Corp Finance Midterm Ch 14

Summary and Conclusions (chapter 14)

1) WACC is the required teturn on the overall firm 2) WACC is also the discount rate appropriate for cash flows that are similar in risk to those of the overall firm 3) alternative approaches to developing discount rates, eg pure play approach 4) flotation costs associated with raising new capital can be included in an NPV analysis

Advantages of the SML Approach

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

Disadvantages of the SML approach

1) requires two things to be estimated: the market risk premium and the beta coefficient, if estimates are poor, the resulting cost of equity will be inaccurate. 2) relies on the past to predict the future. Economic conditions can change quickly, the past may be not always be a good indicator of the future.

Ways to observe cost of debt

1) the cost of debt is the interest rate the firm must pay on new borrowing, and we can observe interest rates in the financial markets. For example, if the firm already has bonds outstanding, then the yield to maturity on those bonds is the market-required rate on the firm's debt. 2) alternatively, if we know the firm's bonds are rated, say AA, then we can find the interest rate on newly issued AA-rated bonds Either way, there is no need to estimate a beta for the debt because we can directly observe the rate we want to know.

Estimating g, the growth rate

1) use historical growth rates or 2) use analysts' forecasts of future growth rates

The required return on a risky investment depends on three thinfs

1. The risk free rate, Rf 2. The market risk premium, E(Rm) - Rf 3. The sysetmatic risk of the asset relative to the average, which we called its beta coefficient, β

Disadvantages of dividend growth model

1st issue: dividend growth model is only applicable to companies that pay dividends, assumes a constant growth rate, and this will never be exactly the case, this growth model is only reasonable in which steady growth is likely to occur. 2nd issue: cost of equity is very sensitive to the estimated growth rate. 3rd issue: this approach does not explicitly consider risk. Unlike the sml approach, there is no direct adjustment for the riskiness of the investment. Difficult to say whether or not the estimated return is correspondent with the level of risk

"Adjusted" cash flow from assets, CFA* formula

CFA* = EBIT + Depreciation -Taxes* - change in NWC -Capital spending or CFA* = EBIT = Depreciation - EBIT x Tc - change in NWC - Capital spending

Simplified CFA* formula

CFA* = EBIT x ( 1 - Tc ) + Depreciation - Change in NWC - Capital spending

formula for the expected dividend for the coming year, D1 is

D1 = D0 x (1 + g)

Securities Market Line (SML Approach) formula:

E(Re) = Rf + βE x [E(Rm)-Rf]

What is the pure play approach and its uses

Pure play approach is used to estimate a particular company's cost of capital or assess risk by observing the capital structure of a "pure play" company—a company involved in only one line of business or industry.

RsubE formula and explanation

Re = D1/P0 + g ... because Re is the return that shareholders require on the stock, it can be interpreted as the firm's cost of capital

Required return under SML

Re= Rf + βE x (Rm - Rf)

Risk free rate formula sign

Rf

estimate of the market risk premium

Rm - Rf

Cost of preferred stock formula notation

Rp

Cost of preffered stock formula:

Rp = D/P0, D is the fixed dividend, P0 is the current price per share of the preferred stock. Preferred stock are rated in the much the same ways as bonds, the cost of preferred stock can be estimated by oberving the required returns on other, similarly rated shares of preferred stock.

Cost of Debt formula notation

RsubD

What is the subjective approach and how it helps companies establish discount rates for projects?

Subjective approach: companies place proposed projects into categories defined by the level of risk associated with the investment. With this approach, the firm's WACC may change through time as economic conditions change. As this happens, discount rates for the different projects will also change.

Taxes* if had not used debt financing formula

TAxes* = EBIT x Tc

What is WACC

The overall return the firm must earn on its existing assets to maintain the value of its stock. Also the required return on any investments by the firm that have essentially the same risks as existing operations if we were evaluating the cash flows from a proposed expansion of our existing operations, this is the discount rate we would use. Also used for performance evaluations.

Capital Structure weight formula

V (value) = E + D, value equals the combined market value of the debt and equity 100% = E/V + D/V, this calculates the percentages of the total capital represented by debt and equity

Nonconstant Growth Model

V0 = (CFA*sub1 / 1 + WACC) + (CFA*sub2 / (1 + WACC)^2) + ... CFA*sub t + Vt / (1 + WACC) ^ t

Growing perpetuity formula

Vt = CFA*sub t+1 / WACC - g, terminal value = adjusted cash fl0w that occurs at the end of that period at Time, t +1, divided by the WACC minus the growth

Weighted Average Cost of Capital (WACC)

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

WACC preferred stock formula

WACC = (E/V) x Re +(P/V) x Rp + (D/V) x Rd x (1 - Tc)

Why separate divisional costs of capital

a firm has a high risk division, and a low risk division. Using a single WACC as a cutoff, the riskier division would tend to have greater returns, because a single WACC would mislead them to believe that it is more attractive and profitable. However, the low risk division could have been really profitable had it been greater funds for investment. Companies are encouraged to create separate cost of capital upon division.

appropriate discount rate, required return, cost of capital

all essentially mean the samw thing. Key fact to grasp is that the cost of capital associated wth an investment depends on the risk of that investment.

Basic approach formula (flotation cost)

fa = (E/V)xfe + (D/V)xfd the weighted average flotation cost = percentage of equity multiplied by the equity flotation cost plus the percentage of debt multiplied by the debt flotation cost

To calculate cash flow from assets, we must...

first calculate what the firm's tax bill would have been if it had not used debt financing.

Flotation costs

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, flotation costs.

Disadvantage of the Subjective Approach

in principle, it would be better, to objectively determine the required return for each project separately. Necessary info is unavailable, cost and effort is not always worthwhile.

Dividend growth model: D1

next period's projected dividend

Valuing a firm vs Valuing an investment project

no difference, except for the fact that we have to adjust the taxes to remove the effect of any debt financing

Advantages of dividend growth model

simplicity; easy to use and understand

Dividend growth model: g

the assumption that the firm's dividend will grow at a constant rate

Dividend growth model: D0

the dividend just paid

Dividend growth model: P0

the price per share of the stock

Dividend growth model: RsubE

the required return on the stock

Cost of debt

the return the firm's creditors demand on new borrowing. Unlike cost of equity, cost of debt can be observed either directly or indirectly.

Cost of capital depends on...

the use of the funds, not the source

Companies that use WACC to evaluate all projects...

will have a tendency to both accept unprofitable investments and become increasingly risky