Finace 305 Final
Consolidated Edison, Inc. (Con Edison), is a regulated utility company that services the NYC area. Suppose Con Edison plans to pay $2.30 per share in dividends in the coming year. If its equity cost of capital is 7% and dividends are expected to grow by 2% per year in the future, estimate the value of Con Edison's stock.
$46.00
What is the relevant initial cash outflow of the following project for capital budgeting analysis purposes? Equipment cost $50,000 Installation 10,000 Delivery 1,500 Consultant fees for regulation impact study 7,000 Change in operating expenses 2,500/year
$61,500
Suppose you were considering purchasing a security that entitles you to receive payments for three years. You will receive $100/year for the first two years, and $1,000 in year three. Assume your required rate of return for this type of security is 20%. What is the value of the security?
$731.48
The new Shattuck Corporation will offer its preferred stock for sale in the very near future. These shares will have a guaranteed annual dividend of $10 per share. As you research the market, you find that similar preferred stock has an expected return of 12%. If this preferred stock could be purchased today, what price would you expect to pay for it?
$83.33
Suppose Microsoft issues a 7% coupon bond with semiannual payments, a maturity of 20 years and a face value of $1,000. What is the current market value of the bond? Assume the appropriate market rate of return is 8%.
$901.04
An investor purchases a bond ($1000 par value) that has an annual coupon rate of 4.8% and 10 years until maturity. The yield to maturity on the bond is 5%. How much did the investor pay?
$984.56?
You expect to use your new boat for 10 years. After year 10 the salvage value of the boat is $40,000 and the book value of the boat is $25,000. Recall that your marginal tax rate is 30%. What is the shut-down cash flow?
(40,000 - 25,000)*.7 = 10,500
Suppose Microsoft issues a 7% coupon bond with a maturity of 20 years and a face value of $1,000. What is the current market value of the bond? Assume the appropriate market rate of return is 8%.
901.82
What a firms cost of debt?
A firm's cost of debt is the interest rate demanded by bond investors or interest rate on a loan
What is a real option?
A real option- is a right (not an obligation) to make a particular business decision.
What is a sunk cost?
A sunk cost is a cost that has already been incurred and cannot be recovered.
Based on the assigned Wall Street Journal article, which of the following is NOT an example of Marty's fixed costs? A.Hot dogs B.The hot dog stand C.Investment property rent payments D.Advertising expenses
A. this is a variable cost
What are the four possible scenarios for shut down cash flows?
Asset is sold for more than purchase price (capital gains) Asset is sold for less than the purchase price but more than book value (ordinary income) Asset is sold for book value (no tax) Asset is sold for less than book value (reduces taxable income)
What is capital structure?
Capital Structure is the mixture of sources of funds a firm uses. Debt Preferred Stock Common Stock Firms must consider many factors when deciding on the "right" balance of debt and equity, including: Tax effects of interest payments Impacts on firm value
what is combined Leverage
Combined leverage occurs when net income changes by a larger percentage than sales, which occurs if there are any fixed operating or financial costs. Measures changes in Net Income given changes in Sales Combines both Operating and Financial Leverage Computed for a specific level of sales 𝐷𝐶𝐿= _% ∆ 𝑁𝐼_% ∆ 𝑆𝑎𝑙𝑒𝑠_
Recall the resort example. You are planning to purchase the glass bottom boat in two years to take tourists to the artificial reef. Which of the following is a real option on this project? A.The ability to rent the boat out to a third party operator B.The ability to trade-in the boat for a larger boat if you wish C.The ability to return the boat in good repair after 6 months of the initial purchase D.All of the above are real options
D. All of the above are real options
Weighted Average Cost of Capital (WACC)
Debt -Before tax cost of debt: Kd -After tax cost of debt: AT Kd Preferred stock (Kp) Common stock (Ks)
What is the break point in Marginal cost?
Debt break point (_𝑩𝑷_𝒅_)- the point at which the firm's capital from debt can only be increased at a higher cost.
According to the Wall Street Journal article: "If you relish the idea of launching a mobile wiener business, you can get started with a basic, two-wheeled stainless steel cart for just under $2,000. Used carts sell for around $600. . . To set up shop on main roads, vendors typically need to secure state, county and/or city business licenses for annual or monthly fees that vary significantly. . . Other expenses that can take a bit out of your earnings include insurance coverage, commissary fees, fuel costs and, of course, inventory." In terms of Chapter 13, which of the above costs would be considered variable? A.A used cart for $600 B.A city business license with monthly fees C.Insurance coverage D.All of the above E.None of the above
E. None of the above
What is Equity Break Point?
Equity break point (_𝑩𝑷_𝒆_) is the point at which the MCC changes because the cost of equity changes. _𝑩𝑷_𝒆_= _𝑳𝒊𝒎𝒊𝒕_𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 𝒐𝒇 𝑻𝒐𝒕𝒂𝒍_ Why would a firm's equity costs change? They exhaust their supply of internal equity (retained earnings) and have to issue new stock (which has a higher cost, _𝑘_𝑛_).
What are Externalities?
Externalities are positive (or negative) side effects on existing projects if a new capital budgeting project is accepted.
What is Financial Leverage?
Financial leverage is the additional volatility of net income caused by the presence of fixed-cost funds (such as fixed rate debt) in the firm's capital structure. Measures changes in earnings per share as EBIT changes The degree of financial leverage (DFL) measures the magnitude of the financial leverage effect. 𝑫𝑭𝑳= _% ∆ 𝑵𝑰_% ∆ 𝑬𝑩𝑰𝑻_
What are financing cash flows?
Financing cash flows are the cash outflows that occur as creditors are paid interest and principal, and stockholders are paid dividends
What is the difference between fixed cost and variable cost?
Fixed costs (indirect costs) are costs that do not vary with either the firm's sales or output Rent, insurance, salaries, debt payments, etc. Variable costs (direct costs) are costs that change with changes in production. Materials, hourly wages, commissions, etc.
What factors affect the cost of capitol?
General Economic Conditions -Affect interest rates Market Conditions -Affect risk premiums Operating Decisions -Affect business risk Financial Decisions -Affect financial risk Amount of Financing -Affect flotation costs and market price of security
What is initial investment cashflow?
Includes purchase price of asset, installation and delivery costs, and any investment for needed additions to net working capital tied to the project.
What are incremental cash flows?
Incremental cash flows are cash flows that will occur if a capital budgeting project is accepted, but that will not occur if the investment is rejected. -Cash flows directly associated with a project.
What is the Liquidation Value of CommonStock Holders Equity?
Liquidation Value- the amount each common stockholder would receive if the firm closed, sold all assets and paid off all liabilities and preferred stock.
How do you measure incremental cash flows?
Measure cash flows that change if a project is undertaken Do not include sunk costs Do not include allocation of existing overhead do include additions to overhead tied to the proposed project. subtract lost sales of other products if they occur only if this project is accepted Include cost savings as a positive cash flow.
The boat is expected to generate $150,000 in new sales. You predict operating expenses will be $35,000 and depreciation will be $15,000. Tax rate is 30%. How much are your operating cash flows?
New sales resulting from the boat (cash inflow): $150,000 New operating expenses (cash outflow): -35,000 New depreciation expense (non cash expense): -15,000 Net New Taxable Income: 100,000 Taxes on new project income (30%) (cash outflow) - 30,000 Net new project after-tax income: 70,000 Plus depreciation expense (added back) +15,000 Net incremental cash flow 85,000
What is initial Operating cashflow?
Operating cash flows Includes revenues and expenses, taxes (including CFs due to tax deductible depreciation expense), opportunity costs and externalities.
What is operating leverage?
Operating leverage refers to the phenomenon whereby a small change in sales triggers a relatively large change in net operating income. With higher fixed operating costs, a small change in sales will trigger a larger change in operating income (EBIT).
What is shut down cash flows?
Shut down cash flows Include after tax salvage value and reduction in net working capital .
What are shut down cash flows?
Shut down cash flows occur at the end of the useful life of a proposed capital budgeting project Example: salvage value of the glass bottom boat
What are the three values that affect future earnings?
Size of cash flows, Timing of cash flows, Risk associated with the cash flows this effects the investors required rate of return
What are sunk cost?
Sunk costs- costs that have already occurred or will occur in the future, regardless of whether a project is accepted or rejected. May be associated with researching the project Are irrelevant in the capital budgeting decision
Which one has a greater required rate of return? Suppliers of equity capital (stockholders) or Suppliers of debt capitol?
Suppliers of equity capital (stockholders)
What is the Optimal capital budget
The Optimal capital budget the list of all accepted projects and the total amount of initial cash outlays for these projects.
What is the marginal cost of capital?
The WACC of the next dollar of capital raised in called the marginal cost of capital (MCC).
What is the after tax cost of debt?
The after-tax cost of debt (Atkd) is the cost to the company of obtaining debt funds.
What is the cost of equity from new common stock?
The cost of equity from new common stock (kn) is the cost incurred by a company when new common stock is sold Includes stockholders' expected returns AND flotation costs
What is the cost of internal common equity?
The cost of internal common equity (ks) is the required rate of return on funds supplied by existing common stockholders.
What is the cost of preferred stock and flotation cost?
The cost of preferred stock (kp) is the rate of return investors require on a company's new preferred stock, plus the cost of issuing the stock. The flotation cost is the cost of issuing new securities
What is the discounted cash flows model?
The discounted cash flow model (DCF) values an asset by calculating the sum of the present values of all expected future cash flows. 𝑉_𝑜_=__𝐶𝐹_1____1+𝑘__1__+__𝐶𝐹_2____1+𝑘__2__+...+__𝐶𝐹_𝑛____1+𝑘__𝑛__ Where: _ 𝑉_𝑜_= an asset's current value _𝐶𝐹_1,2,...,𝑛_=cash flows expected in each period k= discount rate (investor's required rate of return)
What are relevant cash flows?
The relevant cash flows for an investment are its incremental, after-tax, cash flows, which ignore financing costs and reflect adjustments for any noncash charges, typically depreciation. (more on financing near end of chapter)
How do you find the marginal cost of capital?
To find the MCC... Assess at what point a firm's cost of debt or equity will change the firm's WACC Estimate how much the change will be Calculate the cost of capital up to and after the points of change.
What is the Yield to maturity on a bond, what would be considered a discount bond, what would be considered and premium bond?
Yield to maturity- the rate of return a bondholder will receive if the bond is held to maturity (the equivalent to the expected rate of return) Discount- the price of the bond is less than the par value because the coupon rate is BELOW the market rate on the entire investment Premium- the price of the bond is more than the par value because the coupon rate is above the market rate on the whole investment (yield to maturity).
Consider the Guajardo family in the Wall Street Journal article distributed. Assume they purchased their hot dog stand for $2000. Suppose they pay another $1000 for fees, licenses, and insurance and that each hot dog they sell costs approximately $.50 in labor and supplies. If they sell hot-dogs for $2.00 each, how many hot dogs do they need sell to break-even on the costs of their operation?
You figure this out by by dividing the fix cost (3000) by the profit which is (1.50) and you get 2000
You are considering replacing your old motorboat in two years with a glass bottom boat for tours to the artificial reef. The cost of the new boat is $80,000. Delivery, licenses, and permits will cost $5000. Your old boat's salvage value is $30,000 and it's book value is $0. Your marginal tax rate is 30%. What is your initial investment?
Your initial outlay is: $80,000 + $5000 - after tax return for the sale of the old boat = $80,000 + $5000 - $21,000= $64,000
What is the formula for break point?
_𝑩𝑷_𝒅_= _𝑳𝒊𝒎𝒊𝒕_𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 𝒐𝒇 𝑻𝒐𝒕𝒂𝒍_ 𝑤ℎ𝑒𝑟𝑒:_𝑩𝑷_𝒅_=𝑡ℎ𝑒 𝑑𝑒𝑏𝑡 𝑏𝑟𝑒𝑎𝑘 𝑝𝑜𝑖𝑛𝑡 𝑳𝒊𝒎𝒊𝒕=𝑡ℎ𝑒 𝑝𝑜𝑖𝑛𝑡 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑜𝑢𝑟𝑐𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒𝑠 𝑷𝒓𝒐𝒑𝒐𝒓𝒕𝒊𝒐𝒏 𝒐𝒇 𝒕𝒐𝒕𝒂𝒍=𝑡ℎ𝑒 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 of this source 𝑖𝑛 𝑡ℎ𝑒 𝑓𝑖𝑟_𝑚_′_𝑠 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑠𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒
What is the cost of capitol?
cost of capital is the required rate of return, k, for each type of security issued the cost of capital is the compensation investors demand of firms that use their funds
What is the relevant operating cash flow in year three for the following projected cash flows of the new and old boat? Year New Old 0 0 0 1 $200,000 $150,000 2 123,672 40,000 3 75,000 30,000
replacing the old machine with a new one... this is the asset replacement decision pg 272-273 75,000-30,000=45,000
What is the P/E ratio and the P/E model?
the P/E ratio is the price per share of common stock divided by the company's earnings per share (EPS) The P/E Model Uses the firm's earnings per share and an industry average P/E ratio to solve for an expected price of the firm's shares Tells us how much investors are willing to pay for each dollar of a stock's current earnings. Often used to value stocks for businesses that are not "public" "method of comparables" 𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒=𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 _𝑃_𝐸_ 𝑟𝑎𝑡𝑖𝑜 ×𝐸𝑃𝑆
Free Enterprise, Inc. had a net income of $5,610,000 in 2014. In 2014 Free Enterprise had 500,000 shares outstanding. The P/E ratio for a typical company in Free Enterprise, Inc.'s industry is estimated to be 6. Using this information, calculate the price of one share of common stock at the beginning of 2015, assuming that Free Enterprise commands a P/E ratio value equal to that of an average company in the industry.
𝑆𝑡𝑜𝑐𝑘 𝑝𝑟𝑖𝑐𝑒=𝐼𝑛𝑑𝑢𝑠𝑡𝑟𝑦 _𝑃_𝐸_ 𝑟𝑎𝑡𝑖𝑜 ×𝐸𝑃𝑆 = 6 x (5,610,000 / 500,000) = 6 x 11.22 = $67.32
