Finance Final Exam

An IT company's expected earnings per share is $7.50 for this year. Assuming the IT industry's price/earning (P/E) ratio is 15. Estimate the price of the company's common stock.

$112.50

A firm has preferred stocks outstanding that has a stated annual dividend of $3 per share. The required return on the preferred stock has been estimated to be 15 percent. The value of the preferred stock is ________.

$20

A firm has issued cumulative preferred stock with a $100 par value and offering 8 percent annual dividend. For the past two years, the board of directors has decided not to pay a dividend to stockholders. If the firm decides to pay dividends at the end of the current year, the preferred stockholders must be paid ________.

$24/share

You being asked to prepare data for optimizing the firm's capital structure with EBIT-EPS approach. The firm has a current capital structure consisting of $100,000 debt with 8% annual interest expenses and 40,000 shares outstanding of common stock. The firm's tax rate is 21 percent on ordinary income. If the expected EBIT is to be $300,000, what is the firm's EPS? (Hint: EBIT - interest - tax - preferred stock dividends = earnings available for common stockholders)

$5.725

capital budgeting process

-Consists of five distinct but interrelated steps: proposal generation, review and analysis, decision making, implementation, and follow-up

Firms sometimes can alter the mix of fixed and variable costs in their operations

-For example, a firm could compensate sales representatives with a fixed salary and bonus rather than on a pure percent-of-sales commission basis -Or it could outsource some of its activities, such as manufacturing, paying manufacturing costs only when sales volume justifies doing so

decision criteria

-If the payback period is less than the maximum acceptable payback period, accept the project -If the payback period is greater than the maximum acceptable payback period, reject the project

Capital Structure of Non-US Firms

-In general, non-U.S. companies have much higher degrees of indebtedness than their U.S. counterparts -This is largely because U.S. capital markets are more developed than those elsewhere and have played a greater role in corporate financing than has been the case in other countries -In most European countries, and especially in Japan and other Pacific Rim nations, large commercial banks are more actively involved in the financing of corporate activity than has been true in the United States-Furthermore, in many of these countries, banks are allowed to make large equity investments in nonfinancial corporations, a practice prohibited for U.S. banks -Finally, share ownership tends to be more tightly controlled among founding-family, institutional, and even public investors in Europe and Asia than is the case for most large U.S. corporations -Tight ownership enables owners to understand the firm's financial condition better, resulting in their willingness to tolerate a higher degree of indebtedness -Similarities do exist between U.S. corporations and those in other countries §The same industry patterns of capital structure tend to be found all around the world -High-growth firms whose main assets are intangibles (such as patents and rights to intellectual property) tend to borrow less than firms having tangible assets that can be pledged as collateral for loans §In most countries, larger firms tend to borrow more than smaller firms do §Companies that are riskier and have more volatile income streams tend to borrow less, as do firms that are highly profitable §The worldwide trend is away from reliance on banks for financing and toward greater reliance on security issuance

What happens when a firm is unable to pay its debt and goes bankrupt?

-In theory, because lenders have a higher priority claim than shareholders, when a firm cannot repay its lenders in full, the shareholders walk away empty handed and lenders receive whatever assets remain -In practice, the ownership transition just described can be slow, contentious, and expensive -A firm in or approaching bankruptcy incurs a variety of costs that siphon cash flows away from the firm's investors -These bankruptcy costs reduce the value of the firm relative to what it would be in the absence of those cost

Sources of Long-Term Capital

-Long-term capital for firms derives from four basic sources: long-term debt, preferred stock, common stock, and retained earnings -Not every firm will use all of these financing sources

Capital Structure Theory

-Modigliani and Miller (M and M) demonstrated mathematically that, in a world with perfect markets, the capital structure that a firm chooses does not affect its value -Many researches, including M and M, have examined whether capital structure may, in fact, affect firm value in imperfect, real-world markets -The general consensus is that for any particular firm there is an optimal capital structure that balances the benefits and costs of debt financing -The major benefit of debt financing is the tax savings that arise because firms can deduct interest expense from taxable income -The costs of debt financing are related to (1) the increased probability of bankruptcy associated with heavier borrowing, (2) the agency costs of the lender's constraining the firm's actions, and (3) the costs associated with managers having more information about the firm's prospects than do investors

indepenedent projects

-Projects whose cash flows are unrelated to (or independent of) one another; accepting or rejecting one project does not change the desirability of other projects

operating leverage

-Relates to the relationship between the firm's sales revenue and its earnings before interest and taxes (EBIT) or operating profit -The use of fixed operating costs to magnify the effects of changes in sales on the firm's earnings before interest and taxes

Comparing the Constant-Growth and CAPM Techniques

-The CAPM technique differs from the constant-growth valuation model in that it directly considers the firm's risk, as reflected by beta, in determining the required return on common stock equity -The constant-growth model does not look at risk directly; it uses an indirect approach to infer what return shareholders expect based upon the price they are willing to pay for the stock today, given estimates of the firm's future dividends

Before-Tax Cost of Debt

-The before-tax cost of debt, rd, is simply the rate of return the firm must pay on new borrowing -Using Market Quotations §A relatively quick method for finding the before-tax cost of debt is to observe the yield to maturity (YTM) on the firm's existing bonds or bonds of similar risk issued by other companies -Calculating the Cost §Managers can calculate the cost of debt associated with a particular bond issue by calculating the bond's YTM

total leverage

-The combined effect of operating and financial leverage It relates to the relationship between the firm's sales revenue and EPS

types of capital

-The cost of debt is lower than the cost of other forms of financing -Lenders demand relatively lower returns because they take the least risk of any contributors of long-term capital -Lenders have a higher priority of claim against any earnings or assets available for payment, and they can exert far greater legal pressure against the company to make payment than can owners of preferred or common stock -The tax deductibility of interest payments also lowers the debt cost to the firm substantially -Unlike debt capital, which the firm must eventually repay, equity capital remains invested in the firm indefinitely; it has no maturity date -The two main sources of equity are (1) preferred stock and (2) common stock and retained earnings -Common stock is typically the most expensive form of equity, followed by retained earnings and then preferred stock -In general, the more debt a firm uses, the greater will be the firm's financial leverage -That leverage makes the claims of common stockholders even more risky, so the cost of equity increases as debt rises -In addition, a firm that increases its borrowing significantly can see its cost of debt rise as lenders begin to worry about the firm's ability to repay its debts -Whether the firm borrows very little or a great deal, it is always true that the claims of common stockholders are riskier than those of lenders, so the cost of equity always exceeds the cost of debt

internal rate of return (irr)

-The discount rate that equates the NPV of an investment opportunity with $0 (because the present value of cash inflows equals the initial investment); it is the rate of return that the firm will earn if it invests in the project and receives the given cash inflows

capital budgeting

-The process of evaluating and selecting long-term investments that contribute to the firm's goal of maximizing owners' wealth

external assessment of capital structure

-Those outside the firm can make a rough assessment of capital structure by using measures found in the firm's financial statements -The level of debt (financial leverage) that is acceptable for one industry or line of business can be highly risky in another, because different industries and lines of business have different operating characteristics (1) A direct measure of the degree of indebtedness is the debt ratio (total liabilities / total assets). The higher this ratio is, the greater the relative amount of debt (financial leverage). (2) Measures of the firm's ability to meet contractual payments associated with debt include the times interest earned ratio (EBIT / interest). These ratios provide indirect information on financial leverage.

the two most common fixed financial costs are

-interest on debt -preferred stock dividends

A firm will issue preferred stock at $100 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $5 per share. The cost of the preferred stock is ________.

10.5 percent

A firm's outstanding preferred stock has a par value of $100 and a 5% dividend. If the current market price of the preferred stock is $40. What is the yield (required return, or effective cost of capital) on this preferred stock?

12.5%

A firm has a beta of 1.3. The current market return equals 12% and the risk-free rate of return equals 4%. Applying CAPM, the estimated cost of common stock equity of this firm is ________.

14.4%

A company's common stock has a cost of 10 percent, dividends are $0.55 per share and the current market price of the stock is $15.50 per share. What is the annual growth rate of dividends?

6.45%

If a corporation pays a tax rate of 21 percent, the after-tax cost of debt for a 10-year, 8 percent, $1,000 par value bond selling at $1,150 is ________. A) 4.71 percent B) 3.58 percent C) 1.25 percent D) 6.32 percent

A - 4.71 percent

The reason why maximizing share value and maximizing EPS do not give the same optimal capital structure is because ________. A) EPS maximization does not consider market risk B) share value maximization does not consider market risk C) share value maximization consider cash flows D) EPS maximization does consider risk

A - EPS maximization does not consider market risk

Optimal Capital Structure

A financing action by management that is believed to reflect its view of the firm's stock value; generally, debt financing is viewed as a positive signal that management believes the stock is "undervalued," and a stock issue is viewed as a negative signal that management believes the stock is "overvalued

Signaling Theory - Signal

A financing action by management that is believed to reflect its view of the firm's stock value; generally, debt financing is viewed as a positive signal that management believes the stock is "undervalued," and a stock issue is viewed as a negative signal that management believes the stock is "overvalued

Weighted Average Cost of Capital (WACC)

A weighted average of a firm's cost of debt and equity financing, where the weights reflect the percentage of each type of financing used by the firm

EBIT-EPS Approach

An approach for selecting the capital structure that maximizes earnings per share (EPS) over the expected range of earnings before interest and taxes (EBIT)

Emmy Lucent, Inc. has an expected dividend next year of $5.60 per share, a growth rate of dividends of 10 percent, and a required return of 20 percent. The value of a share of Emmy Lucent, Inc.'s common stock is ________. A) $28.00 B) $56.00 C) $22.40 D) $18.67

B - $56.00

Which of the following is a difference between common stock and bonds? A) Bondholders have a voice in management; common stockholders do not. B) Bondholders have a senior claim on assets and income relative to stockholders. C) Stocks have a stated maturity but bonds do not. D) Dividend paid to stockholders is tax-deductible but interest paid to bondholders are not.

B - bondholders have a senior claim on assets and income relative to stockholders

Which of the following is a reason that makes NPV a better approach to capital budgeting on a purely theoretical basis? A) It measures the tax effects to the firm relative to the amount invested. B) It measures the actual value created by an investment. C) Financial decision makers are inclined to higher rates of return. D) Interest rates are expressed as annual rates of return.

B - it measures the actual value created by an investment

The EBIT-EPS approach to capital structure proposes that an optimal capital structure be selected which ________. A) maximizes the weighted average cost of capital B) minimizes the cost of debt C) maximizes the EPS D) minimizes dividends

B - minimizes the cost of debt

According to the pecking order theory, which of the following is the order in which corporations use different financing sources to fund investment projects? A) retained earnings, equity, debt B) retained earnings, debt, equity C) debt, retained earnings, equity D) equity, retained earnings, debt

B - retained earnings, debt, equity

Ride World has estimated the market value of its assets to be $1,250,000. What is the value of Ride World's common stock if it has $900,000 in liabilities, $50,000 in preferred stock, and 7,500 shares of common stock outstanding? A) $30 B) $50 C) $40 D) $18

C - $40

A firm has experienced a constant annual rate of dividend growth of 9 percent on its common stock and expects the dividend per share in the coming year to be $2.70. The required return on the firm's stock is 12 percent. The value of the firm's common stock is ________. A) $22.50/share B) $9/share C) $90/share D) $30/share

C - $90/share

What is the NPV for a project whose cost of capital is 15 percent and initial after-tax cost is $5,000,000 and is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $1,700,000 in year 3, and $1,300,000 in year 4? A) $1,700,000 B) $371,764 C) -$137,053 D) -$4,862,947

C - -$137,053

If a corporation faces a tax rate of 21 percent, the after-tax cost of debt for a 15-year, 12 percent, $1,000 par value bond, selling at $950 is ________. A) 2.68 percent B) 12.76 percent C) 10.08 percent D) 5.11 percent

C - 10.08 percent

A firm has determined its cost of each source of capital and the percentage of each source making up the firm's capital structure: The weighted average cost of capital is ________. A) 6 percent B) 10.7 percent C) 11 percent D) 15 percent

C - 11 percent

What is the IRR for the following project if its initial after-tax cost is $5,000,000 and it is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $1,700,000 in year 3, and $1,300,000 in year 4? A) 15.57% B) 0.00% C) 13.57% D) 12.25%

C - 13.57%

Which of the following is TRUE of common stock? A) It is often considered quasi-debt due to fixed payment obligation. B) It pays a fixed dividend. C) Class A common stock gives the holder voting rights which permit selection of the firm's directors. D) Its holders have priority over preferred stockholders in the event of liquidation of assets.

C - Class A common stock gives the holder voting rights which permit selection of the firm's directors

According to the traditional approach to capital structure, the value of a firm will be maximized when ________. A) the financial leverage is maximized B) the operating cost is minimized C) the weighted average cost of capital is minimized (WACC) D) the dividend payout is maximized

C - the weighted average cost of capital is minimized (WACC)

DEF Corporation is a high tech company. The current price of DEF's stock is $26.50 per share. Earnings next year should be $2 per share. The P/E multiple is 15 times on average in high tech industry. What price would you expect for DEF's stock in the future? A) $13.50 B) $15.00 C) $26.50 D) $30.00

D - $30.00

A firm has issued 10 percent preferred stock, which sold for $100 per share par value. The cost of issuing and selling the stock was $2 per share. The firm's marginal tax rate is 40 percent. The cost of the preferred stock is ________. A) 3.9 percent B) 6.1 percent C) 9.8 percent D) 10.2 percent

D - 10.2 percent

A firm has common stock with a market price of $25 per share and an expected dividend of $2 per share at the end of the coming year. The growth rate in dividends has been 5 percent. The cost of the firm's common stock equity is ________. (Applying Gordon Growth model) A) 5 percent B) 8 percent C) 10 percent D) 13 percent

D - 13 percent

A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate of return equals 6 percent. The estimated cost of common stock equity is ________. (Applying CAPM model) A) 6 percent B) 7.2 percent C) 14 percent D) 15.6 percent

D - 15.6 Percent

A firm is evaluating a proposal which has an initial investment of $35,000 and has cash flows of $10,000 in year 1, $20,000 in year 2, and $10,000 in year 3. The payback period of the project is ________. The acceptable payback period is 3 years, should this project be accepted or rejected? A) between 1 and 2 years, rejected B) between 1 and 2 years, accepted C) between 2 and 3 years, rejected D) between 2 and 3 years, accepted

D - between 2 and 3 years, accepted

Holding all other factors constant, a firm that is subject to a greater level of business risk should employ more financial leverage than an otherwise equivalent firm that is subject to a lesser level of business risk.

False

A company has a project proposal; its initial investment is $5,000. The first year cash inflows would be $1,800, second year $1,900, third year $700, and fourth year $1,800, respectively. If its maximum acceptable payback period is 3.25 years, should the manager accept this project?

No, since the payback period of the project is more than the maximum acceptable payback period.

leverage

Refers to the effects that fixed costs have on the returns that shareholders earn; higher leverage generally results in higher but more volatile returns

Cost of capital

Represents the firm's cost of financing and is the minimum rate of return that a project must earn to increase the firm's value

determine the cost of preferred stock

The cost of preferred stock is the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock

Calculate the weighted average cost of capital (WACC), and discuss alternative weighting schemes.

The firm's WACC is a weighted average of the firm's cost of debt and equity capital, where the weights are based on the market values of each type of financing relative to the total market value of all financing used by the firm

In capital budgeting, the preferred approaches in assessing whether a project is acceptable are those that integrate time value procedures, risk and return considerations, and valuation concepts.

True

In general, a firm's theoretical optimal capital structure is that which balances the tax benefits of debt financing against the increase probability of bankruptcy that result from its use.

True

Breakeven Analysis

Used to determine the level of operations necessary to cover all costs and to evaluate the profitability associated with various levels of sales; also called cost-volume-profit analysis

pecking order theory

a hierarchy of financing that begins with retained earnings, which is followed by debt financing and finally external equity financing

operating expenditure

an outlay of funds by the firm resulting in benefits received within 1 year

capital expenditure

an outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year

the primary sources of capital for most firms include

debt, preferred stock, common stock, and retained earnings

Net Proceeds

funds actually received by the firm from the sale of a security

flotation costs _ the cost of common equity

increase

mutually exclusive projects

projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function

cost stability

reflects the relative predictability of input proces such as those for labor and materials

revenue stability

reflects the variability of the firms sales revenue

financial leverage

relates to the relationship between the firm's EBIT and its common stock earnings per share (EPS)

accept-reject approach

the evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion

capital rationing

the financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects compete for these dollars

unlimited funds

the financial situation in which a firm is able to accept all independent projects that provide an acceptable return

Cost of Long-Term Debt

the financing cost associated with new funds raised through long-term borrowing

Operating Breakeven Point

the level of sales necessary to cover all operating costs; the point at which EBIT = $0

capital structure

the mix of long-term and equity maintained by a firm

ranking approach

the ranking of capital expenditure projects on the basis of some predetermined measure, such as how much value the project creates for shareholders

Asymmetric Information

the situation in which managers of a firm have more information about operations and future prospects than do investors

payback period

the time it takes an investment to generate cash inflows sufficient to recoup the initial outlay required to make the investment

flotation costs

the total cost of issuing and selling a security, including fees paid to investment banks, law firm, and accounting firm, etc.

Preferred Stock Dividends

when companies issue preferred shares, the shares usually pay a fixed dividend and have a fixed par value

Changing costs and the operating breakeven point

§A firm's operating breakeven point is sensitive to a number of variables: the fixed operating cost (FC), the sale price per unit (P), and the variable operating cost per unit (VC) §An increase in cost (FC or VC) tends to increase the operating breakeven point, whereas an increase in the sale price per unit (P) decreases the operating breakeven point

Tax Benefits of Capital Structure Theory

§Allowing firms to deduct interest payments on debt when calculating taxable income reduces the taxes they pay, which means that bondholders and stockholders receive a greater percentage of a firm's earnings §The deductibility of interest indicates that the government subsidizes a firm's cost of debt

Bankruptcy Costs and the probability of bankruptcy

§Bankruptcy costs may include direct costs, such as the fees paid to lawyers to negotiate with lenders, or the costs may be indirect, such as missed investment opportunities the firm does not undertake because managers are too distracted by the bankruptcy process to focus on running the business §Because these costs reduce the cash flows that investors receive and thereby lower the value of the firm, managers must exercise care in taking any actions that could increase the probability of bankruptcy with its attendant costs §The chance that a firm will go bankrupt because it is unable to pay its debt and other expenses depends on how much exposure the firm has to business risk and financial risk

decision making (step 3)

§Firms typically delegate capital expenditure decisions on the basis of dollar limits §Generally, the board of directors or a team of very senior executives must authorize expenditures beyond a certain amount §Often, plant managers have authority to make decisions necessary to keep the production line moving

implementation (step 4)

§Following approval, firms make expenditures and implement projects; expenditures for a large project often occur in phases

proposal generation (step 1)

§Managers at all levels in a business make proposals for new investment projects that are reviewed by finance personnel §Proposals that require large outlays receive greater scrutiny than less costly ones

review and analysis (step 2)

§Managers at all levels in a business make proposals for new investment projects that are reviewed by finance personnel §Proposals that require large outlays receive greater scrutiny than less costly ones

Determine the cost of long-term debt, and explain why the after-tax cost of debt is the relevant cost of debt.

§Managers can find the before-tax cost of long-term debt by using cost quotations, calculations (either by calculator or spreadsheet), or an approximation §The after-tax cost of debt is the product of the before-tax cost of debt and 1 minus the tax rate §The after-tax cost of debt is the relevant cost of debt because it is the lowest possible cost of debt for the firm due to the deductibility of interest expenses

follow up (step 5)

§Managers monitor results and compare actual costs and benefits to the projections that they originally used to justify making the investment §Managers may take actions to expand, contract, or shut down investments when actual outcomes differ from projected ones

theoretical view

§On a theoretical basis, NPV is the better approach to capital budgeting for several reasons §Most importantly, the NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders

understand operating, financial, and total leverage and the relationships among them

§Operating leverage is the use of fixed operating costs by the firm to magnify the effects of changes in sales on EBIT §The higher the fixed operating costs, the greater the operating leverage §Financial leverage is the use of fixed financial costs by the firm to magnify the effects of changes in EBIT on EPS §The higher the fixed financial costs, the greater the financial leverage §The total leverage of the firm is the use of fixed costs—both operating and financial—to magnify the effects of changes in sales on EPS

Discuss the EBIT-EPS approach to capital structure.

§The EBIT-EPS approach evaluates capital structures in light of the returns they provide the firm's owners and their degree of financial risk §Under the EBIT-EPS approach, the preferred capital structure is the one expected to provide maximum EPS over the firm's expected range of EBIT §Graphically, this approach reflects risk in terms of the financial breakeven point and the slope of the capital structure line §The major shortcoming of EBIT-EPS analysis is that it concentrates on maximizing earnings (returns) rather than owners' wealth, which considers risk as well as return

Review the return and risk of alternative capital structures, their linkage to market value, and other important considerations related to capital structure.

§The best capital structure can be selected by using a valuation model to link return and risk factors §The preferred capital structure is the one that results in the highest estimated share value, not the highest EPS §Other important nonquantitative factors must also be considered when making capital structure decisions

Understand the basic concept of the cost of capital.

§The cost of capital is the minimum rate of return that a firm must earn on its investments to increase the firm's value §The weighted average cost of capital is a number that blends the costs of each type of capital that a firm uses and establishes a minimum rate of return that the firm's investment should earn

Cost of Common Stock Equity

§The costs associated with using common stock equity financing §The cost of common stock equity is equal to the required return on the firm's common stock in the absence of flotation costs §Thus, the cost of common stock equity is the same as the cost of retained earnings, but the cost of issuing new common equity is higher

Target Capital Structure

§The mix of debt and equity financing that a firm desires over the long term §The target capital structure should reflect the optimal mix of debt and equity for a particular firm

Calculate the required return on a company's common stock, and explain how it relates to the cost of retained earnings and the cost of new issues of common stock.

§The required return on the firm's stock can be calculated by using the constant-growth valuation (Gordon growth) model or the CAPM §The cost of retained earnings is equal to the required return on common stock equity §An adjustment to the required return on common stock equity to reflect underpricing and flotation costs is necessary to find the cost of new issues of common stock

Calculating the Weighted Average Cost of Capital (WACC) - Important Points

§The weights must be nonnegative and sum to 1.0 §The weights are based on the market value of each capital source as a percentage of the market value of the firm's total capital §We multiply the firm's common stock equity weight, ws, by either the required return on the firm's stock, rs, or the cost of new common stock, rn §We multiply the firm's cost of debt by (1 − T) to capture the tax deduction tied to interest payments

Explain the optimal capital structure using a graphical view of the firm's cost-of-capital functions and a zero-growth valuation model.

§The zero-growth valuation model defines the firm's value as its net operating profits after taxes (NOPAT), or after-tax EBIT, divided by its weighted average cost of capital §Assuming that NOPAT is constant, the value of the firm is maximized by minimizing its weighted average cost of capital (WACC) §The optimal capital structure minimizes the WACC §Graphically, the firm's WACC exhibits a U-shaped curve whose minimum value defines the optimal capital structure that maximizes owner wealth

Market Value Weights

§Weights that use market values to measure the proportion of each type of capital in the firm's financial structure §In calculating a firm's WACC, market value weights should be used rather than book or par values

Agency Costs Imposed by Lendors

§When a lender provides funds to a firm, the interest rate charged is based on the lender's assessment of the firm's risk §The lender-borrower relationship therefore depends on the lender's expectations for the firm's subsequent behavior §After obtaining a loan at a certain rate, the firm could increase its risk by investing in risky projects or by incurring additional debt §Such action could weaken the lender's position in terms of its claim on the cash flow of the firm §From another point of view, if these risky investment strategies paid off, the stockholders would benefit §Because payment obligations to the lender remain unchanged, the excess cash flows generated by a positive outcome from the riskier action would enhance the value of the firm to its owners