FIN 3400 FINAL

What are 3 adjustments that have to be made going from annual to semiannual bond analysis

1. Divide the annual interest rate by 2 2. Multiply the number of years by 2 3. Divide the annual yield by 2

5 financial applications of time value of money

1. Equipment purchase or new product decision 2. Present value of contract providing future payments 3. Future value of an investment 4. regular payment needed to provide a future sum 5. 4. regular payment needed to amortize a loan

what approaches can be taken in valuing a firms stock whan there is no cash dividend payment

1. assume that at some point in the future a cash dividend will be payed out, then you can take the present value of future cash dividends 2. take the present value of future earning as well as a future anticipated stock price. The discount rate applied to future earnings is generally higher than the discount rate applied to future dividends

What 2 components make up the required rate of return on common stock

1. dividend yield D1/P0 2. The growth rate g

3 factors that influence rate of return by investors

1. real rate of return 2. the inflation premium 3. the risk premium

Why is the cost of retained earnings the equivalent of the firm's own required rate of return on common stock (Ke)?

Because stockholders can earn a return at least equal to their present investment. For this reason, the firm's rate of return (Ke) serves as a means of approximating the opportunities for alternate investments.

Why does capital budgeting rely on analysis of cash flows rather than on net income

Cash flow rather than net income is used in capital budgeting analysis because the primary concern is with the amount of actual dollars generated. For example, depreciation is subtracted out in arriving at net income, but this non- cash deduction should be added back in to determine cash flow or actual dollars generated.

What is better interest compounded daily, weekly, monthly, or quarterly

Daily- the more compounding periods the larger the future value

What is deferred annuity

Defers the payment until a later date

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?

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 taxdeductible 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).

Future value formula

FV=PV(1+i)n

If a corporation has projects that will earn more than the cost of capital, should it ration capital?

From a purely economic viewpoint, a firm should not ration capital. The firm should be able to find additional funds and increase its overall profitability and wealth through accepting investments to the point where marginal return equals marginal cost.

Why does money have time value

Funds received today can be invested to reach a greater value in the future.

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

If a firm utilized the cost of the form of capital it was going to employ in a project to evaluate that project's profitability, it would not be able to compare and rank the projected performance of its various strategic initiatives. One project may be financed with debt while another alternative may be financed with equity. Each has a different cost of capital, and this would lead to inconsistent decision making in the firm. In addition, this would tend to favor use of debt over equity because it is cheaper. And we know that the overuse of debt can lead to other problems. Although debt is the cheapest source of capital, there are limits to the amount of debt capital that lenders will provide (recall the Debt/Equity (D/E) relationships discussed in Chapter 3). The cost of both debt and equity financing rise as debt becomes a larger portion of the capital structure. Therefore, 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

It has often been said that if the company can't earn a rate of return greater than the cost of capital it should not make investments. Explain.

If the firm cannot earn the overall cost of financing on a given project, the investment will have a negative impact on the firm's operations and will lower the overall wealth of the shareholders. Clearly, it is undesirable to invest in a project yielding 8 percent if the financing cost is 10 percent.

What are the important administrative considerations in the capital budgeting

Important administrative considerations relate to: the search for and discovery of investment opportunities, the collection of data, the evaluation of projects, and the reevaluation of prior decisions.

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, we must earn a slightly higher return than the normal cost of common equity in order to cover the distribution costs of the new security. In the case of the Baker Corporation, the cost of new common stock was six percent higher.

What effect would inflation have on a company's cost of capital? (Hint: Think about how inflation influences interest rates, stock prices, corporate profits, and growth.)

Inflation can only have a negative impact on a firm's cost of capital-forcing it to go up. This is true because inflation tends to increase interest rates and lower stock prices, thus raising the cost of debt and equity directly and the cost of preferred stock indirectly.

Does inflation have anything to do with making a dollar today worth more than a dollar tomorrow

Inflation tends to erode the purchasing power of money, funds received today will be worth more than the same amount received in the future

Present value formula

PV=FV (1/(1+i)^n)

If inflation expectations increase what is likely to happen to yield to maturity on bonds in the market place

ROR will increase

Explain why retained earnings have an opportunity cost associated?

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 an asset's ADR (asset depreciation range) relate to its MACRS category?

The ADR represents the asset depreciation range or the expected physical life of the asset. Generally, the midpoint of the range or life is utilized. The longer the ADR midpoint, the longer the MACRS category in which the asset is placed. However, most assets can still be written off more rapidly than the midpoint of the ADR. For example, assets with ADR midpoints of 10 years to 15 years can be placed in the 7-year MACRS category for depreciation purposes.

How does the SML react to changes in the rate of interest, changes in the rate of inflation, and changing investor expectations?

The SML, Security Market Line, reflects the risk-return tradeoffs of securities. As interest rates increase, the SML moves up parallel to the old SML. Now investors require a higher minimum return on risk free assets and an equally higher rate for all levels of risk. A change in the rate of inflation has a similar impact. The risk free rate goes up to provide the appropriate inflation premium and there is an upward shift in the SML. In regard to changing investor expectations, as investors become more risk averse, the SML increases its slope. The more risk taken, the greater the return premium that is desired (see figure 11A-4).

How does the capital asset pricing model help explain changing costs of capital?

The capital asset pricing model explains the relationship between risk and return, and the price adjustment of capital assets to changes in risk and return. As investors react to their economic environment and their willingness to take risk, they change the prices of financial assets like common stock, bonds, and preferred stock. As the prices of these securities adjust to investors' required returns, the company's cost of capital is adjusted accordingly.

How does the cost of a source of capital relate to the valuation concepts presented previously in Chapter 10?

The cost of a source of financing directly relates to the required rate of return for that means of financing. Of course, the required rate of return is used to establish valuation.

What is normally used as the discount rate in the net present value method?

The cost of capital as determined in Chapter 11.

Future value of a single sum (appendix A)

The future value represents the expected worth of a single amount

Explain the traditional, U-shaped approach to the cost of capital.

The logic of the U-shaped approach to cost of capital can be explained through Figure 11-1. It is assumed that as we initially increase the debt-to-equity mix the cost of capital will go down. After we 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.

Why is the remaining time to maturity an important factor in evaluating the impact of a change in yield to maturity on bond prices

The longer the time period remaining to maturity, the greater the impact of a difference between the rate the bond is paying and the current yield to maturity

What is the concept of marginal cost of capital?

The marginal cost of capital is the cost of incremental funds. After a firm reaches a given level of financing, capital costs will go up because the firm must tap more expensive sources. For example, new common stock may be needed to replace retained earnings as a source of equity capital.

How does the modified internal rate of return include concepts from both the traditional internal rate of return and the net present value methods?

The modified internal rate of return calls for the determination of the interest rate that equates future inflows to the investment as does the traditional internal rate or return. However, it incorporates the reinvestment rate assumption of the net present value method. That is that inflows are reinvested at the cost of capital.

What is the net present value profile? What three points should be determined to graph the profile?

The net present value profile allows for the graphic portrayal of the net present value of a project at different discount rates. Net present values are shown along the vertical axis and discount rates are shown along the horizontal axis. The points that must be determined to graph the profile are: a. The net present value at zero discount rate. b. The net present value as determined by a normal discount rate. c. The internal rate of return for the investment.

What type of dividend pattern for common stock is similar to the dividend on prefered stock

The no growth pattern for common stock is similar to the dividend on preferred stock

How is the present value of a single sum (app B) related to the present value of an annuity (app D)

The present value of a single amount is discounted for 1 future payment , present value of annuity discounted value of a series of consecutive future payments of equal amount

Present value of a single sum (appendix B)

The present value represent current worth

What does the term mutually exclusive investments mean?

The selection of one investment precludes the selection of other alternative investments because the investments compete with one another. For example if a company is going to build one new plant and is considering 5 cities, one city will win and the others will lose.

What are the two sources of equity (ownership) capital for the firm?

The two sources of equity capital are retained earnings and new common stock.

What are the weaknesses of the payback method?

The weaknesses of the payback method are: a. There is no consideration of inflows after payback is reached. b. The concept fails to consider the time value of money.

How are the weights determined to arrive at the optimal weighted average cost of capital?

The weights are determined by examining different capital structures and using that mix which gives the minimum cost of capital. We must solve a multidimensional problem to determine the proper weights.

WHat factors might influence a firms price earnings ratio

earnings and sales growth of the firm risk in performance debt to equity structure dividend policy, quality of management high expectations tend to trade high PE ratios

Why might investor demand a lower rate of return for an investment in 1 company vs the next

risk

How is the supernormal growth pattern likely to vary from the normal constant growth pattern

supernormal is rapid growth in early years that levels off

Why is a change in required yield for preferred stock likely to have a greater impact on price than a change in required yield for bonds?

the longer the life of an investment the greater the impact of a change in the required rate of return. Since preferred stock has a perpetual life the impact is likely to be maximum

How is valuation of any financial asset related to future cash flows

they are equal

What will happen to price bonds with inflation increase

this will lower bond price