Chapter 14 - FIN320

Holdup Bank has an issue of preferred stock with a $3.75 stated dividend that just sold for $87 per share. What is the Bank's Cost of preferred stock?

=4.31%

Why is the coupon rate bad estimate of a firms cost of debt?

The coupon rate is the rate of debt when the bonds were issued. It is not relevant in current period. The better way to ascertain cost of debt would be to compare the current yield to maturity.

On the most basic level, if a firms WACC is 12 % what does this mean?

The firms WACC of 12% means that it is the lowest rate of return the firm must earn overall on the existing asset. if it earns more than this, value is created.

What is the relationship between the required return on an investment and the cost of capital associated with that investment

The required return of an investment is to observe firm must earn return on investment to compensate the investors for use of capital required to finance the project.

What are two approaches to estimating the cost of equity capital?

The two approaches underlying cost of equity capital are ? -Dividend growth Model -Security Market Line Approach

How do you determine the appropriate cost of debt for a company? Examples?

- Cost of debt is the interest rate that the company is willing to pay on a new borrowing. - Appropriate cost of debt is the after tax cost of debt because interest payments are tax deductible. Therefore, appropriate cost of debt is after tax of debt. Examples : - If the company has outstanding bonds than yield to maturity is the cost of debt. - We can estimate cost of debt by using rating of bonds. if bonds are related AA than we can find the interest rate bonds has cost of debt.

In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?

During WACC calucation, book value of debt should be considered as it almost equal to the market value of debt. But, in case of common equity, the market value should be considered as the market value vary from time and the market value of equity would either be high or low to the book value of equity.

Why do we adjust a firms taxes when we do a firm valuation?

- Tax is a cost to the company. Also it mandated under the regulation that is all the profit earning companies have to pay the certain % of taxes. - It will affect the validity and reliability of a the firms valuation. Hence, tax paid by the company cannot consider for the firm valuations.

Why do we multiply the cost of debt by (1-Tc) when we compute the WACC?

-Cost of debt is multiplied (1-Tc) because interest paid by corporation is tax deductible, which means that government pays some interest. Therefore, it is necessary to distinguish between pre-tax cost of debt. After tax interest rate is equal to pretax multiplied by 1 minus the tax rate or Rd(1-Tc)

Why do you think we might prefer to use a ratio when calculating the terminal value when we do a firm valuation?

-Terminal value in the firm valuation is the present value of expected value of the firm in the future period. Hence, it is a discounted cash flow technique.

What are the advantages of using the DCF model for determining the cost of equity capital?

1. Easy to understand and is simple

The absolute Zero Co. just issued a dividend of $3.40 per share on its common stock. The company is expected to maintain a constant 4.5 % growth rate in its dividends indefinitely. If the stock sells $53 a share, what is the company's cost of equity?

11.20%

The Graber Corporations common stock has a beta of 1.15. if the risk free rate is 3.5 percent and the expected return on the market is 11 %, what is the companys cost of equity capital?

12.13%

How is WACC calculated?

=(E/V x Re) + (D/V X Rd) + (1-Tc)

What is the primary determinant of the cost of capital for an investment?

The primary determinant of the cost of capital for an investment depends primarily on how and where the capital is raised. The cost of capital depends on the use of funds and not the source of funds. The source of funds which has less cost of capital involves high risk. Hence, cost of source of funds is compared with the risk involved.

EX: Project - Beta - IRR W - (.75) - (8.9%) X - (90) - (10.8) Y - (1.15) - (12.8) Z - (1.45) - (13.9) ( The T-bill rate is 4% and the expected return on the market is 11 %) A. Which project has a higher expected return that the firms 11% cost of capital? B. Which project should be accepted? C. Which project would be incorrectly accepted or rejected if the firms overall cost of capital were used as a hurdle rate?

A. - Calculate the IRR (Inter rate of return) -Based on your IRR the project Y and Z has more than the firms expected return 11%. Hence, these both projects have higher return that the firms expected return. B. Use (CAPM) : If the result of CAPM is lesser than the IRR, the project should be accepted. If the result of CAPM is greater than the IRR, the project should be rejected. - The expected return on Project W is 9.25%, which is greater than the IRR 8.90 %, HENCE, the project should be rejected. -The expected return on Project Y is 10.30%, which is lesser than the IRR 10.80%, HENCE, the project should be accepted. C-Project X is wrongly accepted, because of the expected rate of return is less than 11% - Project Z is wrongly rejected, because the expected return is higher than 11%

Mullineaux Co. has a target capital structure of 70 % common stock, 5 % preferred stock, and 25% debt. its cost of equity is 11 %, the cost of preferred stock 5 %, and the pretax cost of debt is 7 %. The relevant tax rate is 35 %. A. What is Mullineaux WACC? B. The company president has approached you about Mullineaux's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?

A. = (0.70x0.11) + (0.05x0.05) + (0.25x0.07) x (1-0.35) WACC =9.09% B. Calculate after-tax cost of debt -Hence, the after tax cost debt is 4.55%. Based on the after tax cost of debt, the debt is cheaper then preferred stock

Epley industries stock has a beta of 1.15. The company just paid a dividend of $.45, and the dividends are expected to grow at 4%. The expected return on the market is 11% and treasury bills yielding 3.7 %. The most recent stock price for company is $72. A. Calculate the cost of equity using the DCF method B. Calculate the cost of equity using the SML method C. Why do you think your estimates in (A) and (B) are so different?

A. = 4.65% B. = 12.10% C. Both model (DGM AND CAPM) estimates the cost of equity. However, the methods imply different assumptions to calculate equity. These assumptions, under DGM the cost of equity is related to assumption that next year "growth rate" will be the same as the current year. Under CAPM, cost of equity is calculated regard to the assumption next year "beat" will be the same as the current year "beta". Therefore, arrived cost of equity varies.

Why do we use the aftertax figure for cost of debt but not for cost of equity?

The after tax figure cost of debt is used for cost of capital because a firm is able to save its tax liability as the interest on debt is deductible in tax. Interest functions to shield the tax which in turn leads to reduction in the firms tax liability.

What do we mean when we say that a corporation cost of equity capital is 16%

This means the corporation's equity investors require 16% of return on their investment.

Lannister Manufacturing has a target debt - equity ratio of .35 it cost of equity is 12 % and its cost of debt is 6 %. If the tax rate is 35%, what is the company's WACC?

WACC= ((Equity capital/total value of capital) X Cost of equity)) + (( Preference share capital/Total value of capital) X Cost of preference)) + ((Debt capital/Total value of capital) X Cost of debt)) X (1 - Corporate tax) =(12% X 1/1.35) + 0 + (6% X 0.35/1.35) X (1-35%) =9.90%

Jimmy Cricket Farm issued a 30-year, 7 % semiannual bond 3 years ago. The bond currently sells for 93 % of its face the company's tax rate is 35% A. What is the pretax cost of debt? B. What is the after tax cost of debt? C. Which is more relevant, the pretax or the after tax cost of debt? Why?

- Calculate Present Value = % of bond X Face value - Calculate Coupon Rate = (Face value X Semiannual bond rate) / 2 - Calculate number of years = (Number of years - Years ago) X Semiannually A. Pretax cost of debt = 7.61% B. Cost of debt = Pretax X (1-TAX) =4.95% C. The "after-tax cost of debt" is the relevant and best cost of debt. The reason is that, the after tax cost debt gives the actual cost incurred in the debt for the company. The before tax omits the tax cost incurred. Hence, after tax cost of debt is MORE RELEVANT.

What are flotation cost?

- To raise capital from shares and bonds, the enterprises incur costs. These costs are known as floatation cost. The cost or expanses are legal fee, underwriting fees, registration fees, audit fees, etc. - These cost are relevant for decision making

Does it make a difference if the company's debt is privately placed as opposed to being publicly traded?

- YES! there is a difference for determining cost of debt for a company whose debt privately place and publicity traded. - PRIVATELY PLACED: if a firm has no publicly traded debt (privately placed) yield to maturity on similar rated bonds can be taken as cost of debt. - PUBLICLY PLACED: if the firm has publicly traded debt to maturity on the outstanding bonds can be taken as cost of debt.

Dorogo inc. is trying to determine its cold of debt. The firm has a debt issue outstanding with 23 years to maturity that is quoted at 97% of face value. The issue makes semiannual payments and has an embedded cost of 5 % annually. What is the company's pretax cost of debt? If the tax rate is 35 %, what is the after cost debt?

- YTM = 2.613 X 2 = 5.23% - After tax cost of debt = 3.40%

Stock in Deanery's industries has a beta of .95 the market risk premium is 7% and T-bill are currently yielding 3.6 %. The company's most recent dividend was $2.05 per share, and dividends are expected to grow at an annual rate of 4.1 % indefinitely. if the stock sells for $39 per share, what is your best estimate of the company's cost of equity?

-1st: Dividend growth model =0.095719 or 9.57% -2nd: SML approach : Find CAPM =0.1025 or 10.25% -3rd: Cost of equity (CAPM + Dividend from growth model) / 2 =9.91% COST OF EQUITY = 9.91%

How can the cost of preferred stock be calculated?

-A fixed dividend is paid to preferred stockholders. The formula is : R=D/P

Under what conditions is it correct to use the WACC to determine NPV?

-It is appropriate to use WACC to determine the NPV for the use of cash flows similar in rick to those of the overall firm. As the firms WACC is the overall required return on the firm.

What is the pure play approach to determining the appropriate discount rate? When might it be used?

-The cost of capital of similar investments in the market place is used in pureplay. The WACC of market place investment is used to develop the appropriate discount rate. -The focus on the type of project in which we are interest to find the discount rate. Thus, it is known as pure play. -The WACC has short comings when determine the required rate of return or the discount rate. To overcome this, pure play approach is used to determine the appropriate discount rate. -It is also used when the company enters in a new line of business or when the company is focusing on single or similar line of business, to determine the required rate or discount rate for decision making.

If you can borrow all the money you need for a project a 6 %, doesn't it follow a 6 % is your cost of capital for the project?

-The money is borrowed at 6%, can be 6% be considered as the cost of capital for the project or not. -The borrowing rate is the rate of the source of the fund whereas the cost of capital for a project is related to the risk that project or investment posses. Both the rates, borrowing rate and cost of capital are different as one is related to source of money an the other is related to the risk of respectively. -Hence it does not follow the 6 % is the cost of capital for the project.

What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?

-The weighted average cost of capital (WACC) is the average return paid by the company to its security holders. -The weighted average cost of capital is ascertained by multiplying the weights of proportion of capital raised and the rate of return of each type of security. -If WACC is used to analyze a proposed investment, it is possible that it may incorrectly accept a risky project and reject a less risky project or investment. -If WACC is used as cut-off, it will tend to make unprofitable investments.

How would you estimate the cost of debt for a firm whose only debt issues are privately held by institutional investors.

1. By taking cost of debt of similar firms cost of debt. 2. Taking average of similar credit rated firms debt which are privately placed. 3. Consulting professional like investment bankers.

What are the disadvantages of using the SML approach to finding the cost of equity capital?

1. SML approach has 3 variables : Risk free rate, expected market return and beta which are to be estimated. 2. The method uses historical information to get values for the variables and not the current information.

What are the advantages of using SML approach to finding the cost of equity capital?

1. SML approach includes risk related to the stock while calculating cost of equity capital. 2. The model is widely used than the dividend discount model as it does not make any expectations for the dividend for the firm.

What re the disadvantages of using the DCF model for determine the cost of equity capital?

1. The companies declaring dividends can only use this model. 2. This model assumes that the dividend will grow at a constant rate. This assumption is impractical. 3. This approach does NOT consider market, or any other risk related to the return. 4. The cost of equity is sensitive to the growth rate. A small change in growth rate affects the cost of equity.

How can the cost of debt be calculated?

The cost of debt is in the interest a company would pay for the debt taken. This can be ascertained using the yield of maturity. -The cost of debt can ascertained using the cost of debt of similar firms with similar risks or credit rating. Alternatively, analysts an investment bankers can also help to ascertain the cost of debt.