Finance Exam III Ch. 14

new project positive NPV

- NPV will only be positive if the project's return exceeds what the financial markets offer on investments of similar risk - cost of capital: the minimum required return associated with the project (so the return must be higher than this)

weighted average cost of capital (WACC)

- WACC is the overall required return on our assets, based on the market's perception of the risk of those assets - WACC is the average return required to attract different types of capital providers - WACC is our required return for capital budgeting projects: NPV, IRR, discounted payback, and profitability index depend on it

pure play

- a company that focuses on a single line of busienss

***WACC for a firm reflects the risk and target capital structure of the firm's existing assets as a whole

- as a result, the firm's WACC is the appropriate discount rate only if the proposed investment is a replica of the firm's existing operating activities

if you use internal equity

- assign a value of 0 to the flotation cost of equity

premium bond

- bond selling above $1000 - rate will be lower than the coupon rate

discount bond

- bond selling at below $1000 - rate will be higher than the coupon rate

when we evaluate investments with risks that are substantially different from those of the overall firm

- can result in the firm's incorrectly accept relatively risky projects and incorrectly rejecting relatively safe ones - through time, a firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky

subjective approach

- consider the project's risk relative to the firm overall - the firm places projects into one of several risk class: the discount rate used to value the project is then determined by adding (for high risk) or subtracting (for low risk) an adjustment factor to or from the firm's WACC

preferred stock

- has a fixed dividend paid forever, so a share of preferred stock is essential perpetuity

risk class

- projects that have the same risk are said to be in the same risk class

advantages of dividend growth model approach

- simplicity (easy to understand)

when debt equity ratio increases

- the WACC for a firm will generally decrease (more debt generally decreases WACC)

weighted average cost of capital (WACC)

- the cost of capital for the firm as a whole, and it can be interpreted as the required return on the overall firm

flotation costs

- the cost of issuing new securities - if a company accepts a new project, it may be required to issue, or float, new bonds and stocks; this means that the firm will incur some costs, which we call flotation costs - because the costs arise as a consequence of the decision to undertake a project, they are relevant cash flows

debt issued at par

- the debt is issued at face value - likely $1000

incorrect decisions still exist with the subjective approach

- the magnitude of potential error though is less with the subjective approach - some risk adjustment is better than no risk adjustment

value (V)

- the market value of the firm = equity + debt + preferred

debt (D)

- the market value of the firm's debt

equity (E)

- the market value of the firm's equity

preferred (P)

- the market value of the firm's preferred

cost of capital

- the minimum required return on a new investment - this minimum required return is what the firm must earn on its capital investment in a project just to breakeven - thus, it can also be interpreted as the opportunity cost associated with the firm's capital investment - this is also called the discount rate

capital structure

- the mixture of debt and equity a firm chooses to employ

capital structure weights

- the percentages of the total capital represented by the debt and equity

yield to maturity

- the rate required in the market on a bond - you know the bond's price, coupon rate, and maturity date, and using a calculator you can find the yield

cost of preferred

- the return preferred stockholders require on their investment in the firm - the cost of preferred stock is simply equal to the dividend yield on the preferred stock; it is a perpetuity

cost of equity

- the return that equity investors require on their investment in the firm

cost of debt

- the return that lenders require on the firm's debt - the yield to maturity on the existing debt of similar bond issues - the cost of debt is simply the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets - must look at the yield on the deb in today's marketplace (the coupon rate on the firm's outstanding debt is irrelevant here)

the cost of capital with an investment depends on

- the risk of that investment - if a project is risky, the cost of capital for this project is greater than the risk free rate, and the appropriate discount rate would exceed the risk free rate - not, the cost of capital depends primarily on the use of the funds, not the source of the funds

firm's total capitalization

- the sum of its long term debt and equity

pure play approach

- the use of a WACC that is unique to a particular project, based on companies in similar lines of business

if you get a negative NPV using the WACC as the discount rate

- this means that financial markets offer superior projects in the same risk class (namely, the firm itself)

important note on WACC

- using the WACC as our discount rate is only appropriate for projects that are the same risk and will be financed in the same way as the firm's current operations - so, if we were evaluating the cash flows from a proposed expansion of our existing operations, WACC is the discount rate we would use - if we are looking at a project that is NOT the same risk or financed in the same way as the firm, then we need to determine the appropriate discount rate for that project - for example, divisions often require separate discount rates

taxes

- we are concerned with after tax cash flows, so we need to consider the effect of taxes on payments to capital providers - interest paid by a corporation is deductible for tax purposes - payments to stockholders, such as dividends, are not tax deductible

target capital structure

- we will assume the firm has a fixed debt-equity ratio

a firm's cost of capital

- will reflect both its cost of debt capital and its cost of equity capital - remember a firm's overall cost of capital will reflect the required return on the firm's assets as a whole

advantages of security market line approach

1. explicitly adjusts for risk 2. is applicable to companies other than just those with steady dividend growth

ignoring taxes, if the firm issues a debt at par, then the cost of debt

1. is equal to the coupon rate 2. is equal to its yield to maturity

disadvantages of dividend growth model approach

1. model is only applicable to companies that pay dividends growing at a constant rate 2. the estimated cost of equity is very sensitive to the estimated growth rate 3. model does not consider risk (there is no direct adjustment for the riskiness of the investment)

steps to determine WACC

1. opportunity cost of capital providers 2. taxes 3. fraction of capital provided

disadvantages of security market line approach

1. requires two things to be estimated - the market risk premium and the beta coefficient 2. we essentially rely on the past to predict the future when we use the SML approach

initial assumptions

1. the cash flows of the project are of similar risk to those of the existing firm 2. the project will use a similar mix of financing as the existing firm (debt-equity ratio)

two approaches to determine the cost of equity

1. the dividend growth model approach 2. the security market line approach

SML approach: the expected return on a risky investment depends on 3 things

1. the risk free rate 2. the market risk premium 3. the systematic risk of the asset relative to the average, which we call beta

two ways of estimating the dividend growth rate (g)

1. use historical growth rates 2. use analysts' forecasts of future growth rates