FIN 300 Exam 3

Calculate Net incremental Cash flow

+ Change in NWC (Change in asset - change in liability) + Cost of New machine + Cost of Set up = Change Incremental Cash Flow

Project Cash Flows (3)

- Initial Investment Cash Flow - Operating Cash Flow - Shut Down Cash Flow

Jay Lo Enterprises finances its assets with 60 percent debt, 10 percent preferred stock, and 30 percent common stock. Jay Lo's after-tax cost of debt is 5 percent, its cost of preferred stock is 8 percent, and its cost of common equity financing is 12 percent. Given these conditions, what is Jay Lo's WACC

0.60(0.05) + 0.10(0.08) + 0.30(0.12) = 0.074 = 7.4%

3 steps to determine incremental cash flows from sale of asset

1) Realized gain = Sales Price - Cost Basis 2) Tax = realized Gain * Tax 3) Incremental cash Flow = Sale Price - Tax

Steps for Solving MIRR (4)

1) Solve for the NPV using a $0 cash outflow 2) Use TVM to find FV of the found NPV at the given interest or WACC 3) Plug initial cash outflow into PV and leave the new FV. 4) Solve for I%

Shut Down Process

1) Taxable amount: Sale Price - Cost Basis 2) Recover Net Working Capital

Calculate the After-tax cost of debt for a loan with an annual interest rate of 10% and an interest subsidy tax rate of 22%

10% X (1 - .22) = 7.8

A firm is issuing new bonds that pay 8 percent annual interest. The market required annual rate of return on these bonds is 13 percent. The firm has an interest subsidy rate of 25 percent. a. What is the before-tax cost of debt? b. What is the after-tax cost of debt?

A. 13% (Market required rate) B. 13% X (1 - .25) = 9.75

The Bedford Falls Bridge Building Company is considering the purchase of a new crane. George Bailey, the new manager, has had some past management experience while he was the chief financial officer of the local savings and loan. The cost of the crane is $17,291.42, and the expected incremental cash flows are $5,000 at the end of year 1, $8,000 at the end of year 2, and $10,000 at the end of year 3. A. Calculate the net present value if the required rate of return is 9 percent. B. Calculate the internal rate of return. C. Should Mr. Bailey purchase this crane?

A. NPV = 5000/((1 + .09)^1) + 8000/((1 + .09)^2) + 10000/((1 + .09)^3) - 17,291.42 = $1751.01 B. NPV = (17,291.42) + 5,000[1/(1+k)1] + 8,000[1/(1+k)2] + 10,000[1/(1+k)3] = $0 IRR = k = 14% C. Yes. NPV is positive and IRR > Cost of capital

African Queen River Tours, Inc. has capitalized on the renewed interest in riverboat travel. Charlie Allnut, the lone financial analyst, estimates the firm's earnings, dividends, and stock price will continue to grow at the historical 5 percent rate. AQRT's common stock is currently selling for $30 per share. The dividend just paid was $2. They pay dividends every year. The rate of return expected on the overall stock market is 12 percent. A. What is AQRT's cost of equity? B. If they issue new common stock today and pay flotation costs of $2 per share, what is the cost of new common equity? C. If AQRT has a risk-free rate of 3 percent and a beta of 1.4, what will be AQRT's cost of equity using the CAPM approach

A. ks = ($2 X 1.05)/$30 + .05 = 12.0% B. kn = ($2 X 1.05)/($30-$2) + .05 = 12.5% C. ks = .03 + (.12 - .03) x 1.4 = 15.6%

Twister Corporation is expected to pay a dividend of $7 per share one year from now on its common stock, which has a current market price of $143. Twister's dividends are expected to grow at 13 percent. A. Calculate the cost of the company's retained earnings. B. If the flotation cost per share of new common stock is $4, calculate the cost of issuing new common stock.

A. ks = ($7/$143) + 0. 13 = 17.90% B. kn = ($7/($143 - $4) + 0. 13 = 18.04%

A company has an optimal capital structure as follows: Total Assets - $600,000 Debt - $300,000 Preferred Stock - $100,000 Common Equity - $200,000 What would be the minimum expected return from a new capital investment project to satisfy the suppliers of the capital? Assume the applicable interest subsidy tax rate is 15 percent, YTM of its debt is 11 percent, flotation cost per share of preferred stock is $0.75, and flotation cost per share of common stock is $4. The preferred and common stocks are selling in the market for $26 and $143 a share, respectively, and they are expected to pay a dividend of $2 and $7, respectively, in one year. The company's dividends are expected to grow at 13 percent per year. The firm would like to maintain the foregoing optimal capital structure to finance the new project.

AT kd = 0.11(1-0.15) = 9.35% kp = $2/($26 - $0.75) = 7.92% kn = $7/($143 - $4) + .13 = 18.04% ka = (300,000/600,000)(0.0935) + (100,000/600,000)(0.0792) + (200,000/600,000)(0.1804) = 12%

How do tax considerations affect the cost of debt and the cost of equity?

Because interest on debt is tax deductible to the issuing firm, the higher the tax rate the lower the after tax cost of debt financing. Tax considerations do not enter into the cost of equity calculation since dividends paid to stockholders are not tax deductible to the firm.

Operating cash flow process

Change in Revenues + Change in Expenses - Depreciation =Change in EBIT - Tax = Change in NOPAT + Depreciation = Net Operating Cash Flow

Book Value interchangeable term

Cost Basis

For a given IOS and MCC, how do financial managers decide which proposed capital budgeting projects to accept, and which to reject?

For a given IOS and MCC, all independent projects that plot on the IOS above the MCC are accepted. Those projects on the IOS below the MCC are rejected.

Do you include Financing costs when computing cash flows?

No, financing costs such as dividends and interest expenses are already including in the WACC/k?

Which is lower for a given company: the cost of debt or the cost of equity?

The cost of debt is always less than the cost of equity for a given firm. This is because the debt investor is taking a lower risk than the equity investor and therefore the required rate of return is lower.

What is the investment opportunity schedule (IOS)? How does it help financial managers make business decisions?

The investment opportunity schedule shows graphically proposed capital budgeting projects depicting the IRR and dollar amount of investment for each project. This helps the financial manager make business decisions since the investment opportunity schedule and the marginal cost of capital schedule can be plotted together, with those projects on the IOS schedule above the MCC being acceptable.

What is a marginal cost of capital schedule (MCC)? Is the schedule always a horizontal line? Explain.

The marginal cost of capital schedule is a graphic depiction of the weighted average cost of capital at different levels of financing. The MCC schedule is not always a horizontal line. For many firms the MCC schedule increases, usually at discreet intervals, as the amount of funds to be raised increases.

What does the "weight" refer to in the weighted average cost of capital?

The weight referred to in weighted average cost of capital refers to the portion of the total capital raised by the firm that comes from a given source such as debt, preferred stock or equity.

How do we calculate the payback period for a proposed capital budgeting project? What are the main criticisms of the payback method?

We calculate the payback period for a proposed project by adding a project's positive cash flows, one period at a time, until the sum equals the initial investment. The number of time periods it takes to cover this investment is the payback period. The main criticisms of the payback method are that cash flows after the payback period are ignored and the time value of money is not considered.

When a company issues new securities, how do flotation costs affect the cost of raising that capital?

When a company issues new securities flotation costs increase the cost of raising the capital. The company receives a smaller amount of the proceeds from the new issues, the greater the flotation costs.

What would be the after-tax cost of debt for a company with a YTM of 7% and a tax rate of 20%

YTM = 7% X (1 - .20) = 5.6

Fans By Fay Company has a capital structure of 60 percent debt and 40 percent common equity. The company expects to realize $200,000 in net income this year and will pay no dividends. The effective annual interest rate on its new borrowings increases by 3 percent for amounts over $500,000. A. At what capital budget size will Fans By Fay's cost of equity increase? In other words, what is its equity break point? B. At what capital budget size will its cost of debt increase (debt break point)?

a ) $200,000/0.40 = $500,000 equity break-point b ) $500,000/0.60 = $833,333 debt break-point

Great Expectations, a wedding and maternity clothing manufacturer, has a cost of equity of 16 percent and a cost of preferred stock of 14 percent. Its before-tax cost of debt is 12 percent, and its marginal tax rate is 40 percent. Assume that the most recent balance sheet shown here reflects the optimal capital structure. Calculate Great Expectations' after-tax WACC. Long-Term Debt - 600,000 Preferred Stock - 250,000 Common Stock - 400,000 Total Assets - $ 1,250,000

ka = (600/1250)(0.12(1-0.4)) + (250/1250)(0.14) + (400/1250)(0.16) = 11.38%

El Norte Industries will issue $100 Par, 12% preferred Stock. The market price is expected to be $89 per share. El Norte must pay flotation costs of 5% of the market price. What is El Norte's cost of preferred stock?

kp = $100 X 0.12/($89 - ($89 X 0.05)) = $12/($89 - $4.45) = 14.19%

A company can sell preferred stock for $26 per share, and each share of stock is expected to pay a dividend of $2. If the flotation cost per share of stock is $0.75, what would be the estimate of the cost of capital from this source?

kp = $2/($26 - $0.75) = $2/$25.25 = 7.92%

Free Willy, Inc., (Nasdaq: FWIC) has a beta of 1.4. If the rate on U.S. Treasury bills is 4.5 percent and the expected rate of return on the stock market is 12 percent, what is Free Willy's cost of common equity financing?

ks = .045 + 1.4(.12 - .045) = 15%

CAPM approach - Estimate the cost of equity. The rate on a short-term U.S. Treasury bill is 3% and the expected rate of return on the overall stock market is 11%. The Beta is 1.6

ks = kRF + (kM - kRF) x β = .03 + (.11 - .03) X 1.6 = 15.8%