fina4210 exam 2 ch3, recap, ch 4, ch 5

example of value drivers

sales growth, GPM, operating expenses/sales, base year sales, terminal salvage value/book

how to find default spread?

spread amount/10,000 + Rf rate

firms are faced with a variety of investment opportunities with different risks and financing alternatives. investment projects that are less risky should require a higher/lower discount rate

lower

cost of equity is dollar amount?

no, its a percentage.

preferred shares issued pay 5.4% annual dividend on a $25.00 par value, or $1.33 per share. on feb 26 2014, these preferred shares were selling for $24.96 per share. consequently, investors require a 5.33% return on these shres, calculated as follows:

Kps= 1.33/24.96= 5.33%

if one believes that the stock market will generate high returns over the next 10 years, then the required rate of return on a firms stock will be...low/high

high.

how to decide if you should invest?

is NPV positive and exceeds initial cost? does IRR exceed the discount rate?

in CAPM, which risk matters to stock prices? why?

systematic. bc idiosyncratic/diversifiable can be diversified aweu. CAPM does think diversifiable risk matters too, just not as much.

internal growth rate

the max growth rate that can be sustained without external financing of any kind. the point at which addtnl assets needed equals the amount of additional income plowed back into the firm. IGR= (ROAxB)/(1-(ROAxB))

in the US the RF rate of interest can be estimated by using a ...

US treasury rate. long term 10-20 year , intermediate term, short term. it should be consistent wit the market risk premium assumption, and ideally matches the useful economic life of the asset to be valued.

breakeven sensitivity analysis. sensitivity analysis monte carlo different distributions scenario analysis

break-even sens: calc percent change from one column to second. which percent change is smallest, closest to 0?. does NOT look for a range of values. critical value of particular value driver that pushes NPV to zero? this analysis suggests that three variables are particularly critical to the outcome of the earthilizer investment. limitations: considers only one value driver at a time, while holding all others constant. this can produce misleading results if 2+ critical value drivers are correlated with one another. we don't have any idea about probabilities associated with exceeding or dropping below break-even value drivers. no formal way of incorporating consideration for interrelationships among the variables. break-even sensititvy analysis ignores likely range of values for the individual variables sensitivity analysis: looks for a range of values and makes tornado chart. how different values of an independent variable impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables, such as the effect that changes in interest rates have on bond prices. sensitivity analysis refers to changing the value of a single datapoint. try to determine the sensitivity of a project's NPV to changes in the input variables, one variable at a time. The purpose is to identify those variables to which the NPV is the most sensitive: these are sometimes called the "key drivers" of the NPV. By identifying the key drivers, we know what to focus on for further analysis and not waste our time on the less important variables. always considers only one value driver at a time, while holding all others equal to their expected values. breakeven sensitivity analysis analyzes the percentage change btwn expect value of value driver and its critical value, but this is not the only type of sensitivity analysis. alternatively, the analyst can choose a likely min and max value for the value driver. this has the benefit of incorporating the probability of extreme values into the analysis monte carlo: uniform if you know min and max. min and max with a most likely value is triangular. choose normal over triangular if theres NOT a most likely value. choose triangular if theres a most likely value. distributional assumptions made-treating like random variables. used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. It is a technique used to understand the impact of risk and uncertainty in prediction and forecasting models. aka probability simulation. outcomes from large projects are often the result of the interaction of a number of interrelated factors or value drivers. makes it difficult to determine the probability distribution of a projects cash flows. this can help the analyst evaluate what can happen to an investments future cash flows and summarize the possibilities in a probability. simulation models require deep consideration about underlying sources of uncertainty that affect an investments profits. requires explicit assumptions, benefits arise from the process and from the actual output of the simulation. scenario analysis: involves setting up different values for model parameters to get desired results. try to determine the sensitivity of a project's NPV to changes in a setof variables, which, together, make a consistent scenario. encompasses more than single scenario that changes only one value driver. sensitivity of an investments value under different situations.

chapter 8

comp paid out lender percent of revenues as fixed cost then target did. target has higher operating leverage =higher risk= higher percent fixed assets. move numbers by 10% to check operating leverage. know net op y, multiples mechanism. know comm real estate. method of com parables: using price multiple to evaluate whether asset is relatively fairly valued, under or overvalued in relation to benchmark value of multiple.

in practice, firms often use ..... to evaluate their investments

companywide WACC

if you have coupon rate and YTM, use which for forecasts?

use future forecasts over historical values. coupon rates are historical, so use YTM to estimate rate of debt.

how to find Wd, Wp, We in firm WACC?

use market weights (market cap, etc. don't use financial statement info)

when should multiple discount rates be used? incentive problems?

use when risk attributes of projects varies widely. firms operating in different lines of business. firms operating in different countries. incentive problems that arise with managerial discretion can be mitigated. systematic and verifiable cost of capital estimation. discount rates tied to outside market forces.

decision trees

value project flexibility. they're useful tools that illustrate the degree of flexibility in a projects implementation, and how future decisions can affect values. they contain number of nodes identified by vertical lines, circles, and boxes. vertical lines denote terminal node that signals end of decision process. circles signify event node that reps a point where nature intervenes and something happens that is subject to chance.

project finance WACC

we extend our analysis of the value of the equity invested in a project to include the value of the project s a whole and the corresponding project-specific WACC, which, for the special case where project finance is used, we refer to it as this

cost of capital best practices

yield on a long term bond in the estimation of the MRP as well as in calculating the excess market returns that are used in the estimation of beta. use multiple methods for estimating Ke. the focus of our analysis should be forward looking; but should not ignore historical data.

increase change in CS=

stock issuance. decrease change in CS =repurchase.

which of these factors does break-even sensitivity analysis ignore? percentage difference in best guess and break-even figure by variable nov of the project underlying financial model likely range of values for the individual variables

break-even sensititvy analysis ignores likely range of values for the individual variables

traditional CAPM equation

risk adjusted return CAPM takes into account beta, rf rate and expected return on the market. its also the equation for the security market line:(Ke-Krf)t = a + Be(Km-Krf)t + et

the dupont identity

roe=NI/equity. BOOK equity. market value of equity is never used in ROE formula. if it were, you'd have NI/market cap which is same as inverse of PE ratio which is called earnings yield and isn't same as ROE. ROE derives its value from profitability (income/sales), efficiency (sales/assets), and leverage (assets/equity). difference between ROA and ROE is merely leverage.

does leverage impact beta?

yes, bc leverage =risk=volatility

3 steps in a WACC. estimation issues

1) estimate capital structure and determine the weights of each component: Wd,Wp,We. use market values!! 2) estimate the opportunity cost of each of the sources of financing : Kd,Kp,Ke and adjust for the effects of taxes where appropriate. use YTM on publicly traded bonds. if your firm is AA rated, look at all other AA rattings and average of their debt. 3) calculate WACC by computing a weighted average of the estimated after tax costs of capital sources used by the firm. use market weights. reflect current importance of each source of financing to the firm. use market based opportunity costs. costs should reflect the current required rates of return, rather than historical rates. use forward looking weights and opportunity costs. WACC assumes constant capital structure, if this does not exist. analyst should apply APV model

three step procedure for implementing discounted cash flow analysis:

1_estimate future cash flows 2)estimate a discount rate 3)calculate present value of the cash flows using the discount rate estimated in step 2

estimation approaches for cost of common equity

Ke asset pricing models-variants of capital asset pricing model CAPM discounted cash flow approach

hurdle rates

A hurdle rate is the minimum rate of return on a project or investment required by a manager or investor. The hurdle rate denotes appropriate compensation for the level of risk present; riskier projects generally have higher hurdle rates than those that are deemed to be less risky. in practice firms tend to discount cash flow using discount rates, often referred to as hurdle rates, which exceed appropriate cost of capital for the project being evaluated. its not unusual to see corporate hurdle rates as high as 15% for firms with WACCs, as well as project WACCs, as low at 10% firms generally require that accepted projects have a substantial NPV cushion or margin of safety. most managers would consider an NPV cushion of 0.2% of the projects initial expenditures to be too small. for example, most managers are unwilling to invest in a project with an initial expenditure of 100 million if the projects NPV is only 200,000. this is a positive NPV project that will add 200,000 to the firms value.

equity made up of what on financial statements

CS+RE. so if equity increases by 50% of NI if theres 50% dividend payout. equity= equity + change in CS + change in RE

earthilizer example

CSM considers investment in earthilizer- new organic fertilizer. developed in response to growing demand from organic farmers and more restrictions on disposal of cattle manure. CSM financed from internally generated cfs, project all equity financed. promising investment opportunity- product undergone extensive testing and is wholly organic and cheaper than traditional application. phase 1: found NPV estimate is positive. how confident can we be that project will unfold as we expect? key value drivers of the project that firm should monitor over life of investment to ensure its success? phase 2: use variety of tools to address these concerns- scenario analysis, break-even sensitivity analysis, simulation anaylustion.

Duke paid dividend of 3.12 per share, and on feb 26 2014 the firms stock closed trading at a price of 70.91. the analysts expected rate of growth in earnings for 2014 through 2019 is 3.92% per annum. bc equation assumes tha the firms dividends grow forever at a constant rate, we use 5 year estimate to estimate Dukes cost of equity capital as follows:

Ke= Divyear0 (1+g)/Pe +g = (3.12(1+.0392))/70.91 + .0392 = .085-8.5%

commercial real estate uses what rates?

they use cap rates instead of discount rates. these two are not the same thing.

multiple discount rates may result in influence costs.

a manager who benefits personally from a project being accepted has incentives to put the investment proposal in the most favorable light possible. optimistic cash flow forecasts, understated risk. extra time and effort is spent. project advocate: justifying a lower discount rate. managers evaluating the project: determinings extent of the bias. using a single discount rate for all projects may increase perception of fairness, improve employee morale, and improve on source of influence cost.

sensitivity analysis

always considers only one value driver at a time, while holding all others equal to their expected values. breakeven sensitivity analysis analyzes the percentage change btwn expect value of value driver and its critical value, but this is not the only type of sensitivity analysis. alternatively, the analyst can choose a likely min and max value for the value driver. this has the benefit of incorporating the probability of extreme values into the analysis

equity risk premium is a...

an estimate of excess returns above the risk free rate. the discount rate must reflect the opportunity cost of capital, which is in turn determined by the rate of return associated with insetting in other risky investments.

benefits to use of a single discount rate

appx 6 out of 10 firms use a single companywide discount rate to evaluate investment projects. works well for firms engaging in a narrow spectrum of activities. using multiple discount rates can be difficult and can pose admin costs.

discount rates used to evaluate individual investment projects are/are not the same as WACC

are not

sensitivity analysis is often presented as what

tornado diagram

what is the lowest risk bond?

treasury bonds

how to estimate the cost of debt, preferred and common equity

cost of debt Kd: use YTM on publicly traded bonds or Rf rate plus default spread given actual debt rating. cost of debt capital is after tax (Kd(1-t)) bond price= (interest + principal) / (1+YTM) cost of preferred Kp: preferred generally pays a constant dividend every period (perpetuity) so we take the perpetuity formula, rearrange and solve for Kp. cost of common equity Ke: we use CAPM methods or DCF approach

project fcf= equity fcf=

creditor cash flows+equity fcf project fcf-creditor cash flows. equity fcf can easily be computed from project fcf by recalling that a projects fcf is equal to the sum of the cad flows available to be paid to the firms creditors (creditor cash flows) and owners (equity fcf) so what are the cash flows paid to , or received from, the firms creditors? there are two types of cash flows to consider: interest and principal. we can summarize the calculation of creditor cash flows as follows:

breakeven sensitivity analysis

critical value of particular value driver that pushes NPV to zero? this analysis suggests that three variables are particularly critical to the outcome of the earthilizer investment. limitations: considers only one value driver at a time, while holding all others constant. this can produce misleading results if 2+ critical value drivers are correlated with one another. we don't have any idea about probabilities associated with exceeding or dropping below break-even value drivers. no formal way of incorporating consideration for interrelationships among the variables.

these should reflect the opportunity cost of capital/the risk of the investment

discount rates

the ability to sustain growth must come from one of four factors:

divined policy, ROE (profit margin, leverage, asset turnover (capital intensity)

DCF valuation requires two important inputs:

estimates of future cash flows and discount rates

problems with CAPM

failure in finding significant relation btwn beta estimates of stocks and their future rates of return. firm characteristics like market cap ad book to market ratios provide much better predictions of future returns than do betas. proposed modifications of CAPM, like size premium.

general ledger article

fed minutes. meeting under old fed chair vs new fed chair. number directors in meeting pushing for more optimistic production of future economy, saying economy isn't slowing down. market reacted in which direction? initially upwards, then went way down.

mutually exclusive projects

for firms that have constraints limiting the number of projects that can be accepted, the opportunity cost of capital reflects the return on alternative investments that may have to be passed up. the opportunity cost of capital must reflect the rate of return foregone on the next best project that must be rejected if the evaluated project is accepted.

so does use of debt have positive or negative effect on ability to grow?

incrasing debt doesn't always have a positive effect on firm value. if it did, firm would lever up to max level possible. increasing debt also increases risk of financial distress. this can be difficult to measure. to gauge the suitability of a particular debt level for a firm, we often turn to similar firms competitors and see what the industry participants use for capitalization ratios.

determining value of investment opportunity is/ is not straightforward when fcf are known. what complicates the valuation process. analysts can utilize three basic tools to assess the impact of uncertainty on a project: project flexibility allows firms to modify investments in response to...

is. uncertainty. scenario analysis, break-even sensitivity analysis, and simulation analysis. all three provide info that analyst can use to understand key factors that drive projects success or failure. changing circumstances.

advantages of divisional WACC and limitations

isolates costs of capital for each business unit or division. divisions defined either by geographical regions or industry lines of business. only one cost of capital estimate per division (as opposed to per project). advantages: discount rates reflect differences in the systematic risk within each division. minimizes time and effort. limits managerial latitude and influence costs. implementation using industry based comparison has a number of potential shortcomings.poor sample of comparable firms in a given industry. sample size may either be too small or too large causing subjectivity in selection. capital structure- differences in use of leverage. differences in project risks for investments within a division. good "comps" for a particular division may be difficult to find.

adjusting project WACC using project debt capacity

key assumption in the approach we have taken in the analysis of the project specific WACC is that, by accounting for differences in project debt capacity, we are fully accounting for differences in project risk. this is a reasonable assumption for projects that are in the same line of business- are are thus subject to the same risk factors -but have different cost structures and profit margins, and thus different sensitivities to these risk factors. for example, bc of improved tech, power plants built with the most recent tech are more fuel efficient and have lower operating costs per kWh than plants built using older tech. bc of this, new tech power plants have higher profit margins, which make them less risky and give the higher debt capacities.

CPK.

know recap slides. why stock price changes the way they do? memorize how to get present value of tax shield. debtxtax rate=amount of tax shield. if firm announces recap, share prices increase.

issues with Ke estimates based on historical returns

limitations of cost of equity estimates based on historical returns. historical security returns are highly variable. market conditions are changing. historical returns exhibit survivor bias.

another approach to estimate Ke is through the use of multi factor risk models that capture the risk of investments with multiple betas and factor risk premiums risk factors:

macroeconomic variables: changes in IRs, inflation, GDP. factor portolios. fama french three factor model is the most widely used. it attempts to capture the determinants of equity returns using three risk premiums: equity risk premium of camp: RMRF-return on equity index minus 30 day Tbills. size risk premium: SMB small minus big- return on small cap portfolio minus return on large cap portfolio. risk premium related to the relative value of the firm when compared to its book value (historical cost based value): HML high minus low. Ke=Krf+bxERP+sxSMBPxhxHMLP

capital structure- use what weights for capital structure? if a change is expected, use target or current weights?

market value weights. target weights should replace current weights.

sustainable growth rate

max growth rate that can be sustained while holding the capital structure of the firm unchanged. SGR= (ROExB)/(1-(ROExB)) what makes this the sustainable growth and not larger number? can firm not just simply let the capital structure of the firm change, increase leverage , and pay for more growth?

having completed a basic DCF analysis, i discuss the initial findings with firms CFO. we outline several sources of risk affecting some basic assumptions of the model, and identify ranges of likely values for these parameters. after making some distributional assumptions about the value drivers, the CFO asks me to analyze how these affect the NPV and IRR of our project, and to estate likelihood of breaking even if we go forward. what kind of risk analysis am i likely to perform to make that assessment? sensitivity analysis, break-even senstitivtity analysis, scenario analysis, monte carlo simulation

monte carlo simulation

this can help the analyst evaluate what can happen to an investments future cash flows and summarize the possibilities in a probability. earthilizer example steps:

monte carlo simulation. outcomes from large projects are often the result of the interaction of a number of interrelated factors or value drivers. makes it difficult to determine the probability distribution of a projects cash flows. this can help the analyst evaluate what can happen to an investments future cash flows and summarize the possibilities in a probability. simulation models require deep consideration about underlying sources of uncertainty that affect an investments profits. requires explicit assumptions, benefits arise from the process and from the actual output of the simulation. Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. It is a technique used to understand the impact of risk and uncertainty in prediction and forecasting models. aka probability simulation. When faced with significant uncertainty in the process of making a forecast or estimation, rather than just replacing the uncertain variable with a single average number, the Monte Carlo Simulation might prove to be a better solution. Since business and finance are plagued by random variables, Monte Carlo simulations have a vast array of potential applications in these fields. They are used to estimate the probability of cost overruns in large projects and the likelihood that an asset price will move in a certain way. Telecoms use them to assess network performance in different scenarios, helping them to optimize the network. Analysts use them to asses the risk that an entity will default and to analyze derivatives such as options. Insurers and oil well drillers also use them. Monte Carlo simulations have countless applications outside of business and finance, such as in meteorology, astronomy and particle physics. Monte Carlo simulations are named after the gambling hot spot in Monaco, since chance and random outcomes are central to the modeling technique, much as they are to games like roulette, dice, and slot machines.

bond issue currently outstanding with 26 years left to maturity. coupon rate is 9% paid semiannually. bond currently selling for 908.72 per 1000 bond. what is the pre tax Kd?

n=50, pmt=45, fv=1000, pv=-908.72, cpt i/y=5%, YTM=5x2=10%

2 phases of evaluating new investment opportunities

phase 1: analyst tries to envision the possible outcomes from an investment. analyst prepares estimates and forecast- analysis forms the basis for estimating an expected value for the investment along with nov, ire, and other measures of investment worth. phase 2: analyst details underlying sources of risk - identify value drivers and uncertainty. analyst seeks ways to mitigate risks and monitors throughout the life of the project.

accounting for optimistic projections and selection bias

process used to select projects often induces an optimistic bias in the cash flow forecasts for those projects that are eventually selected. it generally makes sense to use a high hurdle rate to offset the optimistic cash flow forecasts.

timing of recapitalization. change in price change in shares other effects

recap has two events: an announcement date and an execution date. when announcement occurs, stock price adjusts. why? if you were a shareholder, would you sell for the old price after you knew the value was increasing? when the execution occurs, the number of shares outstanding changes. on announcement date, share price goes up to reflect addtnl info. if original price before announcement is P0, then we expect it to go up to P1 by the per share value of the effect. on execution date, number of shares goes down when firm repurchases the shares. how much? however much they are spending (the new debt issuance) divided by the price they pay. they will pay the new stock price bc this step takes place after announcement, and stock price has already adjusted. it reflects exiting shareholders receiving fair value for their equity stake. recap has wide ranging effects based solely on the recap itself and the changes in stock price and number of shares. EPS changes since number shares changed. PE ratio changes, since EPS changes. beta changes as a result of the new leverage, which changes both the cost of equity and the WACC. use of debt also changes the sustainable growth rate.

panera

recently growth has been slowing. increase in transactions per store, but growth in transactions is lower than expected. rising costs and lower transaction growth. so you shouldn't increase prices, so stock price drops 40% massive stock price drop. how have they been financing growth? internally financed funds. company must decide how to finance its continued growth. let their credit line expire. increasing prices would hinder growth.dec sales due to inc prices could cause stock price to decrease further. in response to stock price decline, panera is considering stock repurchase. but not enough cash for big purchase. must choose what kind of external funding to use. panera has a lack of capital and needs external capital to continue their growth strategy. how to secure external funding? either issuing equity, financing through LT NP, or obtain new credit line. they obtained new credit line.

when a single discount rate (firm WACC) is used, the firm will tend to take on investment projects that are...

relatively risky, which appear to be attractive because they generate an IRR that exceed the firms WACC. the firm will tend to pass up investment projects that are relatively safe, but which generate an IRR that is less than the firms WACC. this bias in favor of high risk projects will make the firm riskier over time.

effects of recapitalization

repurchase has a signaling effect. firm management signals that it believes its shares are undervalued, and importantly is willing to buy shares at their current market price. if investors assumes firm management knows more than they do about the stock, they may interpret this as a positive signal and invest more heavily in the stock or be willing to pay more. issuing new debt has its own effect. positive bc of the tax deductibility of interest payments. negative if the firm is introducing distress risk. miller and modigligiani proposition says capital structure is irrelevant (adding debt has no effect on firm value) but that result depends on no taxes and no distress risk.

high hurdle rates may provide better incentives for project sponsors

requiring high hurdle rates may signal that firms have good investment opportunities which may have the side benefit of motivating project sponsors to find better projects. high hurdle rate can help in the negotiation process

sensitivity of an investments value under different situations.

scenario analysis. encompasses more than single scenario that changes only one value driver. sensitivity of an investments value under different situations. what would happen to earthilizer npv if we applied pessimistic estimate of initial sales of 500k? dcc value drops, negative NPV investment. we could also analyze scenarios involving multiple sets of changes in assumptions and forecasts. evaluate the project using optimistic and pessimistic estimates for value drivers. typical scenarios: base case, best, worst case. others: beat to market, economic recession, industry disruption

various approaches are used to analyze risk and deal with uncertainty

scenario analysis: involves setting up different values for model parameters to get desired results. sensitivity analysis: A sensitivity analysis is a technique used to determine how different values of an independent variable impact a particular dependent variable under a given set of assumptions. This technique is used within specific boundaries that depend on one or more input variables, such as the effect that changes in interest rates have on bond prices. sensitivity analysis refers to changing the value of a single datapoint or a parameter of the model in order to note its effect on the results. This process is often employed for dimensionality reduction which results in simpler models, if they exist. break-even sensitivity analysis, and monte carlo simulation: Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted due to the intervention of random variables. It is a technique used to understand the impact of risk and uncertainty in prediction and forecasting models. aka probability simulation. n sensitivity analysis, we try to determine the sensitivity of a project's NPV to changes in the input variables, one variable at a time. The purpose is to identify those variables to which the NPV is the most sensitive: these are sometimes called the "key drivers" of the NPV. By identifying the key drivers, we know what to focus on for further analysis and not waste our time on the less important variables. With scenario analysis, on the other hand, we try to determine the sensitivity of a project's NPV to changes in a setof variables, which, together, make a consistent scenario. For example, you ask, "If my costs turn out x% higher than expected, then I will raise my selling price by y%, but that means I will sell z% less, so what is the NPV going to be under these circumstances?" The major component of a project's sensitivity to changing circumstances is the relative magnitudes of fixed and variable costs. This also is a major determinant of project risk

matching cash flows and discount rates in DCF analysis. steps and object of the valuation exercise (equity valuation vs project/firm valuation)

step 1: estimate the amount and timing of future cash flows. equity valuation: equity fvf. project/firm valuation: project/firm fcf. step 2: estimate a risk appropriate discount rate. equity valuation: equity required rate of return. project/firm valuation: combine debt and equity discount rates (WACC) step 3: discount the cash flows. equity valuation: calculate the PV of estimated equity FCFs using the equity discount rate to estimate the value of the equity invested in the project. project/firm valuation (debt plus equity claims): calculate the PV of the project or firm FCF using the WACC to estimate the value of the project/firm as an entity.

an analyst at morgan stanley has a client interested in acquiring office mart inc. steps:

step 1: forecast fcf. sales-cogs-dep=EBIT-taxes=NOPAT+dep-capex-nwc=firm fcf. step 2: estimate appropriate discount rate. step 3:discount the estimated fcf. is is a perpetuity with no growth?

if a firm doesn't want to sell new equity, and can't change its PM or capital intensity, and doesn't want to change its dividend policy, and can't or doesn't want to change its capital structure, then this is the only one possible max growth rate:

sustainable growth

to understand relation btwn risk and return its useful to decompose risk associated with an investment into which components:

systematic/nondiversifiable risk- variability that contributes to the risk of a diversified portfolio. ex: changes in interest rates and energy prices. stocks that are sensitive to these sources of risk should have high required rates of return since these stocks contribute more to the variability of diversified portfolios. nonsystematic/diversifiable/idiosyncratic risk: variability that does not contribute to the risk of a diversifiable portfolio. ex: random firm specific events such as lawsuits, product defects, and various technical innovations. these sources of risk should have almost no effect on required rates of return bc they contribute very little to overall variability of diversified portfolio.

theory suggests that firms should evaluate each investment project with individual discount rates that reflect both...

the debt capacity and the unique risks of the investment.

firms WACC provides...

the rate that is used to discount a firms future cash flows and determine how it is likely to be valued in the financial marketplace. the estimation involves three activities: evaluating the composition of the firms capital structure, estimating the opportunity cost of each source of capital, and calculating a weighted average of the after tax cost of each source of capital. our main focus is on how firms evaluate investment opportunities. in this regard,d the WACC plays a key role.

firms beta represents...

the sensitivity of its equity returns to variations in the rates of return on the overall market portfolio. if the value of the market portfolio of risky investments outperforms treasury bonds by 10% during a particular month, then a stock with a beta coefficient of 1.25 would expect to outperform treasury bonds by 12.5%

if we ignore signaling effects, and further assume that the firm is not meaningfully increasing distress risk with a particular amount of new debt, then the value added by this type of recapitalization would be due to...

the tax shield.

flow-through-to-equity approach is an appropriate approach for assessing...

the value of a specific project. for the purpose of comparing investments across different lines of business, firms may also want to know the appropriate project WACCs for their different investments.

firms weighted average cost of capital

the weighted average of the expected after-tax rates of return of the firms various sources of capital. its the discount rate that should be used to discount the firms expected fcfs to estimate firm value. it can be viewed as its opportunity cost of capital. its defined as the average of the estimated required rates of return for the firms interest bearing debt Kd, preferred debt Kp, and common equity Ke. the weights used for each source of funds are equal to the proportions in which funds are raised. note that the cost of debt financing is adjusted downward to reflect the interest tax-shield. WACC=Kd(1-T)Wd+KpWp+KeWe