fin unit 13
WACC
(E/V x RE) + [D/V X RD X (1-Tc)]
levered firm
A company that uses both debt and equity in its capital structure
pure play firm
A firm concentrated in a particular industry or operation (ex: environmental consulting services)
Project X would be incorrectly rejected as it is giving a low rate of return compared to the company's average cost of capital, but higher than what would be required given its risk. Project Y would be incorrectly accepted. It is offering a rate of return that may look good, but is not sufficient to compensate for the risk involved
An all-equity firm is considering the following projects: The T-bill rate is 4 percent, and the expected return (IRR) than the market is 11 percent. a) The company feels that it is a average company with average risks, and thus uses the average market return of 11% as its cost of capital. Which projects offer a return higher than the company's cost of capital and would thus be accepted?b) Which projects should be accepted?c) Which projects will be incorrectly accepted or rejected if the firm's overall cost of capital was set at the average market risk? Project W: beta - .80 IRR - 9.3% Project X: beta - .90 IRR - 10.6% Project Y: beta - 1.1 IRR - 11.4 Project Z: beta - 1.35 IRR - 14.1
1177
Break-even point. NB's managers are concerned about their operating leverage. The forecast sales of 3,500 units and would like to know if they will be profitable at this sales level. The annual depreciation for the Ab Stretcher project is $100,000. Sales price is $200 per unit and variable cost per unit is $30. Fixed operating costs are $100,000 per year and the tax rate is 21%. What is the break-even point? (total annual cost = (fixed operating costs + depreciation)(1 = TC) (contribution margin = (sale price - variable cost per unit)(1 - .21)
4.31
Calculating Cost of Debt. James Products issued a 30-year bond 8 years ago. The bond has a 6.3% annual coupon rate, pays semiannually, and sells for 107 percent of its face value. The company's tax rate is 21 percent. What is the after-tax cost of debt?
12.1
Calculating Cost of Equity Both Methods. Stock in CDB Industries has a beta of 1.10. The market risk premium is 7.8 percent, and T-bills are currently yielding 3.5 percent. CDB's most recent dividend was $2.35 per share, and dividends are expected to grow at an annual rate of 5 percent indefinitely. If the stock sells for $45 per share, what is your best estimate of the company's cost of equity using the CAPM?
11.23
Calculating Cost of Equity: DGM. The Giuntoli Co. just issued a dividend of $2.55 per share on its common stock. The company is expected to maintain a constant 5 percent growth rate in its dividends indefinitely. If the stock sells for $43 a share, what is the company's cost of equity? (div1/P0 + g) (div(1.05)/43 + .05)
12.11
Calculating Cost of Equity: SML. Halestorm Corporation's common stock has a beta of 1.15. If the risk-free rate is 3.6 percent and the expected return on the market is 11 percent, what is the company's cost of equity capital? (risk-free + B(market - risk-free))
4.5
Calculating Cost of Preferred Stock. Jackne Corp. has an issue of preferred stock with a $4.20 stated dividend that just sold for $93 per share. What is the bank's cost of preferred stock? (preferred stock is a perpetuity = dividend/cost per share)
9.4
Calculating WACC. Bargeron Corporation has a target capital structure of 75 percent common stock, 5 percent preferred stock, and 20 percent debt. Its cost of equity is 10.9 percent, the cost of preferred stock is 7.1 percent, and the pretax cost of debt is 5.8 percent. The relevant tax rate is 21 percent. What is the company's WACC? (= common stock(equity of cost of capital) + debt(pre-tax debt cost of capital)(1 - .21)
the pretax cost of debt is the yield-to-maturity of the company's bonds if the debt was publicly or privately traded affects its liquidity privately placed would not be as liquid (take longer to sell, higher rate of return, but is often held by long-term investors for whom liquidity is not a concern)
Calculating the Cost of Debt. How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded?
ts simplicity - makes a straightforward estimation of future cash flows and converts them into a current rate of return that reflects info about the stock
Dividend Growth Model Cost of Equity Estimation. What are the advantages of using the dividend growth model (DGM) for determining the cost of equity capital?
limited bc only for firms what actually pay dividends, makes the assumption they grow at a steady rate the estimated cost of equity is sensitive to changes in growth (uncertain) does not consider risk
Dividend Growth Model Cost of Equity Estimation. What are the disadvantages of using the dividend growth model (DGM) for determining the cost of equity capital?
If the different operating divisions were in different risk classes, then separate cost of capital figures should be used for the different divisions; the use of a single, overall cost of capital would be inappropriate.
Divisional Cost of Capital. Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions?
9.48 (13.17)
Financial Leverage. Given the results of the break-even analysis, Natural Bodyworks has decided to produce the Ab Stretcher and forecasts sales of 4,000 units, with an expected NOI of $480,000. - The managers now face the financing decision. The project has initial costs of $2,000,000, which must be raised by issuing financial securities. - They can raise the entire amount by selling 40,000 shares of stock at $50 per share. - They can raise $800,000 via bonds, and the remaining $1,200,000 by selling 24,000 shares of stock. The bonds would require annual interest payments of $80,000. - What is the EPS of the preferred capital structure?
If the single hurdle rate were used, riskier divisions would tend to receive funds for investment projects, since their return would exceed the hurdle rate despite the fact that they may actually plot below the SML and hence be unprofitable projects on a risk-adjusted basis
If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why?
The typical problem encountered in estimating the cost of capital for a division is that it rarely has its own securities traded on the market, so it is difficult to observe the market's valuation of the risk of the division. Two typical ways around this are to use a pure play proxy for the division, or to use subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division
If you were to try to estimate the appropriate cost of capital for different divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?
efficient markets
In ______ ______ the price of the financial securities reflects all of the info available on the company and can be used as a measure of economic value: the value that reflects the magnitude, timing, and risk of the firm's cash flows
revenues (unit variable costs x unit variables sold) - fixed operating costs
NOI equation
yes NOI increase by 10,000
Operating Leverage. Natural Bodyworks (NB) produces the popular Ab Stretcher that they sell for $200 per unit. NB's total fixed costs (fixed operating costs + depreciation) for the Ab Stretcher are $200,000. Their variable costs are $30 per unit. They are financed entirely by equity and face a 20% corporate tax rate. If sales increase from 4,000 units to 5,000 units, would NOI increase by the same amount as sales? Why or why not? (fixed costs per unit went down, profit went up, NOI increases)
CAPM - risk-free, risk premium, expected return the SML uses only non-diversifiable risk measured by beta (- the riskless asset has a beta of 0; the average risk in the market is where = 1; the beta of the asset is related to the return of the asset) the higher the beta the higher the expected return
Security Market Line: Cost of Equity Estimation. What information is needed to use this method?
operations
The firm's _________ - the projects undertaken - produce cash flows that are available to pay interest and principal to bondholders and dividends to stockholders
investors
Thousands of self-interested ________ have a great incentive to research companies and seek out those that would offer an attractive rate of return but individuals can't obtain/absorb all info concerning a company
each builds on the previous decision to determine the project (Product decision - managers use their marketing skills to identify what potential customers need and provide products and services to meet them) (Production decision - managers identify the specific product of the company and the resources need to produce the product - generally takes the form of cost/benefit analysis, where the costs of undertaking a project are compared w the benefits expected from the project_ (Financial decision - managers decide how to obtain the capital for the company's projects - potential bondholders and shareholders will provide investment capital only if they can expect to get an acceptable rate of return that compensates them for the risks involved in holding the company's financial securities)
Three Managerial Decisions: How are the three managerial decisions related to capital budgeting related
examine the income statement interest expense is a tax-deductible expense on the income statement (reduces taxable income and thus taxes = the appropriate debt cost oof capital reflects the tax shield provided by debt's interest payments) dividends don't appear on the income statement (what the company does w dividends is after tax income - they don't produce a tax shield effect)
WACC and Taxes. Why do we use an after-tax figure for the cost of debt but not for the cost of equity?
WACC - the min rate of return the firm must earn overall existing assets; its oc 12% means security holders require on avg 12% return on investment
WACC: What is the Weighted Average Cost of Capital? What does a WACC of 12 percent mean?
incorporates the relevant risk of the stock, more widely acceptable than the DGM model (since SML doesn't make assumptions about dividends)
What are the advantages of using the SML approach to finding the cost of equity capital?
three things must be estimated: risk-free rate, expected return on the market, and the beta the method essentially uses historical info to estimate these (useful in stable markets but not volatile markets)
What are the disadvantages of using the SML approach to finding the cost of equity capital?
controlling costs
_________ ____ while still providing good value too customers is critical (production decision)
borrowed, fixed, financial
__________ funds create a _____ interest payment, which creates ________ leverage
unlevered
a company that only uses equity in its capital structure
raises
a decrease in sales volume _____ fixed cost per unit and decreases profitability
north american industry classification system
a detailed numbering system developed by the United States, Canada, and Mexico to classify North American business establishments by their main production processes
weighted average cost of capital
a weighted average of the cost of each capital component of a levered firm - the weights are a proportion of debt and equity used by the firm
ford and leverage
activity is manufacturing automobiles - focus and the way they create value for stockholders is by building automobiles people want to buy at an attractive cost The amount of leverage they use is a decision that is associated w how much risk do we want to take w regards to the profits or the cash flows that stockholders receive
lowers
an increase in sales volume ______ fixed costs per unit and increases proftiability
total fixed costs/contribution margin
breakeven point formula
cyclical, oc
companies that are more _______ will have a higher beta and thus a higher __ (their cost of capital)
steady
companies that produce items w a _____ demand will have a lower beta
(sales price - variable cost per unit)(1 - Tc)
contribution margin formula
fixed costs
costs that do not vary w the level of output
total fixed costs
costs that must be covered before the company sees operating profits
variable costs
costs that rise and fall w the level of output
operating leverage
created by the existence of fixed operating costs = a change in sales produce a relatively lager change in profitability
security holders
determine values for a org's securities by evaluating managerial project decisions for their ability to generate sufficient cash flow and an appropriate risk-adjusted rate of return
div1/P0 + g
dividend growth model
dividend yield and capital gain
dividend growth model components
net income/number of shares
earnings per share formula
economic balance sheet left side
economic value of assets
product decision
focuses on marketing - identifying a need and how the company can meet that need, thereby attracting customers and bringing revenues into the company - what product/service are we going to sell - smith's invisible hand
created by using debt, which creates a fixed interest expense that must be paid; also benefits the shareholders' EPS (substituting debt for equity financing means that shareholders are able to benefit from the profitability of the company w a smaller investment) the fewer shares, the larger the EPS
how does financial leverage affect a project
created by using fixed operating costs; costs are fixed a change in sales will produce a larger change in operating income sales increase, fixed cost per unit decrease = increase NOI sales decrease, fixed cost per unit increase = decrease NOI
how does operational leverage affect a project?
market value of debt and equity
investors will invest in a company only if they expect to get a sufficient rate of return from the stocks and bonds issued by the company
economic balance sheet right side
market value of debt and equity
financing decision
obtaining the funds to undertake a project - in addition to equity, companies may borrow funds to finance the project
operating perspective
only costs desirable from an _________ _______ would be deserving of raising capital
banks and leverage
specialize in understanding how various instruments are being priced in the markets and market trends Tend to take on a lot more leverage to magnify any profits they're able to obtain by trading in those financial markets
discount rate, same
the WACC can be used as the ________ _____ for capital budgeting projects of the ______ operating and financial risk as the firm's existing assets
greater, sensitive
the _______ the use of financial leverage (debt), the more ________ net income is to a change in sales
total fixed costs, contribution margin
the breakeven point is the comparison of what two numbers
risk
the cost of capital should reflect the ____ of the project
financial leverage
the degree to which a company uses debt in its capital expenditure (to finance the company rather than equity)
capital gains
the increase in the rate of return driven by growth prospects
cost of capital
the minimum rate of return that investors require for a company to take on a project the oc
breakeven point
the point at which the costs of producing a product equal the revenue made from selling the product point at which sales goes from loss to profit
breakeven analysis
the process of determining the number of units a firm must sell to cover all costs can be done for accounting profitability or cash flow/NPV
expansion project
the project is similar to other projects the company has already taken on - as the project's risks are similar to the company's existing assets, the WACC provides an acceptable estimate of the project's cost of capital - its discount rate
contribution margin
the proportion of each sales dollar that is able to cover TFC
economic value of assets
the rate of return to the company's security holders comes from the cash flows of the projects the company invests in
dividend yield
the return earned on dividends as a proportion of stock price
production decision
the selection of the short-run rate of output involves two types of production cost: variable and fixed
fixed
the use of _____ costs creates operating leverage which has a great impact on profitability
(fixed operating costs + depreciation)(1 - Tc)
total fixed costs formula
less, more
variable costs are ____ risky, while fixed costs are _____ risky
economic balance sheet
w all amounts states in market value - is the foundation for determining the cost of capital bc it shows the relationship between projects and their financing