $320 million, the market value of preferred stock is $98 million, the market value of short-term debt is $508 million, and the market value of long-term debt is $911 million. Analysts have calculated the cost of common equity to be 13%, the cost of preferred equity to be 9%, the cost of short term debt to be 7.5%, and the cost of long-term debt to be 8.5%. If the marginal tax rate of BHB is 40%, what is the weighted average cost of capital?

Answer: 6.52% Value Weight After Tax Weighted Cost STD 508 27.65% 4.50% 1.24% LTD 911 49.59% 5.10% 2.53% Common 320 17.42% 13.00% 2.26% Preferred 98 5.33% 9.00% 0.48% Total 1837 WACC 6.52% *The after tax cost of debt = Kd * (1-t) Cost of STD= .075*(1-.4) = 4.5% Cost of LTD = .085*(1-.4)=5.1%

Cost of Preferred Stock with FLOAT

Answer: 7.31% Use the equation for valuing a preferred stock: Kps = Dps / Vps The dividend is equal to 7% of the Par Value of the Stock or .07*180 = $12.60 Flotation costs are .12 * 195.74 = $23.4889 Kps = 12.60/(195.74 - 23.4889) = 7.31%

A zero-coupon bond is currently priced at $456, has a face value of $1,000, and matures in 10 years. What is the yield to maturity of this bond?

Answer: 8.17% FV = 1,000, PV = -$456, PMT = 0, N = 10, Compute I/Y = 8.17%

Great Minds Inc. has a target capital structure of 45% debt, 35% preferred stock, and 20% Common Stock. The before-tax costs of debt, preferred stock, and common stock are 7%, 9%, and 15%, respectively. What is Great Mind's after-tax WACC? Assume a 35% tax rate.

Answer: 8.20% WACC = 0.45 X (7% x (1 - 0.35)) + 0.35 x 9% + 0.20 x 15% = 8.20% WACC = 2.048 + 3.15 + 3 = 8.20%

A company has the following capital structure: Internal Common Equity: 15% External Common Equity: 30% Preferred Equity: 12% Short-term Notes: 20% Long-term Bonds: 23% If the cost of inside common equity is 14%, the cost of outside common equity is 16%, the cost of preferred equity is 10%, the before-tax cost of short-term debt is 5.5%, the before-tax cost of long-term debt is 8.5%, and the marginal tax rate is 40%, what is the weighted average cost of capital for this firm (as a percentage)?

Answer: 9.93% The weights and the costs of capital for the various components of the WACC are given above in the table: WACC = (.15 x 14%) + (.30 x 16%) + (.12 x 10%) + (.20 x (5.5%(1-.40)) + (.23 x (8.5%(1-.40)) = 9.933% NOTE: Short-term notes are a form of debt and thus receive a tax shield as can be seen above.

Which of the following items from a company's financial statement is considered a non-cash expense? Depreciation Amortization Taxes A & B A & C

Answer: A & B

Which of the following is frequently considered a spontaneous account?

Answer: Accounts payable

Which of the following statements is NOT correct regarding the accrual-based accounting system? Accrual accounting provides a superior view of the operations of a company. Accrual accounting makes reading the financial statements more complex. Accrual accounting recognizes revenue only when cash is received. Accrual accounting requires matching expenses incurred with revenue recognized.

Answer: Accrual accounting recognizes revenue only when cash is received. Solution: The accrual accounting system is complex. A naïve reading of the financial statements is usually misleading. The matching principle requires firms to report revenue and expenses incurred to generate the revenue together. The receipt of cash is not always a trigger for reporting revenue. As the learning resource states, accrual accounting is a great system to understand the operations of a company or enterprise over time.

The decision rule for the IRR states that when the IRR is greater than ______________ the project should be accepted. The discount rate The rate of return required by providers of capital The WACC All of the Above None of the Above

Answer: All of the Above

Cost of capital includes: the coupon payments to the bondholders the opportunity cost of the equity holders All of the above None of the above

Answer: All of the above

PoliBoard has recently been added as a Fortune 500 company. As an analyst, you have calculated a variety of ratios for Poliboard and are looking to interpret the financial health of the firm. Which of the following benchmarks are most appropriate when interpreting PoliBoard's financial ratios? Historical ratios for PoliBoard over the last 5 years Current quarterly ratios for PoliBoard's competitors Both historical and current ratios for PoliBoard's competitors All of the above None of the above

Answer: All of the above

The income statements for Firm A and Firm B have identical sales , identical costs and expenses, and identical tax rates. However, the only difference between the firms' income statements is that Firm B has twice the depreciation of Firm A. Given this information, Firm A will have higher __________ than Firm B. Net Income Taxes Earnings Before Interest and Taxes None of the above All of the above

Answer: All of the above

Which of the statements correctly identifies the disadvantages of the payback period method? The payback period does not identify the varying levels of risk in a project The payback period does not account for the timing of the project's cash flows The payback period does not account for the varying levels of risk in a project

Answer: All of the above

Which of the following ways can a firm decrease it DFN? Reduce sales growth Recheck existing capital constraints Reduce the dividend payout Improve net margin All of the above

Answer: All of the above Answer: All of these ways will reduce DFN.

Red Way Inc. is a small company, much smaller than Fortune or S&P 500 firms. As an analyst, you have calculated a variety of ratios for Red Way and are looking to interpret the financial health of the firm. Which of the following benchmarks would be appropriate when interpreting Red Way's financial ratios? Close competitor ratios to Red Way Goal ratios that Red Way Management has set to achieve Historical quarterly ratios for Red Way Inc. All of the above

Answer: All of the above These are the three benchmarks: cross-section, goals, and time series.

The Net Present Value is a measure of: How much value is added to the firm as a result of undertaking the project. Which projects should be accepted and rejected. The value of a project to the firm. All of the above.

Answer: All of the above.

The ideal decision-making criteria for capital budgeting should: Include all cash flows that occur during the life of the project. Consider the time value of money. Incorporate the required rate of return (i.e., risk) on the project.

Answer: All of the above.

Good capital budgeting techniques should consider: All of the above. All project cash flows. The time value of money. The required rate of return.

Answer: All of the above. Riskiness (required return), all cash flows, and the timing of cash flows are all important to good decision-making.

Which of the following is true with respect to accrual accounting? Net income is the amount of cash a company receives from customers less cash payments to vendors and employees. Amounts reported on the financial statements can be managed or manipulated without violating GAAP. Accrual accounting yields easily interpreted financial statements. Cash based accounting is much better when analyzing the operations of the firm.

Answer: Amounts reported on the financial statements can be managed or manipulated without violating GAAP. Solution: Even though GAAP provides direction for the creation of financial statements, the accrual accounting system is complex and requires lots of input from management. Hence, the amount reported on almost all line items is subject to managerial discretion (which can lead to manipulation).

A spontaneous account refers to:

Answer: An account on the balance sheet or income statement that varies automatically when sales are changed

When evaluating cash flows, an increase in an asset account on the balance sheet such as inventory or fixed assets most directly indicates: An increase in net income An outflow of cash The sale of an asset An increase in an associated liability

Answer: An outflow of cash Solution: An increase in an asset account means the firm has acquired a new asset. Acquiring a new asset results in an outflow of cash from the firm. The sale of an asset results in a decreasing asset balance. Increases in assets must be financed, but do not necessarily require an increase in liabilities. There is no direct link between an increase in an asset account and net income.

The balance sheet equation states: Assets = Liabilities + Owners' Equity. Which of the following best describes the logic behind this equation? Assets are financial resources used to obtain debt and equity. A firm must use assets to payback debt and equity. Assets must generate revenues equal to the firm's liabilities and owners' equity. Assets have to be financed by either by other people's money or the owner's money.

Answer: Assets have to be financed by either by other people's money or the owner's money. Solution. The assets are uses of finance while liabilities and owners' equity are the sources of finance. That is, all of the firm's assets must be financed either by using other's money (liabilities) or the firm's owner's money (owner's equity).

Which of the following is NOT a component of the Statements of Cash Flow? CFO CFI CFA CFF

Answer: CFA Solution: CFO stands for Cash Flow from Operations, CFI stands for Cash Flow from Investing, and CFF stands for Cash Flow from Financing. CFA stands for Chartered Financial Analyst (and maybe other things); the CFA program is a professional designation relevant to financial analysts, especially money managers.

Firm A has preferred stock outstanding that pays a dividend of $9.50. Firm B has preferred stock outstanding that pays a dividend of $4.50. Given this information, the price of Firm A is _________________. At least $5 higher than the price of Firm B At least $5 lower than the price of Firm B Higher than the price of Firm B Cannot be determined by the information given. Lower than the price of Firm B

Answer: Cannot be determined by the information given. Answer: In order to determine the price, the return required by shareholders for that specific stock must be given.

The net present value of a project is smaller when: The required rate is lower Cash inflows are pushed farther into the future The initial outlay is decreased None of the above

Answer: Cash inflows are pushed farther into the future The time value of money means that pushing the inflows farther into the future makes their value smaller today. If the cash inflows are delayed, then the present value of the cash inflows decreases which decreases the NPV. Decreasing the required return (aka discount rate) or the initial outlay will increase the NPV.

Which one of the following is NOT a part of working capital? Accounts payables Inventories Common equity Accounts receivables

Answer: Common equity Working capital (aka Net Working Capital or NWC) is defined as Current Assets minus Current Liabilities. This relationship is sometimes written as: NWC = CA-CL. Common equity is neither a current asset nor a current liability.

In order to determine the future value of some lump sum, we must use the process of _________________.

Answer: Compounding Compounding means moving a sum of money further into the future.

The stated interest payment made on a bond is the:

Answer: Coupon

What is a bond that is unsecured called?

Answer: Debentures

When calculating CFO with the indirect method, depreciation expense is added to Net Income. Why do you add depreciation expense when calculating CFO? Depreciation expense is a non-cash expense. The taxing authority reimburses the firm for depreciation expense in cash. Depreciation expense provides a buffer against negative net income. Depreciation expense is linked to investment that creates a competitive advantage.

Answer: Depreciation expense is a non-cash expense. Solution: Depreciation Expense exists because of the tax code. The taxing authority allows firms to depreciate capital expenses (i.e., the purchase of long-lived equipment) over time. However, a firm is not actually paying depreciation expense. Since depreciation is a non-cash expense, we must add it back to net income when calculating CFO.

Capital budgeting is defined as the process of: Estimating the life of a new capital project. Determining which projects increase firm value. Calculating the initial cost of implementing a new project. Budgeting a company's monthly capital outlays.

Answer: Determining which projects increase firm value. The purpose of capital budgeting is to identify those projects that increase firm value.

Cost of Goods Sold includes: Research and development costs associated with the firm's future products. Direct materials and direct labor associated with the production process. Interest expenses on funds borrowed to purchase production equipment. Both A and B, but not C.

Answer: Direct materials and direct labor associated with the production process. Solution: The correct answer is B. A is an operating expenses. C refers to interest expense, which is reported below EBIT.

If we were to receive some lump sum in the future and we wanted to determine the value of the lump sum in today's dollars, we must _______________ this future cash flow.

Answer: Discount Discount means moving a sum from the future backwards.

In the basic framework, a firm can allocate net income to one of two items. These two items are:

Answer: Dividends and Retained Earnings Solution: Net income is either paid out as dividends or retained in the firm.

Which one of the following is NOT a factor impacting the DuPont Decomposition? Earnings as a percentage of sales. Dividends as a percent of net income. Sales as a percentage of total assets. Portion of assets financed by debt.

Answer: Dividends as a percent of net income. Solution: The DuPont equation (i.e., ROE = net margin x total asset turnover x leverage multiplier) helps identify how the firm generates ROE. Dividend payout is not included in the DuPont decomposition.

A discretionary account:

Answer: Does not vary when sales are changed.

T or F - The Percent of Costs Method is a way to forecast financial statements.

Answer: False

To build intuition, if a firm has ROA greater than its cost of capital, then it is destroying firm value.

Answer: False ROA > Cost of Capital → Increase Firm Value

A company has several 10-year, $1,000 face value bonds outstanding that have a coupon rate of 8%. The bonds are currently priced at par. Given this information, the company's before-tax cost of debt is less than 8%.

Answer: False A bond that is priced at par (or face) value has a yield to maturity equal to the coupon rate. Therefore, the before-tax cost of debt is equal to 8%.

If investors expect returns on the market to be higher next year, then, according to the CAPM, an individual firm's cost of equity will be lower.

Answer: False As E[Rm] increase in the CAPM, the return required by shareholders (or expected return) increases.

As the riskiness of the firm decreases, the cost of capital increases.

Answer: False As the firm becomes more risky, the cost of capital will increase.

Banks can make profits by having a spread of a higher interest rate for depositors and a lower interest rate for borrowers.

Answer: False Banks can make money by having a spread of a lower interest rate for depositors and a higher interest rate at borrowers.

T of F - Accounts Payable are generally considered discretionary (or non-spontaneous) accounts.

Answer: False False - Accounts Payable are generally considered spontaneous accounts.

T or F - According to the Gordon Growth Model, if the growth rate of dividends increases, the price of a stock will decrease.

Answer: False False - As the growth rate increases, the price of a stock will increase (According to the Gordon Growth Model, the numerator will increase and the denominator will decrease if the growth rate increases).

T or F - A bond with a longer time to maturity will have less sensitivity to changes in interest rates.

Answer: False False - Bonds with longer times to maturity have more sensitivity to changes in interest rates.

T or F - The price of preferred stock usually varies more than the price of common stock.

Answer: False False - Common stock varies more than preferred stock

T or F - Bond A has 20 years to maturity while Bond B has 5 years to maturity. Bond A and Bond B have identical coupon rates. Given this information, Bond A will have the same yield to maturity as Bond B.

Answer: False False - Holding everything else constant, Bond A is more risky because it has a longer time to maturity. Therefore, Bond A will have a higher yield than Bond B.

T or F - Suppose a bond has a duration of 3.5 and a yield to maturity of 10%. If interest rates increase 1%, the bond price is expected to decrease .35%.

Answer: False False - If interest rates increase 1% then the bond price will decrease by the amount of duration in percentage terms, or 3.5%.

T or F - Long term Debt is generally considered a spontaneous account.

Answer: False False - Long-term debt is generally considered a discretionary account.

The replacement cost method and the comparables method both consider the time value of future cash flows to the firm.

Answer: False False - Neither method considers the time value of future cash flows.

T or F - Common shareholders have preferences to dividends while preferred shareholders have preferences to ownership in the firm.

Answer: False False - Preferred shareholders have preferences to dividends while common shareholders have preferences to ownership in the firm (i.e. voting rights)

T or F - Common stock represents a hybrid security while preferred stock represents ownership in the company.

Answer: False False - Preferred stock represents a hybrid stock while both preferred stock and common stock represent ownership in the company.

T or F - Spontaneous accounts are accounts on the financial statements that do not change automatically in proportion with sales.

Answer: False False - Spontaneous accounts are accounts on the financial statements that DO change automatically in proportion with sales.

T or F - The cash flows that common shareholders receive are referred to as coupons.

Answer: False False - The cash flows that common shareholders receive are referred to as dividends.

The replacement cost method is a method used by analysts that compares ratios of privately held companies to other publicly traded companies in order to value the firm.

Answer: False False - The comparables method is a method used to value a firm by comparing ratios of privately held firms to publicly traded companies. The replacement cost method is a method of firm valuation that attempts to quantify the replacement cost of a firm's balance sheet.

The Control Premium is a premium that must be considered when more control is centered in the board of directors.

Answer: False False - The control premium is a premium that considers the lack of control of publicly traded companies.

T or F - A 20-year bond with a $1,000 face value pays an annual coupon of $50. The yield to maturity for the bond is 9.5%. Given this information, the final payment bond holders will receive will be $1,095.

Answer: False False - The final payment will be the last coupon and the face value of the bond which is $50 and $1,000, respectively.

The Liquidity Discount is most concerned with the liquidity of a firm's assets.

Answer: False False - The liquidity discount is concerned with the liquidity of the firm's shares.

The Liquidity Discount is a discount that an analyst must consider when valuing a publicly traded company that is listed on a major stock exchange.

Answer: False False - The liquidity discount is discount given to privately held companies because the firm's ownership is less liquid (less likely to be traded) than the ownership of a publicly traded company.

T or F - A firm recently lowered costs, such that net margin increased 3%. Given this information, the amount of discretionary financing needed will increase.

Answer: False False - an increase in net margin is one of the ways that DFN will decrease.

T or F - If interest rates increase then bond prices will also increase.

Answer: False False - bond prices and interest rates are inversely related. The interest rate on the bond (or the yield to maturity) is the discount rate. As the discount rate gets larger, the price of the bond will decrease.

Flotation costs reduce the cost of capital.

Answer: False Flotation costs are costs associated with new security issuance and will increase the cost of capital.

According to the Gordon Growth Model, firms that pay dividends will always have higher costs of equity than firms that do not pay dividends.

Answer: False Some firms do not pay dividends and will have a high growth rate g, which is approximated by ROE*b. Therefore, if ROE has historically been high, it's possible that a firm that does not pay dividends will have a higher cost of equity than a firm to does pay dividends.

The cost of capital is denoted in dollars.

Answer: False The cost of capital is denoted in percentage returns.

The weighted average cost of capital measures the initial cost of a capital investment project.

Answer: False The cost of capital is the rate of return required by those who have provided the firm capital.

The cost of debt depends solely on the coupon rate of the company's bonds.

Answer: False The cost of debt is the total interest rate paid on bonds or the bond's yield to maturity.

The higher the marginal tax rate, the higher the after-tax cost of debt.

Answer: False The higher the tax rate, the larger the tax shield and the lower the after-tax cost of debt.

When we use DCF with free cash flow to the firm (FCFF), the appropriate discount rate is always the cost of equity.

Answer: False If we compute FCFF and want to value the firm, guess what our k equals? That's right, it equals the WACC!

Internal rate of return is calculated by: Finding the discount rate that forces the NPV of the project to zero. Adjusting the initial outlay of the project so that it is equal to the discounted cash flows. Adjusting the inflows until the NPV is zero. None of the above.

Answer: Finding the discount rate that forces the NPV of the project to zero. The IRR is the return that is "internal" to the cash flow series. That is, the IRR is the discount rate that forces the present value of the future inflows to be equal to the initial outlay.

Firm A has a fixed asset turnover ratio of 1.32 while Firm B has a fixed asset turnover ratio of 1.55. Given this information, which of the following conclusions can be made? Firm B is considered more efficient than Firm A Firm A is considered more efficient that Firm B Firm A is turning fixed assets into sales at a greater rate than Firm B A & C B & C

Answer: Firm B is considered more efficient than Firm A

Which of the following is NOT an example of the three main comparison standards? Looking back over the ratios of the past several years to analyze what has been happening in the company and the industry. Follow the GAAP rules to make sure that the ratios are consistent with other firms. Comparing a firm's ratios with competitor ratios to understand where you stand in the industry to create new strategies. Setting some objectives and checking the ratios to see if you can make some improvement in certain areas to achieve goals.

Answer: Follow the GAAP rules to make sure that the ratios are consistent with other firms. The correct answer is D. A is cross-analysis, B is trend analysis, and C is measuring progress and goal achievement.

A firm has a debt ratio of 0.50. Which of the following is true? For every dollar of assets, the firm has $0.33 of equity The firm is financing with 33% debt and 66% equity For every dollar of assets the firm has $0.50 of liabilities All of the above None of the above

Answer: For every dollar of assets the firm has $0.50 of liabilities

A firm is issuing new debt to finance some capital investment project. The firm will issue 20,000 new $1,000 face-value bonds that will mature in 20 years. The bonds have a coupon rate of 8% and are currently priced at par. The flotation costs that are associated with this new bond issue are expected to be $10 per bond. Further, the company has a marginal tax rate of 34%. Given this information, the before-tax cost of debt is _______________. Less than 7% Equal to 8% Greater than 8% Less than 7.9% Cannot be determined

Answer: Greater than 8% The yield to maturity of this bond is 8% because the price equals the par value. However, flotation costs will increase the borrowing costs so that the yield is higher than 8%.

What is sales revenue minus cost of goods sold?

Answer: Gross Income Gross Income. By definition, Sales minus Cost of goods sold (COGS) equals Gross Income, also referred to as "Gross Profit" or "Gross Loss".

The purpose of financial forecasting can best be described as an answer to which of the following questions

Answer: How much financing will the firm need in the future?

Which one of the following is NOT a potential problem with the IRR approach to capital budgeting? IRR is does not adequately account for risk. The IRR cannot be used to rank mutually exclusive projects. None of the above are problems with IRR. There may be multiply IRRs for some projects.

Answer: IRR is does not adequately account for risk. The IRR approach requires that the calculated IRR be compared to the required return (which is based on risk), so risk is fully impounded into the approach. So, C is not a problem associated with IRR. However, IRR is not a good tool when projects must be ranked and some projects do have multiple IRRs.

Holding all else equal, an increase in net margin will: Decrease the leverage multiplier Increase the debt ratio Decrease ROE Increase ROE None of the above

Answer: Increase ROE

Holding all else equal, an increase in net margin will: Decrease the leverage multiplier Increase the debt ratio Increase ROE Decrease ROE None of the above

Answer: Increase ROE ROE = Net Margin X Total Asset Turnover X Leverage Mutilier If Net Margin increases while other two are constant, ROE should increase as well.

Which of the following is a possible method for reducing the discretionary financing need?

Answer: Increased net margin

Assume a firm's reported revenue is constant from one year to the next. Which of the following is most plausible with respect to changes in the firm's accounts receivable balance? Decreasing accounts receivable may mean the firm's costs are increasing faster than revenues. Decreasing accounts receivable may mean the firm is lowering credit standards. I ncreasing accounts receivable may mean the firm has changed to more strict credit standards. Increasing accounts receivable may mean the firm has not collected all the revenue reported in the current year.

Answer: Increasing accounts receivable may mean the firm has not collected all the revenue reported in the current year. Solution: If accounts receivable are increasing in a stable sales environment, the firm most likely collected less cash than reported revenue. This may be caused by slower payment from customers (typical during a recession) or aggressive revenue recognition on the part of the firm.

What is the written agreement between the bond issuer and its bondholders called?

Answer: Indenture

Which of the following is frequently considered a spontaneous account? Long-term debt Notes payable Inventory All of the above None of the above

Answer: Inventory

Stated in the first paragraph. In the real world, you may hear "fixed income" more often than other terms for bonds/debt, especially if you are around asset managers or investment bankers. In the bond market, firms raise debt financing directly from

Answer: Investors Found in the 2nd paragraph. Firms like bonds because typically they help defray costs by going straight to investors.

Holding all else equal, the future value of a lump sum will be ______________ if the interest rate is larger.

Answer: Larger

UHT Company has a current ratio of 5.2 and a quick ratio of 4.9. The average firm in the industry has a current ratio of 6.7 and a quick ratio of 5.4. Given this information, UHT is: Less liquid than the industry average More liquid than the industry average Cannot tell from the information Suffering from higher costs None of the Above

Answer: Less liquid than the industry average

The period of time for which a bond remains outstanding is called:

Answer: Maturity

What are bonds issued by cities, counties, or states called?

Answer: Municipal Bonds

New York Pizza Kitchen (NYPK) has an equity multiplier of 2.00, total asset turnover of 1.50 and an ROE 18.00%. In last year's annual report, NYPK established financial goals as follows: · ROE of 20% or greater · Asset turnover of 1.5 or greater · No more than 50% of firm to be financed by debt · Net margin of 8% or greater Did NYPK achieve its goals? If not, why? Yes No, asset turnover was too low No, net margin was too low No, debt financing was too high 1 / 1 (100.0%)

Answer: No, net margin was too low Solution: The primary goal was to generate ROE of 20%. As stated in the problem, the ROE was only 18% so NYPK did not achieve its goals. The goal of asset turnover of 1.5 or greater was achieved. The equity multiplier (assets/equity) of 2 implies $2 in assets for every $1 in equity. This is equivalent to at debt ratio of 50% (half of NYPK's financing comes from equity and half from debt). ROE = Net Margin X TAT X Leverage Multiplier, so Net Margin = ROE/(TAT X Leverage Multiplier). For NYPK: net margin = .18/(1.5 x 2) = 6%. Hence, the company did not meet its goal with respect to net margin.

AXE Inc. is planning to issue a $1,000 face-value bond with an annual coupon rate of 7.5% that matures in 5 years. AXE is planning to pay quarterly interest payments. Similar AXE bonds are quoting at 95% of par. Given this information, what is the amount for the final cash flow that a bondholder will receive?

Answer: None of the above The final CF is the last coupon payment + the face value = $18.75 + $1,000 = $1018.75

Which of the following elements on a balance sheet is not a spontaneous account?

Answer: Notes Payable

Which of the following is NEVER considered a spontaneous account?

Answer: Notes payable

Accounts payable represent money a firm:

Answer: Owes to suppliers for purchases made on credit. Solution: Accounts payable represent money owed to suppliers for the purchase of materials on credit.

The Control Premium occurs because _____________________. Public firms have a more difficult time controlling future inflows Private firms control more of the market share than public firms Owners of public firms generally have less managerial control than owners of private firms Public firms cannot control which investors purchase shares of their ownership None of the Above

Answer: Owners of public firms generally have less managerial control than owners of private firms

Which one of the following ways is considered a financial forecasting process?

Answer: Percent of sales method

OIROI is a good measurement of not only efficiency, but also the ___________ of a firm.

Answer: Profitability Solution: OIROI (defined as EBIT/Total Assets) measures the efficiency with which a management team can generate operating profit from asset, but is also interpretable as a profitability measure similar to Return on Assets (ROA = NI/Total Assets).

Before forecasting a change in spontaneous balance sheet accounts, a firm must: Calculate retained earnings Project sales revenue and expenses Determine total financing needs Deal with Discretionary accounts None of the above

Answer: Project sales revenue and expenses

For risk-specific projects, we typically analyze other firms that are already in the new market where we are moving to infer our WACC. This is called a: Free style Similitude Pure play Comparable

Answer: Pure play From text: So if we can't use the WACC, what should we use? For risk-specific projects, we typically analyze other firms that are already in the new market where we are moving. This is called a pure play. We look at their costs of capital and infer, from theirs, how we should adjust ours.

Which of the following is true regarding the Return on Equity (ROE) ratio? ROE is an important measure of management's effectiveness on the firm's profitability ROE is easier to compare across firms than ROA because it is independent of the firm's financing policy ROE is negatively related to the firm's ability to turn assets into sales ROE is unrelated to the firm's net profit margin None of the Above

Answer: ROE is an important measure of management's effectiveness on the firm's profitability

Which one of the following is NOT true with respect to the usefulness of ratios?

Answer: Ratios provide definitive answers to company performance questions. Solution: Ratios do not answer questions; rather, ratios help you ask the right questions to understand firm performance. Ratios do standardize financial data so you can compare different firms.

Which of the following is NOT a valid use of ratios? Report ratio deviations to the taxing authority. Use ratios to gain insight about performance goals. Compare a firm to its industry to determine potential problem areas. Analyzing a firm's ratios over several years.

Answer: Report ratio deviations to the taxing authority. Solution: Ratios (or deviations in ratios) are not reported to the government.

Which of the following is NOT a possible method for reducing the discretionary financing need?

Answer: Smaller retention ratio

All of the following are weaknesses of payback period as an evaluation tool except: All cash flows are not considered. Some projects have multiple paybacks. Timing of cash flows is not considered. Cutoffs are subjective.

Answer: Some projects have multiple paybacks. The payback approach does not suffer from multiple solutions (IRR is the evaluation tool that has issues with multiple solutions).

If the firm's working capital investment increases as a result of accepting a new project, the amount of the increase should be: Added to the net present value of the project. Subtracted from project cash flows when the increase occurs. Added to project cash flows when the increase occurs. Subtracted from the net present value of the project.

Answer: Subtracted from project cash flows when the increase occurs. An increase in working capital is a reduction in free cash flow. Note that working capital investment usually increases in the early years of a project and is recaptured by the end of the project. In the simple case, an investment in working capital is an outflow at time 0 and the recapture/reduction of working capital is an inflow at the end of the life of the project. There are no tax consequences associated with changes in working capital.

Which one of the following items should NOT be included in capital budgeting analysis? Training costs required to safely operate the new equipment if purchased. The cash from selling old equipment that is replaced when new equipment is acquired. The consulting fee associated with a previously completed market analysis. The shipping cost of a new machine.

Answer: The consulting fee associated with a previously completed market analysis. Expenses related to a previously completed market study are a sunk cost and are not relevant to future incremental cash flows or the current decision.

Which of the following is not an ideal criteria for the methods used to evaluate a capital investment project? The method must include all relevant cash flows The method must consider sales of previous products as a benchmark The method must account for the time value of money The method should account for the varying levels of risk None of the above 1 / 1 (100.0%)

Answer: The method must consider sales of previous products as a benchmark

Which of the following is an ideal criteria for the methods used to evaluate a capital investment project? All cash flows should be included, which might consist of opportunity costs, sunk costs, and cannibalization costs The method must account for the success of previous projects The method should set required risk to be constant for all projects that will be considered The method should consider the timing of the project's cash flows

Answer: The method should consider the timing of the project's cash flows

Current assets are normally listed on the balance sheet in the order of:

Answer: The most liquid to the least liquid. Solution: Current assets are the assets expected to generate cash within one year (or one operating cycle, whichever is longer). Current assets are listed in the order of the most to the least liquid. Cash always comes first, followed by marketable securities, accounts receivable, and inventory.

What is the main goal of financial forecasting?

Answer: To understand the implications of today's decisions on tomorrow's performance.

Bonds are the backbone of the world's pension funds.

Answer: True

Capital budgeting is the process of evaluating and planning for purchases of long-term assets.

Answer: True

Found in the second and third paragraphs in this section. Bonds are also known as "fixed income."

Answer: True

T of F - Accruals are generally considered spontaneous accounts.

Answer: True

T or F - In general, current assets are considered spontaneous accounts.

Answer: True

T or F - Notes payable are generally considered discretionary (or non-spontaneous) accounts.

Answer: True

T or F - The opposite of spontaneous accounts are discretionary accounts.

Answer: True

The two main reasons the text states for the importance of understanding bonds are the bond market is an important source of financing and bonds play a role in most personal investment plans.

Answer: True

One of the limitations of WACC is that it should be used to evaluate projects that are extensions of the firm with similar risk as the firm itself. It's not appropriate to use WACC for new projects that have different risk characteristics than the firm in general.

Answer: True From call out box: WACC is for Extensions, NOT for New Projects. Also from text: But what if the project is not extending the existing business? If a project is fundamentally different from the previous business, then the WACC is not the appropriate discount rate.

A dollar today is worth more than a dollar tomorrow.

Answer: True The answer is true. Inflation, risk, and opportunity all make a dollar today worth more than a dollar in the future.

In the Weighted Average Cost of Capital (WACC), the weights are based on the mix of debt, common stock, and preferred stock.

Answer: True "In order to calculate a firm's cost of capital we must first calculate the required rate of return, or cost, of each of these individual funding sources. Once we have those rates (or costs) we can then combine them for a given corporation's mix of debt, common stock, and preferred stock by using a weighted average."

Flotation costs are costs that are incurred when a firm issues new securities.

Answer: True Flotation costs are costs associated with new security issuance.

When a firm's interest expense increases, the firm's tax bill decreases.

Answer: True Interest expense is taken out of the income statement before taxes are calculated.

The three ways to estimate the cost of common equity are with the CAPM, the Build-Up method, and the Gordon Growth Model.

Answer: True The CAPM, the Build-Up method and the Gordon Model are the three ways to estimate the cost of equity.

A more risky firm will have a higher cost of equity.

Answer: True The more risky the firm, the more that investors will require (in terms of return). Therefore, more risk leads to higher costs of equity.

T or F - If the return required by shareholders increases, then the price of a stock will decrease.

Answer: True True - According to the dividend discount model (or the Gordon Growth Model), as the return required by shareholders increases then the price decreases.

T or F - As the coupon rate increases, the bond price will increase.

Answer: True True - Bond prices are calculated by taking the present value of the coupons and face value of bonds. If the coupons are larger, the present value of the coupons will also be larger. Therefore, price of the bond will be higher.

T or F - Both common stock and preferred stock allow shareholders a claim to the assets of the company.

Answer: True True - Both preferred and common stock have a claim on the company's assets.

T or F - Common shareholders have the right to vote while preferred shareholders do not.

Answer: True True - Common shareholders have the right to vote.

T or F - A bond with a face value of $1,000 will have a current price of $1,000 if the coupon rate is equal to the yield to maturity.

Answer: True True - If the coupon rate is equal to the yield to maturity, the bond will be priced at par or face value.

T or F - A bond with a coupon rate that is less than the yield to maturity will be priced at a discount.

Answer: True True - If the coupon rate is less than the yield to maturity, the bond must be priced at a discount.

T or F - The Percent of Sales Method allows firms to project financial statements for capital budgeting purposes.

Answer: True True - Percent of Sales Method can produce pro forma income statements to be used for a capital budgeting project.

T or F - Suppose a company, which fell on hard times and withheld the payment of dividends to both preferred and common shareholders for the past year, decided to reinstitute the payment of dividends. The company cannot pay a dividend to common shareholders without paying dividends to preferred shareholders.

Answer: True True - Preferred shareholders have preferences for dividends and, by law, must be paid dividends before common shareholders.

The discounted cash flow method of firm valuation considers the WACC as the appropriate discount rate.

Answer: True True - The DCF method uses the WACC as the appropriate discount rate when valuing a firm.

The comparables method allows analysts to value privately held companies.

Answer: True True - The comparables method is a method used to value a firm by comparing ratios of privately held firms to publicly traded companies.

The Control Premium is a premium that must be considered because ownership in a publicly traded firm is different than ownership in a privately held firm.

Answer: True True - The control premium is a premium that considers the lack of control of publicly traded companies.

T or F - A 20-year bond with a $1,000 face value has a coupon rate of 8.5% but pays coupons semiannually. The yield to maturity for the bond is 9.5%. Given this information, first coupon that will be paid will be $42.50.

Answer: True True - The first semiannual coupon will be .5*(.085*$1000) = $42.50.

The replacement cost method is a valuation method that is concerned with determining the replacement cost of a firm's balance sheet.

Answer: True True - The replacement cost method is a method of firm valuation that attempts to quantify the replacement cost of a firm's balance sheet.

T or F - Bond A has 20 years to maturity while bond B has 5 years to maturity. Given this information, if interest rates increase, then the price of Bond A will decrease more than the price of Bond B.

Answer: True True - bonds with longer times to maturity are more sensitive to changes in interest rates.

T or F - Suppose a company, which fell on hard times and withheld the payment of dividends to preferred shareholders for the past year, decided to reinstitute the payment of dividends. The company must pay all the dividends owed to preferred shareholders.

Answer: True True - dividend payments to preferred shareholders are cumulative meaning that dividends that are withheld must be paid at some point in the future.

T or F - Firms A and B are very close competitors and are very similar. However, Firm B has a higher sales growth than Firm A. Given this information, Firm A will have less discretionary financing needed.

Answer: True True - slower sales growth is one of the ways that DFN will

The discounted cash flow method considers the time value of future cash flows.

Answer: True True - the DCF method considers the time value of future cash flows.

What is a bond called that has no coupon payments?

Answer: Zeros This is sometimes called a pure discount bond.

Which of the following is (are) sources of cash?

Answer: c. an increase in long-term debt a. An increase in accounts receivable means sales were received on credit not in cash so it is NOT a source of cash. b. A decrease in common stock means that the firm must have bought back shares, meaning an outflow of cash. Thus, this is NOT a source of cash. c. An increase in long-term debt means that the firm took on new loans during the year, meaning that the firm brought in new cash. Thus, this IS a source of cash. d. A decrease in AP means that the firm paid off its debts to its suppliers; thus, this is NOT a source of cash, but an outflow of cash.

According to the statement of cash flows, an increase in accounts receivable will the cash flow from activities.

Answer: decrease; operating According to the statement of cash flows, an increase in accounts receivable will decrease the cash flow from operating activities. An increase in AR means that the firm has more receivables and less cash in pocket. Accounts receivable is an operating account, and the change in AR from one year to the next is reflected in the Cash Flow from Operations section of the statement of cash flows. Found in the following section(s) of the text:

According to 11.1 reading, the most preferred evaluation technique we will discuss in this topic is: payback period net present value internal rate of return profitability index

Answer: net present value

Bonds

Are the vehicles by which corporations raise debt capital. They are the primary means used in the corporate world today for borrowing money. • Fixed income securities • Bond cash flows are comprised of two distinct parts: a stream of annual or semiannual interest payments (an annuity) and a final principal repayment (a lump sum)

Leverage Multiplier

Assets / Equity *Measures how efficiently the firm is using its assets

Balance Sheet Equation

Assets = Liabilities + Owners' Equity

Suppose you were promised the following cash flows: $100 in one year, $100 in two years, $100 in three years, and an additional $1000 in three years. What would these cash flows be worth today if you discounted them at 10%? At 12%?

At a 10% required rate of return, the value of the cash flows today is $1,000 (PMT = $100, FV = $1,000, i/y = 10%, n = 3). At 12%, the cash flows are only worth $951.96 today (PMT = $100, FV = $1,000, i/y = 10%, n = 3). Thus, depending on the rate of return, this asset is worth between $951.96 and $1,000 today.

Financial Statements

Backwards looking.

Modified Accelerated Cost Recovery Depreciation System (MACRS)

Based on a double declining balance system but is operationalized by the tax code. • To apply the MACRS system you simply multiply the total cost of the asset, also known as the depreciable basis, by some given percentage. • Extra year is added to calculation • It depreciates assets more quickly than does the straight-line method (note that it is called accelerated depreciation).

Cash Flow Timing

Before any decisions can be made, we need to calculate all of the incremental cash flows occurring as a result of the project.

The Build-Up Method for cost of equity

Bond yield + Equity risk premium + Micro-cap risk premium + Start-up risk premium Required rate of return

Maturity

Bonds are finite-term securities. They have a starting or issue date and an ending or expiration/maturity date.

Initial Outlay - Profit on Sale A company is looking to invest in new machinery. The cost of the machinery, including shipping and installation costs, is $34.75 million. The company has a buyer for the old machinery who is willing to pay $3.2 million. Currently the book value of the old machinery is $4.8 million. The company will also invest $2.9 million in additional inventory to sustain the higher levels of efficiency that come with the new machinery. If the company's marginal tax rate is 39%, what is the initial outlay?

Book value of old machinery = $4.8 million Sale price of old machinery = $3.2 million *Note: since the book value is higher than the sales price, the firm will record a loss on the machinery. This will generate a tax shield for them Loss = $3.2 million - 4.8 million = -1.6 million Tax shield = -1.6 million x .39 = $.624 million (or $624,000) Cash flow from the sale = $3.2 + .624 = $3.824 million * Why did we add the .624 million? Because it is a tax shield or credit. It is money that the firm would have had to pay but, because of the loss, it no longer has to pay to the IRS. We count that savings as a cash inflow Initial outlay (IO) = 34.75 + 2.9 - 3.824 = $33.826 million

Initial Outlay w/Book Value - Example A company is looking to invest in new machinery. The cost of the machinery, including shipping and installation costs, is $34.75 million. The company has a buyer for the old machinery who is willing to pay $3.2 million. Currently the book value of the old machinery is $4.8 million. The company will also invest $2.9 million in additional inventory to sustain the higher levels of efficiency that come with the new machinery. If the company's marginal tax rate is 39%, what is the initial outlay?

Book value of old machinery = $4.8 million Sale price of old machinery = $3.2 million *Note: since the book value is higher than the sales price, the firm will record a loss on the machinery. This will generate a tax shield for them Loss = $3.2 million - 4.8 million = -1.6 million Tax shield = -1.6 million x .39 = $.624 million (or $624,000) Cash flow from the sale = $3.2 + .624 = $3.824 million * Why did we add the .624 million? Because it is a tax shield or credit. It is money that the firm would have had to pay but, because of the loss, it no longer has to pay to the IRS. We count that savings as a cash inflow Initial outlay (IO) = 34.75 + 2.9 - 3.824 = $33.826 million

Cash Flow Groups

CFO - cash flows from operations CFI - cash flows from investing CFF - cash flows from financing Sum equals company's change in cash position from previous year

Inventory Turnover

COGS / Inventory ***Number of times inventory turns/sells per year***

Replacement Cost

Try to determine what it would cost to start the company from scratch today, advantage INTUITIVE approach/disadvantage trying to estimate intangible assets.. • Look at left side of balance sheet for tangible assets (property, plant, and equipment & current assets - inventory and the like), then loo at intangible assets (patents, teamwork, management synergy, supply chain, firm name). • Right side of balance sheet - estimate the cost of replicating the capital structure of the firm (cost to issue external preferred and common equity? What would be the transaction costs of securing new bank loans or floating new notes or bonds?).

CAPEX

Capital Expenditure (gross property, plant & equipment) changes from the two balance sheets

Valuation Caveats

taking out salary liquidity discount control premium

Terminal Cash Flows

Cash flow at the end of the project's life will consist of the net inflow from operating the asset for the final year (i.e., the last differential cash flow) plus the terminal cash flows due to disposing of or selling the asset, tax impacts from the disposal, and recapture of our net working capital.

Inflation

Causes the value or purchasing power of a dollar to decrease.

If coupon rate < discount rate,

the bond will sell for a discount.

A particular investment product pays an investor 5 equal payments of $15,000 in each year, however the first payment starts immediately. If the appropriate discount rate is 10%, what is the price (or present value) of this annuity due?

Change calculator from end mode to beg. mode. Now, your calculator assumes the first payment is immediately received. Solve for PV FV = 0 I/Y = 10% N = 5 PMT = -15,000 Compute PV = 62,547.98 OR FV = 0 I/Y = 10% N = 4 PMT = -$15,000 Compute PV = $47,547.98 Now add the present value of the $15,000 (which is $15,000 ) that will be received immediately to the present value of the future cash flows: $15,000+$47,547.98 = $62,547.98

Calculate change in retained earnings.

Change in RE = Net Income - Dividends

If coupon rate > discount rate,

the bond will sell for a premium.

If coupon rate = discount rate,

the bond will sell for par value.

Describe careers within Finance

Commercial banking Corporate finance Financial planning Insurance Investment banking Money management Real estate Hedge funds Private equity

Cross Sectional Analysis

Compares firm's financial ratios with those of some peer group

Profitability Index (PI) >0

Compute like NPV, with the IO = 0, THEN divide the (PV) answer by the initial IO. The decision rule for PI is to accept the project if PI > 1. Example: If the PI is 1.07, it can loosely be interpreted that for every $1 the firm invests, it earns a 7 cent return. The PI should never take the place of NPV, but many firms use it as an additional capital budgeting tool.

The intrinsic value of an asset =

the present value of the stream of expected cash flows discounted at an appropriate required rate of return.

Three basic forms of stock

the single period model for both preferred and common stock, followed by the constant growth (aka Gordon Growth) model for mature firms, and then the two-stage model for younger or growth companies.

TVM Time Value Calculations

Use calculator and solve for "3 find 4" game

Cost of Equity - Build Up Method Example with FLOAT A recent start-up company is planning to go public in the next few months. The company has long-term bond yields of 6% and you've estimated the company's equity risk premium to be 6%. The micro-cap premium and the new start-up premium are both estimated to be 5%. If flotation costs are expected to be 3%, what is the cost of equity?

Using the build-up method, the cost of equity is equal to the sum of long-term bond yields, the equity risk premium, the micro-cap premium, and the new start-up premium. This yields the following: kcs = 6% + 6% + 5% + 5% = 22% Kcs after flotation = 22% X (1 + 0.03) = 22.66%

Stage 1, also known as the super-normal period, is characterized by high, often variable growth and extreme cash flows.

Using today's cash flows or dividends, we can estimate what the future super-normal dividends will be from now until the end of the high-growth stage.

Initial Outlay

Usually assumed to be at time 0, includes more than just the purchase price of the long-term asset. Example: Our firm must decide whether to purchase a new atomic powered swizzle-stick machine for $587,000. Installation for the machine will cost $23,000, and a $25,000 increase in net working capital will be needed at the time of installation. The project will increase annual revenues by $175,000 and operating costs will increase by $25,000. The machine will be depreciated via simplified straight-line depreciation. The project will last 5 years. At the end of the 5 years the machine will be sold for its salvage value of $75,000. Our firm has a 15% cost of capital and a 40% marginal tax rate.

g

Constant growth rate

WACC - Internal & External Equity

Continuing our Big Wacc hamburger chain example, let's say our common equity is 20% retained earnings and 80% outside common equity. The cost, after flotation costs, of the outside equity is 16.5%. Compute the WACC now. A WACC Example with Internal and Outside Equity Note that with external common stock, the WACC has risen from 12.8% to 13.6%. This increase reflects the flotation costs incurred by the firm.

Identify the Sub-Specialties within Finance

Corporate finance Investments Institutions.

Kcs

Cost of common stock

Flotation Costs

Costs associated with obtaining new debt. An example of a flotation cost is the transaction fees.

Interest Shield

Created when a company pays interest on their outstanding debt • In general, the after-tax cost of debt is equal to the pre-tax cost of debt minus the tax savings associated with the interest tax shield. The "After-Tax Cost of Debt" box shows how to impound the tax shield to calculate the after-tax cost of debt.

AR Turnover

Credit Sales / AR

A/R Turnover

Credit Sales / AR ***How long to collect on credit sales***

Operating Accounts on Balance Sheets

Current Assets & Current Liability Accounts (operating accounts facilitate company operations).

Current Ratio

Current Assets / Current Liabilities **Higher current ratios generally better (>1)**

Ratios You Need to Know: Liquidity

Current Ratio = Current Assets / Current Liabilities Quick Ratio(ACID TEST) = (Current Assets - Inventory) / Current Liabilities Average Collection Period = AR / Daily Credit Sales AR Turnover = Credit Sales / AR Inventory Turnover = COGS / Inventory

Net Working Capital - NET

Current assets minus current liabilities. • The initial build-up of net working capital is treated as an outflow (frequently at time 0). By the end of the project, all net working capital associated with the project must be liquidated, resulting in a cash inflow Assets = Liabilities + Owner's Equity

Discretionary Financing Needed (DFN)

DFN = Projected Total Assets - Projected Total Liabilities - Projected Owners' Equity • Helps us to predict future financing needs. Based upon the Percent of Sales forecast method.

Discretionary Financing Needed

DFN = projected total assets - projected total liabilities - projected owners' equity

Debentures

Debentures are unsecured bonds.1

Ratios You Need to Know: Financing

Debt Ratio = Total Debt / Total Assets Times Interest Earned = EBIT / Interest Expense

Value of Stock Today - Example Stock QWE plans to pay dividends of $3.00, $3.50, and $4.00 in each of the next three years. If the price of this stock will be $50.00 at the end of three years and the required rate of return by shareholders is 15%, then what is the PV value of the stock today (Use Calculator)?

V0 = ($3.00 / 1.15 yr1) + ($3.50 / 1.15 yr2) + ($4.00 / 1.15 yr3) + ($50.00 / 1.15 yr3) = 2.61 + 2.65 + 2.63 + 32.88 = $40.76

If returns required by bondholders have increased 1.5% from last year, we should expect bond prices to have _______________.

Decreased

Gordon Growth Model Original: Gordon Model (Again)stock valuation option

V0 = value of the stock at time 0 D1 = next period's annual dividend kcs = required rate of return g = constant growth rate

Deferred Annuity

Definition: A standard annuity whose first payment is deferred to sometime in the future. Problem: Cash flows from this investment are expected to be $40 per year at the end of years 4, 5, 6, 7, and 8 (see Figure 5-11) If you require a 20% rate of return, what is the present value of these cash flows? Method: Part 1 N = 5, I% = 20, PMT = 40, FV = 0 PMT:END Solve: PV = -$119.62 ("Alpha" "Enter") Part 2: N = 3, I% = 20, PMT = 0, FV = -119.62 PMT:END Solve: PV = $69.22 ("Alpha" "Enter")

Simplified Straight-line Depreciation

Depreciable Base Amount / Useful Life (no salvage value) Makes the additional assumption that the asset has zero salvage value.

Straight Line Depreciation

Depreciation Expense straight-line = (cost - salvage value) / life)

Depreciation

Depreciation form the Income Statement (or two balance sheets)

Income Statement (2)

Describes the revenues and expenses associated with a company's operations for a given period of time.(usually a year)

Value of Firm - No Terminal Cash Flow Given Suppose you have estimated the free cash flows to the firm over the next 5 years in the following way: Year FCFF 1 $108.5 Million 2 $114.2 Million 3 $119.7 Million 4 $124.1 Million 5 $128.9 Million You expect FCFF continue to grow at a constant rate of 5% per year, indefinitely, after year 5. If the company's weighted average cost of capital is 10%, then what is the value of the firm?

Discounted Year 1 108,500,000 - 98,636,364 Year 2 114,200,000 - $94,380,165.29 Year 3 119,700,000 - $89,932,381.67 Year 4 124,100,000 - $84,761,969.81 Year 5 128,900,000 + = $1,680,771,929 Year 6 Terminal Value - (128.9M*1.05)/0.10 - 0.05 = 135.345/.05 = $2,706,900,000 PV of TV 1,680,771,929 WACC 10.00% Value 2,128,519,568 In order to determine the value of firm, we must discount the future free cash flows and the terminal cash flow back by the weighted average cost of capital. In the problem, we do not have the terminal cash flow. To find it, we take the final year's free cash flow ($128.9 million) along with the assumption that cash flows will grow at a constant rate of 5% per year, indefinitely, and use the Gordon growth model. Recall: V = D1/(kcs - g) so, we have the cash flow in year 6 in the numerator: 128.9*(1.05) = 135.345 and the difference between the WACC and the growth rate in the denominator: .10 - .05 = .05. Dividing these numbers gives us a terminal cash flow of 2,706.90. With the terminal cash flow, we can solve for the value of the entire firm: Value = (108.5/1.10^1) + (114.2/1.10^2) + (119.7/1.10^3) + (124.1/1.10^4) + ({128.9 + 2706.9}/1.105^5 = 1,680,771,929) = 2,128.52 or 2,129

Dividend Payout Ratio

Dividend / Net income

Gordon Model

Don't make the same mistakes as everyone else . . . Remember, in the Gordon Model, the dividend is for the next year, not for this year.

Free Cash Flow to the Firm (FCFF)

EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC • Free cash flows used for valuations

Net Income

EBIT - Interest & Taxes ALSO NI = Dividends + Change in Retained Earnings

Times Interest Earned

EBIT / Interest Expense

Times Interest Earned (TIE)

EBIT / Interest Expense *Compares company operating profit (EBIT) to interest expense.

Operating Margin

EBIT / Sales

EBIT = Interest Earned

EBIT = Interest Earned

NI (Net Income)

EBT - Tax Expense

EBT (Taxable Income/Earnings Before Taxes)

EBT = Sales - COGS - Depreciation Expense - Interest Expense

Tax Expense

EBT x Tax Rate

Annuity

Equally spaced payment sequence of equal cash flow amounts. • Common in lending relationships, such as car loans, mortgages, and bonds, as well as in financial contracts, such as insurance contracts and rental agreements (****Payments occur at the end of the period)

Annual (PMT) Coupon

Equals Annual PMT Amount in Calculation

Yield to Maturity/ Market Requiring Rate/Discount Rate

Equals Interest Rate • When a bond sells at a discount, its YTM will always be higher than its coupon yield because investors not only receive the coupon payments that make up the coupon yield but also the increase in price over time.

Equity = Owner's Equity

Equity = Owner's Equity

Capital Budgeting—A Three-Step Process

Evaluate the Cash Flows Assess Project Risk Accept or Reject the Project

External Common Equity

Externally generated funds resulting from an issue of new common stock. (In contrast with internal equity, the issue of new external stock requires that firms hire investment bankers and other third parties to help place the stock issue.)

FCFE

FCFE = NI + Depreciation - CAPEX - Increases in NWC + Increases in Net Long-Term Debt • Where NI is net income and net debt is new long-term debt minus principal (debt due) payments. Everything else is as defined for FCFF.

FCFF

FCFF = EBIT - Cash Tax Payments + Depreciation - CAPEX - Increases in NWC • Where FCFF is the free cash flow to the firm, EBIT is the earnings before interest and taxes from the income statement, Depreciation is the depreciation from the income statement (or two balance sheets), Cash Tax Payments is the total tax payments from the income statement, CAPEX is the capital expenditure (gross property, plant, and equipment) changes from two balance sheets, and NWC is the net working capital (current assets - current liabilities) changes from two balance sheets.

After Tax Cost of Debt SEMIANNUAL INTEREST PAYMENTS - Example (Calculator) A company is planning to issue several bonds to help finance the purchase of new internal technology equipment. The 10-year bonds will have face value of $1,000 and an annual coupon rate of 6%. The company has similar bonds outstanding that are currently priced at 96% of par (or face value). The estimated flotation costs for the bonds will be $18 per bond. If INTEREST PAYMENTS are made SEMIANNUALLY and the company's marginal tax rate is 39%, what is the after-tax cost of debt?

FV = -$1,000 PMT = -$100 N = 20 years PV = $1,098 before including flotation costs; $1,098×(1-.05) = $1,043.10 after including flotation costs. Compute I/Y = 9.511% After-tax cost of debt = 9.511%×(1-.34) = 6.28%

Future Value of an Annuity

FV = PMT x {(1 +i) ^n - 1 / i} PMT = annuity payment n= number of payments i = discount rate

Cash Flows Formulas

FV = PV x (1 + i)^n or PV = FV / (1 + i)^n

Suppose today is January 1st, and you have planned to invest $12,000 at the end of this year, $14,220 at the end of the second year, and $15,600 at the end of the third year. If you can earn a 14% rate of return in each year, what is the future value of this stream of cash flows at the end of 4 years?

FV = PV × (1 + i)n Year CFs FV 1 $12,000 $17,778.53 *Compound 3 years 2 $14,220 $18,480.31 *Compound 2 years 3 $15,600 $17,784.00 *Compound 1 year Sum of FVs $54,042.84

When examining capacity constraints to determine whether the discretionary financing need can be reduced, which spontaneous account should be looked at first? Fixed Assets Notes Payable Accounts Payable Accounts Receivable None of the above

Fixed Assets

Differential Cash Flows

For each year of the project's life, calculate: Incremental Revenue - Incremental Costs - Depreciation on Project = Incremental Earnings before Taxes (EBT) - Tax on Incremental EBT = Incremental Earnings after Taxes (aka NI) + Depreciation Reversal = Annual Cash Flow

Return on Market (Rm)

Forecast of the return the general stock market will gain over time. This number is typically taken from an analyst consensus or from a data provider such as Ibbotson and Associates.

Net Present Value (NPV) Calculate on Ti

From the Finance menu, select: • 7:npv( • Enter it like this: • npv(rate%,-IO,{CF1,CF2, . . . },{N1,N2, . . . }) • Where CF1 is Cash flow #1, and N1 is Number of periods in a row cash flow #1 occurs Example: npv(15,-276400,{83000,116000},{4,1})= 18,235.71

Taxes on Sale of an Asset

Gains are taxed NOT revenues.

To compute cost of equity: Gordon Model (Again)

where: D1 = next period's annual dividend P0 = V0 = price of the stock at time 0 g = constant growth rate

Explain how Finance fits into Business Management

Generally, a company survives and maximizes owner value by constantly investing in projects. Finance is used to determine which projects will add the most value to the firm. Along with the investing decision, finance also determines which form of financing is optimal. This capital budgeting decision is just one function of finance. By the time you make it through all of the topics in this course, you'll know the other functions as well.

Gross Margin

Gross Profit (or Sales - COGS) / Sales • Express as %

Future Value Interest Factor for an Annuity (FVIFA)

{(1 +i) ^n - 1 / i}

Current Liabilities I

• A/P • Accruals (Obligations incurred in the current period but has not yet been paid) • Notes Payable (involve explicit interest-bearing lending arrangement with lending institution)

Multiple Holding Periods/Constant Dividend Growth Model

• Assumes common stock dividends grow at a constant rate forever. • This assumption applies best for stable, mature firms such as utility companies, rather than for new, high growth firms such as Google (also works surprisingly well for the Fortune 500 companies taken as a group).

Current Assets I

• Cash • Marketable Securities (T-Bills, CD's) • A/R • Inventory (least liquid)

Equity

• Common Stock • Additional Paid-In Capital • Retained Earnings

Information for the Two-Stage Growth Model

Growth rate during super-normal period Industry average growth rate Length of the super-normal period Required return Recent dividend

Ordinary Annuities

Have a one period delay between the start of the annuity period and the time of the first payment. **Make sure to remember that you are calculating the present value one period before the first cash flow.

External Financing Needed (EFN)

Helps us to predict future financing needs. Based upon the Percent of Sales forecast method.

Taxes.

How do taxes affect the cost of borrowing? They lower borrowing costs by creating a tax shield. To illustrate this concept, we will use the following example.

Preferred Stock

Hybrid security - it has some elements that resemble equity and others that resemble debt. • Dividend is fixed • Payments can be skipped • Cumulative skipped payments must be paid • Calculate dividend by multiplying par value by quoted percentage • Do not have the voting rights o common shareholders • Have less exposure to variable share prices

Financing Ratios

• Debt Ratio • Times Interest Earned Ratio

Leverages to Pull

• Decrease costs, while holding sales constant (thus increasing NI) • Increase sales, while holding assets constant (thus increasing asset turnover) • Increase debt, while holding equity constant (we lever up) Third option most precarious!!

Present Value of a Bond's Future Cash Flows

• Determine the future cash flows from that asset. • Discount all future cash flows at the appropriate discount rate. This is a powerful statement, because it means that if we can just chart the future cash flows of any asset, we can find its value today.

Single Holding Period Model

• Easy to understand and use • FV of stock in one year not known

Statement of Cash Flows (3)

• Explains sources and uses of cash for a company - cash in and cash out for a company in a given year • Most transparent of three statements

Fixed Assets

• Gross Fixed Assets (less: Accumulated Depreciation = Net Fixed Assets) • Recorded on balance sheet at historical cost • Assets on balance sheet with a life span greater than one year

IRR Decision Rule

• If IRR is greater than or equal to the required rate of return, ACCEPT. • If IRR is less than the required rate of return, REJECT. *WE MUST KNOW HURDLE RATE TO INTERPRET!! • Better than Payback Period but not as good as NPV

Discount Rate II

• If coupon rate = discount rate, the bond will sell for par value. N = 20 I/YR = 12 FV = 1000 PMT = 120 • If coupon rate > discount rate, the bond will sell for a premium. N = 20 I/YR = 10 FV = 1000 PMT = 120 • If coupon rate < discount rate, the bond will sell for a discount. N = 20 I/YR = 14 FV = 1000 PMT = 120

Net Present Value (NPV) +/-

• Most foolproof of all evaluation methods • Like IRR examine all project cash flows, consider the time value of money, and if need be allow us to adjust for differences in project risk by changing the required return. • Expressed in dollars rather than percentages like IRR. • It is the sum (or net) of the present values of all of the project's expected cash flows. • It is the amount in present terms by which the value of the firm will increase because of the project. • If positive ACCEPT, if NEGATIVE reject.

Depreciation Expense

• Non-cash expense affecting net income on the Income Statement • Created solely for taxation purposes • If not explicitly stated on the Income Statement, can be inferred from balance sheet; change in accumulated depreciation is equal to depreciation expense. **Formula--> Cost of Machine / Life of Machine

Internal Rate of Return (IRR) ≥ Required Rate of Return, accept: < reject

IRR is the rate of return (%) that the firm earns on its capital projects. • Simply the percentage return that we are making on the investment (similar to the return we make on an investment portfolio, etc.). • Mathematically, the IRR is the rate of return that makes the NPV of the project equal to zero. • YTM is the IRR of a bond; IRR when working with real investments.

RE Relationships (Retained Earnings)

• Projected RE = Old RE + Change in RE • Projected RE = Old RE + NI - Dividends • Projected RE = Old RE + [(Projected Sales × net margin) × (1 - payout ratio)]

The IRR Decision Rule

If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.

Profitability Ratios

• Return on Assets (ROA) • Return on Equity (ROE) • Gross Margin • Operating Margin • Net Margin

There is an inverse relationship between prices and yields:

If market interest rates increase, the price of existing bonds will fall. If market interest rates fall, the price of existing bonds will increase.

Build Up Method

In comparison to CAPM, the Build-Up Method is much more ad hoc. Used in an environment where we cannot assume that we have well-diversified investors. Bond yield + Equity risk premium + Micro-cap risk premium + Start-up risk premium = Required rate of return Used in small businesses where the beta cannot be computed.

Discount Rate I

In finance jargon, we usually refer to the rate at which we move money through time as the discount rate, regardless of whether we are compounding (i.e., calculating the future value of a sum) or discounting (i.e., calculating the present value of a sum). This rate actually has several names (i.e., the discount rate, the cost of capital, the required rate of return, the interest rate) and several possible abbreviations (i.e., r, i, k, y), but all these refer to the same rate/idea.1

Payback Period Example Some company is considering a project with an initial cost of $46,000. The project will produce cash inflows of $18,000 a year for the first 2 years and $19,000 a year for the following 2 years. What is the payback period?

In year 1, according to the payback period, the company will pay back $18,000 of the $46,000, which leaves $28,000. In year 2, the company will pay back $18,000 of the remaining $28,000 left over from year 1, which leaves $10,000. In year 3, the company will pay back the remaining $10,000 during this third year. In fact, when we divide the remaining amount left to pay back, by the third year's cash flow we obtain: 10,000/19,000 = 0.53, suggesting that the payback period is 2.53 years.

Capital Budgeting The ideal decision-making criteria for capital budgeting should:

Include all cash flows that occur during the life of the project. Consider the time value of money. Incorporate the required rate of return (i.e., risk) on the project.

CFF Financing - Cash Flows

Includes any cash flows resulting from increased borrowing, debt repayment, stock issuance, stock repurchase or dividend payment. • Calculate CFF by comparing appropriate balance sheet accounts from one year to the next. • An increase in a financing account (ie. debt, notes payable, equity) signals a source of cash flowed into the company. • A decrease in financing account indicates that the company used cash to pay lenders or to buy back stock. Dividends = (Old RE + Net Income) - New RE * RE = Retained Earnings

Capital Gains

Increases in the value of stock

The relation between bond prices and yields to maturity can best be described as:

Inverse

Interest Rate/Price Sensitivity

Inverse Relationship • If market interest rates increase, the price of existing bonds will fall. • If market interest rates fall, the price of existing bonds will increase.

CFI Investing - Cash Flows

Involves any cash in or out of the company due to investment in or disposal of fixed assets. (assume for text investing is reflected in Gross PP&E account and that no assets are retired during the year.) **NetPP&E + Depreciation expense = Gross PP&E

WACC Attack Example - Internal equity You have been hired as an external consultant to perform a cost of capital analysis for a large hamburger chain that offers its signature burger known as the Big Wacc. You have gathered the following information: market value of common equity = $500 million; market value of preferred equity = $50 million; market value of debt = $150 million; cost of common equity = 15%; cost of preferred equity = 11%; YTM on debt = 10%; tax rate = 40%. With all of this info, you are ready to compute the WACC:

Just using internal equity

Two Stage Valuation Model - Example Due to a recent patent approval, earnings and dividends at Alpha Inc. are expected to grow at a rate of 15% for the next 3 years. After this period, the firm is expected to grow at the industry average rate of 5% forever. The firm recently paid a dividend of $1 and the required rate of return is 10%. What is the most you should pay for Alpha?

Value = PV(Stage 1) + (PVStage 2) Stage 1 1. Find FV by multiplying by super-normal growth rate. 2. Find the PV values of the super-normal dividends by year (use calculator) back to the present at the required rate of return. Total Stage 1 PV dividends to find value for formula (i.e. 1.05 + 1.09 + 1.14 = $3.28). Stage 2 3. Find the first normal growth dividend by multiplying last super-growth rate by normal rate (i.e. 1.52 x 1.05 = 1.60). 4. Use the Gordon Growth Model to find the value of the cash flows from the end of the high-growth period through infinity. Divide total from Step 3 by (Required Rate of Return - Constant Growth Rate) [i.e. 1.60 / (.10 - .05) = $32] 5. Discount the Gordon Model result back to the present (remembering to place it in the last super-normal period using calculator). [i.e. N:3, i:10, FV:32, solve for PV = $24.04] 6. Add the values from steps 2 and 5 (i.e. 3.28 + 24.04 = $27.32).

Final Stock / Firm Value

Value = PV(Stage 1) + PV(Stage 2)

Multiple Holding Period Models—The Two-Stage Growth Model

Value = PV(Stage 1) + PV(Stage 2)

Final Cash Flow

Last coupon payment (interest payment) plus face value

Total Projected RE

Last year's balance plus this estimated increase.

Responsibilities of the Financial Manager

Learn to measure the health of the firm via financial statement analysis. Using ratio analysis and free cash flow measures, we will understand how to assess if our firm is doing well and in what areas we can improve. We will also learn how to use ratios as goals for the firm. Learn to prepare financial forecasts through pro forma financial statements. Use discounted cash flows to value stocks, bonds, and other cash-flow generating assets. Learn how to think about and quantify risk in a financial setting. Learn how to estimate the various components of the weighted average cost of capital (WACC) and why the WACC is important to the firm. Use a portfolio of capital budgeting tools to determine which investments will add value to our firm. Learn several methods for valuing the company as an entity.

Stock Value

Like bonds, the value of any stock is equal to the present value of its future expected cash flows. Unlike bonds, the future cash flows pertaining to a share of stock are highly uncertain and vary from year to year.

Subordinated Debentures

Like normal debentures, subordinated debentures are bonds that are not backed by any specific collateral. In addition, subordinated debentures have a lower claim than normal debentures to the assets of the firm in the event of firm liquidation.

Present Value

Value that you would accept today.

Trend Analysis

Looks at firm's financial ratios over time Trend analysis time series generally looks backwards five years and forecasts forward three years

Taxes

Lowers borrowing costs by creating a tax shield.

What Counts?

Main Principle: Incremental CFs - cash in minus cash out Points to Remember: Incidental CFs - directly and indirectly related Sunk costs - don't matter Opportunity costs - do matter

Should You Buy Stock at Current Price - Example You are looking to purchase BA Plastics common stock at its current price per share, which is $1.75, hold it 1 year, and sell after a dividend of $.50 is paid. At what price would you have to purchase the stock if you had a required rate of return of 20% and growth is expected to be 7% per year, indefinitely? Should you buy the stock at its current price?

Vcs = D1 / (kcs - g) = 0.50 / (0.20 - 0.07) = $3.85; The current share price is only $1.75 per share. To obtain a required return of 20%, the price could be as high as $3.85. Therefore, you should buy the stock (i.e. it is undervalued).

Differential Cash Flows In Stated Period Ch. 12.5 A company is looking to invest in new machinery. The cost of the machinery, including shipping and installation costs, is $34.75 million. The company has estimated that revenues will increase to $38.9 million in each of the next three years if the machinery is purchased. Costs (both variable and fixed) are also expected to increase to $10.2 million in each of the next three years. The company uses a standard straight-line depreciation method. In particular, the company will straight-line depreciate the machinery to $7.8 million over the three year life of the project. If the marginal tax rate is 39%, what will the differential cash flows be in each of the next three years?

• Revenue 38,900,000 Cost -10,200,000 • Depr Exp -8,983,333 --> (34,750,000-7,800,000)/3 • EBIT 19,716,667 --> (revenue - cost - depreciation) • Tax -7,689,500 EBIT * tax rate • NOPAT 12,027,167 EBIT - tax • Add: Depr 8,983,333 • Differential CF 21,010,500

Red Flags in Earnings

Watch the inventories Beware of rising receivables Uncover extraordinary expenses Investigate asset sales Who's skimping on research? When is revenue really not? Spot out-of-balance growth

Common Stock WACC

We mean Total Assets - Total Liabilities - Preferred Stock. So, common stock includes retained earnings, the common stock account, additional paid in capital, treasury stock—all of the common equity items summed together.

Ratio Analysis Advantages

• Standardize Financial Data • Flexibility • Leads to look-ins to right places to question • Evaluates whether the firm is achieving stated goal to maximize shareholder wealth • Evaluates management action to see if they are fully exploiting the firm's earning potential.

Gross Profit/Gross Income/Gross Loss

• Subtracting the cost of goods sold (or cost of services) from revenue • Sales Revenue - Cost of Goods Sold (COGS)

Efficiency Ratios

• Total Asset Turnover • Fixed Asset Turnover • OIROI (Profitability Ratio)

Comparison Methods In Ratio Analysis

• Trend Analysis • Cross Sectional Analysis • Progress Measurement

PV Annuity DUE USE BEG MODE!!!!! (2 Methods)

Method 1: All we need to do is find the present value of the other payments using the ordinary annuity method and then simply add in the first payment. Using your financial calculator (after setting it up), the keystrokes will be: -1000 PMT 8 I / Yr 2 N Solve: PVpmts 2 and 3 = $1,783.26 Annuity due = $1,783.26 + $1,000 = $2,783.26 Method 2: Enter Begin Mode (Figure 5-2). -1000 PMT 8 I / Yr 3 N Solve: PVannuity due = $2,783.26 ****Be sure to reset to END MODE as most annuity questions are ordinary annuity questions!!!!

Retained Earnings (RE)

Money generated from the operations of the company that is plowed back (or retained) in the business. Represents funds that already have been reinvested in the existing assets of the firm. • Change in RE = Net Income - Dividends • New RE = Old RE + Change in RE • New RE = Old RE + Net Income - Dividends**

Convertible Bonds

More than being a "type" of bond, convertibility is a feature that may be added to any of the above bond types. Convertibility refers to the ability to convert a bond into equity securities, usually common stock

Annual versus Semiannual Payments

Most US bonds pay interest on a semiannual basis, while European bonds typically pay interest annually.

Annual vs Semiannual Payments - Bonds

Most US bonds pay interest on a semiannual basis, while European bonds typically pay interest annually.

Compounding

Moving a sum of money further into the future (from left to right on the timeline).

How do you calculate the tax effects of the sale of an asset?

Multiply the market value minus the book value of the asset by the tax rate. Tax Effect = (Market Value - Book Value) X Tax Rate

Muni-Bonds

Munis, short for municipal bonds, are floated by local governments (states, cities, counties) to usually fund infrastructure improvements, such as new roads or government buildings. Munis are almost always exempt from federal taxation, which makes them attractive investments for investors in high tax brackets.

Return on Equity (ROE)

NI / Equity the return on equity (ROE) ratio compares annual net income to total equity.

Return on Assets (ROA)

NI / Total Assets *express as PERCENTAGE!! It shows how profitable the firm is, given its asset investment. ROA is comparable across industries and thus is a good profitability ratio to use when benchmarking a firm against a multi-industry group.

After Tax Operating Profit

NOPAT = EBIT (1 - t)

NI - Net Income

Net Income

Free Cash Flow to Equity Holders (FCFE)

Net Income + Depreciation - CAPEX - Increase in Net Working Capital (NWC) + Increase in Net Long-Term Debt

Indirect Method

Net Income + Non-Cash Expenses (from income statement) then adjust for changes in the operating accounts on the comparative balance sheet.

Net (Profit) Margin

Net Income / Sales For example, a net margin of 5% means that for every dollar of sales, 5 cents drops to the bottom line as net income.

Net Profit Margin

Net Income / Sales *Measures Firm's efficiency in controlling its costs

EVA (Economic Value Added)

Net Operating Profit After Taxes (NOPAT) - Invested Capital x Weighted Average Cost of Capital (WACC) • NOPAT • Invested Capital EVA = NOPAT - (WACC X Costly Capital) = (680 - 140) - (10% X 6005) = -$60.5 · WACC is given as 10% · NOPAT (net operating profit after taxes) =EBIT - taxes = 680-140 = 540 · Costly capital = equity + interest-bearing debt = 6005 o Note: Interest-bearing debt does NOT include accounts payable (all other liabilities are included) Note: a negative value for EVA indicates that the management team destroyed value during the period.

NWC

Net Working Capital (current assets - current liabilities) changes from the two balance sheets

Non-Spontaneous Accounts(DISCRETIONARY ACCOUNTS)

Notes Payable Long-term Financing Accounts Common Stock all of them deal with the financing of the firm.

WACC - Two Types of Debt

Now let's suppose we not only have internal and external common equity, but we also have two types of debt—say short-term notes and long-term bonds. Back to the Big Wacc hamburger. (Are you getting hungry yet?) Let's suppose the hamburger chain has recapitalized its old $150 million in debt with a $100 million bank loan at 10% and a $200 million bond issuance at 12%. (Note: V now equals $850 million.) All other data from above is the same. Here's the math: A WACC Example with Two Types of Debt Note that this time, the WACC has decreased with the new debt structure. Why? Because the cost of debt (especially after tax) is cheaper than equity. We went from $150 million in debt to $300 million in debt. The additional debt decreased the cost of capital, even though the cost of bonds was 2% higher than the old debt.

Dividend

Old R/E [Retained Earnings]+ NI [Net Income] - New R/E[Retained Earnings]

OIROI (Profitability Ratio)

Operating Income (or EBIT) / Total Assets *Describes relationship between operating profit (EBIT) and the company's total asset base. *Tells how much pre-tax, pre-financing profit the company generates per dollar of assets

OIROI

Operating income (EBIT)/ total assets

Book Value - Assets

Original Purchase Price - Accumulated Depreciation

Suppose you bought a 10-year $1,000 face-value bond for $925 one year ago. The annual coupon rate is 7% and interest payments are paid annually. If the price today is $1,004, the yield to maturity must have changed from _____________ to ______________.

Original Year Later PV -925 -1004 FV 1000 1000 PMT 70 70 N 10 9 I 8.12% 6.94%

Current Expenses

Outlays for goods and services that will be used during the current year (i.e. gas for company car). • Flow directly to the income statement as cost of goods sold, operating expenses, or any other expense category.

Covenants - Bonds

Outline things the company is obligating itself to do or not do in order to protect bondholders. There are two types of bond covenants: affirmative and negative. • Negative - are things the company pledges not to do—for example, not to sell off certain assets, not to pay out large dividends, or not to issue new debt with a superior claim • Affirmative - describe things the company pledges itself to do

Perpetuity

PV (perpetuity) = PMT / i An infinite stream of equally spaced, equal cash flows (an annuity with an infinite number of periods).

Future Value Equation (FV)

PV = (1 + i)^n i = interest rate/discount rate n = number of time (compounding)periods

Past Value Equation (PV)

PV = FV / (1 + i)^n

Evaluation Methods

Payback period Net present value Internal rate of return

Which of the following is NOT introduced as an evaluation method?

Payback period Net present value (NPV) Internal rate of return (IRR) All of the above are listed as evaluation methods. Answer: All of the above are listed as evaluation methods.

Preferred Stock Valuations

Preferred easier to value than common stock.

Current Price Per Share - Example UHFD has just (ALREADY) paid a dividend of $2.56 and is expected to increase the future dividends at a rate of 5% per year indefinitely. If you, as a share holder, require 15% per year, what is the current price per share?

Price = (2.56 X 1.05)/(0.15 - 0.05) = $26.88 Price = (Dividend x Indefinite Rate) / (RRR - Rate)

Price of Stock with Indefinite RRR - Example Some Co. is (PLANNING) to pay a dividend of $5.60 in the next year and expects to grow the dividend at a constant rate of 4% per year, indefinitely. If the required rate of return by shareholders is 13%, then the price of this stock should be:

Price = 5.60 / (0.13 - 0.04) = $62.22

Sustainable Growth Rate is a Function of:

Profitability (net margin) Asset usage efficiency (asset turnover) Leverage (assets/equity) Plowback (dividend policy) Note: This assumes that assets and ALL liabilities vary directly with sales and that the plowback and debt ratio are constant.

Percent of Sales Method

Project sales revenues and expenses Forecast change in spontaneous balance sheet accounts Deal with discretionary accounts Calculate retained earnings Determine total financing needs/assets Calculate DFN

Estimated Future Addition to RE

Projected net income multiplied by the plowback ratio (alternatively one minus the payout ratio)

PP&E

Property, Plant & Equipment

Initial Outlay

Purchase Price of the Asset + Shipping and Installation Costs Depreciable Asset + Investment in Working Capital +/- After-Tax Proceeds from Sale of Old Asset = Net Initial Outlay

Financial Forecasting

Purpose to predict: how much financing will the firm need in the future? Primary means of convincing others of the economic value of one's ideas regarding capital uses or changes within the firm; assumption driven.

Return Required by Shareholders - Example YTR has JUST PAID a dividend of $3.20 and is expected to increase the future dividends at a rate of 4% per year indefinitely. If the current share price is $34.50, what is the return required by share holders?

R = [(3.20 x 1.04) / 34.50] + 0.04 = 13.65%

Project Evaluation Standard

ROA > Cost of Capital → Increase Firm Value ROA < Cost of Capital → Decrease Firm Value

Total Asset Turnover II

ROE / (Net Margin x Leverage Multiplier)

Leverage Multiplier II

ROE / (Net Margin x Total Asset Turnover)

Dupont Decomposition

ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) = (Net profit/Sales)*(Sales/Assets)*(Assets/Equity) = (Net Profit/Equity) • Profitability (measured by profit margin) • Asset Use efficiency (measured by asset turnover) • Financial leverage (measured by equity multiplier) The DuPont equation (i.e., ROE = net margin x total asset turnover x leverage multiplier) helps identify how the firm generates ROE. Dividend payout is not included in the DuPont decomposition.

Leverage Multiplier Note

ROE = NI/S x S/A x (L/E + 1)

ROE Dupont Equation

ROE = Net Profit Margin x Total Asset Turnover x Leverage Multiplier

Return on Invested Capital

ROIC = NOPAT / (Costly Capital) where NOPAT is equal to net operating profit after taxes and is defined as EBIT (1 - t) and Costly Capital equals all interest bearing debt plus total equity.

Return on Invested Capital (ROIC)

ROIC = NOPAT / (Costly Capital) • NOPAT = EBIT • Costly Capital = All interest bearing debt + Total Equity *The advantage of ROIC is that it measures the return regardless of whether the company's financing comes from debt or equity.

Dupont Rate/Sustainable Growth Rate

Regrouping terms in the DuPont allows us to express ROE as the product of three distinct ratios: net margin (net income over sales), asset turnover (sales over assets), and the equity multiplier (assets over equity).

Sustainable Growth Rate/Dupont Rate

Regrouping terms in the DuPont allows us to express ROE as the product of three distinct ratios: net margin (net income over sales), asset turnover (sales over assets), and the equity multiplier (assets over equity).

Three Ways to Value a Firm

Replacement cost Discounted Cash Flows (DCF) Comparable multiples

Capital Expenses

Represent outlays for items that will provide a benefit to the firm over many years i.e. company car). • Included as assets on the balance sheet.

Cost of Goods Sold/Cost of Services

Represents direct costs (direct materials and direct labor) associated with the production process.

EBIT

Revenue - Cost - Depreciation

Sustainable Growth Rate

SGR = ROE (1 - b) = NI/S x S/A x A/E x (1-b) • SGR = Sustainable Rate • b = Dividend Payout Ratio • Dividend Payout Ratio = (dividends / net income)

Gross Profit

Sales - COGS

Total Asset Turnover I

Sales / Assets *Measure for amount of bang for the buck the firm sells

Fixed Asset Turnover

Sales / Fixed Assets (Net PP&E) *Holdings determined by the industry in which it operates Fixed asset turnover calculates sales generated per dollar of fixed assets. Fixed assets include all non-current assets, or total assets minus current assets.

Total Asset Turnover

Sales / Total Assets *Current assets determined by management A total asset turnover ratio of three means that for every dollar of assets within the firm, it produces three dollars of sales. High asset turnover is desirable because of the cost of assets

Fixed Asset turnover

Sales / fixed assets

Payback Period

Simply the number of years required to recover the initial cash outlay. Flaws: 1. it does not consider all of the project's cash flows, but only those up to the time of payback 2. payback does not discount future cash flows to account for the time value of money 3. payback also fails to account for different levels of risk through a required rate of return

What is FCFF of eBuy in 20x1?

Solution: FCFF = EBIT - Cash Taxes + Depr Exp - CapEx - increase in NWC = 680 - 140 + 364 - 1303 - (-99) = -300. · EBIT, taxes, and depreciation expense come directly from the income statement · CapEx = Gross PP&E20x1 - Gross PP&E20x0 = 6454 - 5151 = 1303 · Increase in Net Working capital = NWC20x1 - NWC20x0 = $650 - $749 = -$99 o NWC20x1 = Current assets - current liabilities = 1296-646 = 650 o NWC20x0 = 1335-586 = 749 Note: The increase in NWC is -$99. This means that the firm reduced NWC over the period.S

Spontaneous Accounts

Spontaneous accounts are accounts on the income statement and balance sheet that change automatically in proportion with sales. • Current Asset Accounts (cash, marketable securities, A/R, inventory), A/P, accrued expenses [accrued wages] • Line items on income statements

Estimate cash flows for two different growth stages:

Stage 1: dividends grow at above-average rates Stage 2: dividends grow at the industry average rate

What is today's value of a $5,000 annual perpetuity starting in 40 years discounted at 8%?

Step 1: Value of Perpetuity at the beginning of year 40 = PMT/I = 5,000/0.08 = 62500 The perpetuity formula calculates discounted perpetuity back to a year before the first payment is given. Therefore, you have to discount what you find in the first step back by 39 years not 40 years. Step 2: FV = 62500 I = 8% N = 39 PMT = 0 PV = 3,107.09

Percent of Sales Forecasting

Steps: 1. Identify Key Variables 2. Identify Key Limitations of Process Most common type of forecasting.

Intrinsic/Correct Stock Price

Stock price as high or higher than than the intrinsic value of company cash flows.

Inverse Price-Yield Relationship

When a bond sells at a discount, its YTM will always be higher than its coupon yield because investors not only receive the coupon payments that make up the coupon yield but also the increase in price over time. • The price differential is what is increasing the yield. This relationship is known as the inverse price-yield relationship. The YTM is higher than the coupon yield because you get to buy the bond at $952, but you get $1,000 in the future in addition to 10% payments.

Uneven Cash Flows

When all of the cash flows are different, we have to discount or compound each individual flow separately using the present/future value approach that we used for single sums and then add them together. Cash flows of unequal amounts even if distributed at even intervals. Not a perpetuity because of finite length.

Compounding Problem

When the periods, payments and interest must be adjusted for non-annual time value of money problems.

Market Risk Premium (Rm - Rrf)

When we subtract Rrf from Rm we get a term we call the market risk premium (Rm - Rrf). The first risk free rate and the second risk free rate in the CAPM have become a matter of debate. Some analysts prefer using the 3-month t-bill because it has the shortest maturity, and, as such, the lowest risk.

EBIT (Earnings Before Interest & Taxes/Operating Profit/Operating Income)

Subtracting operating expenses from gross profit. EBIT = Sales - Operation Expense - COGS - Depreciation Expense [NOT INTEREST EXPENSE!] or Sales - COGS - Depreciation

Effective Yield (Annual Percentage Yield - APY)

Suppose we invest $100 in the account paying 8% compounded quarterly. How much will we have at the end of the year? On your financial calculator, this is equivalent to investing for 4 periods (N = 4) at 2% per period, or: -100 PV 4 N 2 I/Yr Solve: FV = $108.24

Optimal Debt Ratio

Will minimize the cost of financing and thus maximize company value.

Yield to Maturity II

YTM = I / Y as opposed to less accurate Current Yield = Annual Coupon / Market Price

Value of Firm - Given Estimated Cash Flows/Terminal Free Cash Flow/WACC (Use Calc to Discount Each Year) A company has estimated its free cash flows to be $41.9 million in each of the next four years and the final terminal free cash flow to be $113.5 million in the fifth year. The firm has a weighted average cost of capital of 10.5%. Given this information, what is the value of the firm?

Year 1 Year 2 Year 3 Year 4 Terminal Year 5 41,900,000 41,900,000 41,900,000 41,900,000 113,500,000 $37,918,552.04 $34,315,431.71 $31,054,689.33 $28,103,791.25 $68,894,487.12 WACC 10.50% Value 200,286,951 To determine the value of the firm, we must discount back the future free cash flows and the terminal cash flow by the weighted average cost of capital. The value of the firm is equal to the following: Value = (41.9/1.1051) + (41.9/1.1052) + (41.9/1.1053) + (41.9/1.1054) + (113.58/1.1055) = 200.28695

Net Present Value (NPV) - Example Assignment: Make a recommendation on the economic viability of the construction of a nuclear power plant. Report: The initial outlay is $5 billion. The cash flows are spread out over 40 years. You do all the necessary analysis, discount the cash flows at 11%, and perform extensive sensitivity analysis. The analysis alone takes four years. While the complexity of the report is overwhelming, in the executive summary, you report an NPV of $3.38. Question: Would you really invest $5 billion to earn $3.38?

Yes, the NPV is greater than zero, simple! ***Increasing the discount rate decreases the NPV

Promised Yield

Yield to Maturity • The return we are promised if we buy a bond today and hold it to maturity

Capital Asset Pricing Model (CAPM)

You are interested in computing the cost of equity for the House of Pain Gym (HoP Gym). This fictitious gym is publicly traded, so you were able to compute a beta of 1.15. In addition, you have determined the analyst consensus for the market risk premium (Rm - Rrf) to be 6%. Finally, you looked on Yahoo Finance and determined the 3-month t-bill is currently yielding 2%. Having dug up all of this data, you are prepared to use the CAPM to compute the cost of equity for HoP as: kcs = Rrf + βc (Rm - Rrf) kcs = .02 + 1.15 × .06 kcs = 0.089 or 8.9%.