Finance Ch 10-11

If interest rates increase, what happens to the price at which bonds trade? If interest rates decrease, what happens to the price at which bonds trade?

If interest rates increase, the price at which bonds trade decreases. If interest rates decrease, the price at which bonds trade increases

What are the characteristics of preferred stock?

It has a fixed dividend payment carrying a higher order of precedence than common stock dividends, but not the binding contractual obligation of interest on debt. Being a hybrid security, it has neither the ownership privilege of common stock nor the legally enforceable provisions of debt. It has no maturity date so it is called a perpetuity.

How is the supernormal growth pattern likely to vary from the constant growth pattern? How does one value the stock?

A supernormal growth pattern is represented by very rapid growth in the early years of a company or industry that eventually levels off to more normal growth. The supernormal growth pattern is often experienced by firms in emerging industries, such as in the early days of electronics or microcomputers. To value the stock, find the present value of dividends during the exceptional growth period. Then find the price of the stock at the end of the supernormal growth period by taking the "present" value of the normal dividends. Discount the price back to the represent and adult to the first result.

Why is the cost of debt less than the cost of preferred stock if both securities are priced to yield 10 percent in the market? Give an example.

Even though debt and preferred stock may be both priced to yield 10 percent in the market, the cost of debt is less because the interest on debt is a tax-deductible expense. A 10 percent market rate of interest on debt will only cost a firm in a 35 percent tax bracket an aftertax rate of 6.5 percent. The answer is the yield multiplied by the difference of (one minus the tax rate).

In computing the cost of capital, do we use the historical costs of existing debt and equity or the current costs as determined in the market? Why?

In computing the cost of capital, we use the current costs for the various sources of financing rather than the historical costs. We must consider what these funds will cost us to finance projects in the future rather than their past costs.

Why is the cost of issuing new common stock (Kn) higher than the cost of retained earnings (Ke)?

In issuing new common stock, the company must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. These are also called flotation costs.

What approach can be taken in valuing a firm's stock when there is no cash dividend payment?

In valuing a firm with no cash dividends, one approach is to assume that at some point in the future a cash dividend will be paid. You can then take the present value of future cash dividends.

Explain the traditional, U-shaped model of the cost of capital. Draw it.

Starting with no debt, as a company increases the debt-to-equity mix, the cost of capital will at first go down. After they reach an optimum point, the increased use of debt will increase the overall cost of financing to the firm. Thus we say the weighted average cost of capital curve is U-shaped.

In determining the valuation of financial assets, how is the required rate of return, or discount rate, determined?

The market-determined required rate of return, which is the discount rate, depends on the market's perceived level of risk associated with the individual security. Also important is the idea that required rates of return are competitively determined among the many companies seeking financial capital.

Identify and briefly describe the three factors that influence the required rate of return by investors.

The three factors that influence the demanded rate of return are: The real rate of return = the financial "rent" the investor charges for using his or her funds for a period of time. The inflation premium = a premium to compensate for the eroding effects of inflation The risk premium = a compensate for the business and financial risks of a given investment

What two components make up the required rate of return on common stock?

The two components that make up the required return on common stock are: *the dividend yield D1/P0 *the growth rate (g). This actually represents the anticipated growth in dividends, earnings, and stock price over the long term.

What are the two sources of equity (ownership) capital for the firm? One of these has an opportunity cost; explain why.

The two sources of equity capital are retained earnings and new common stock. Retained earnings belong to the existing common stockholders. If the funds are paid out instead of reinvested, the stockholders could earn a return on them. Thus, we say retaining funds for reinvestment carries an opportunity cost.

How does one value common stock? What if a firm currently reinvests all its earnings and pays no dividends?

The value of a share of common stock may be interpreted by the shareholder as the present value of an expected stream of future dividends. Though the stockholder may benefit from the retention and reinvestment of earnings by the corporation, at some point the earnings must be translated into cash flow for the stockholder.

Why do we use the overall weighted cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)?

Though an investment financed by low-cost debt might appear acceptable at first glance, the use of debt could increase the overall risk of the firm and eventually make all forms of financing more expensive. Each project must be measured against the overall cost of funds to the firm.