FINANCE EXAM 2 *****

Chuck Swimmer estimates that the dividend of Denham Company, an established textile producer, is expected to remain constant at $3 per share indefinitely. If his required return on its stock is 15%, the stock's value is:

($3 ÷ 0.15) = $20 per share

If dividends are to remain constant at $3 and the required rate of return is 10%, using the dividend growth model, what is the stock's intrinsic value?

(3/.10)= $30

Changes in Risk

-any measure of return consists of 2 components: a risk-free rate and a risk premium -any action taken by the financial manager that increases the risk shareholders must will also increase the risk premium required by shareholders, and hence the required return -additionally, the required return can be affected by changes in the risk free rate - even if the risk premium remains constant

nominal rate differs from the real rate of interest, r* as a result of two factors:

Inflationary expectations reflected in an inflation premium (IP), and Issuer and issue characteristics such as default risks and contractual provisions as reflected in a risk premium (RP).

Why is interest expense not subtracted when calculating project cash flow?

It is already accounted for in the discount rate

The ____________ the maturity of a bond and the __________ the coupon rate, the more sensitive the bond is to interest rate fluctuations.

Longer, lower

Modified Accelerate Cost Recovery System

MACRS is the fastest depreciation that the IRS will allow. Faster depreciation reduces profits, reducing taxes, increasing cash flow MACRS is a double-declining balance with a mid-year convention, but there are tables.

Why is NPV a better methodology for capital budget assessments than the payback method

NPV accounts for time value of money

Comparing NPV and IRR Techniques

NPV is the better approach because: NPV measures how much wealth a project creates (or destroys if the NPV is negative) for shareholders. Certain mathematical properties may cause a project to have multiple IRRs—more than one IRR resulting from a capital budgeting project with a nonconventional cash flow pattern; the maximum number of IRRs for a project is equal to the number of sign changes in its cash flows. Despite its theoretical superiority, however, financial managers prefer to use the IRR approach just as often as the NPV method because of the preference for rates of return.

the historical annual growth rate of Lamar Company dividends equals 7%. The required rate of return is 15%. What is the stock's price?

P0= 1.50/ (.15-.07)= $18.75

Three basic methodologies of capital budgeting

Payback - simple Internal go / no-go signal No value measurement NPV - a robust valuation method Value-creation measurement Correct mathematics Ranks projects IRR - complex calculation, fraught with math problems Visually and intuitively preferred No value measurement Can rank projects if math correctly assessed

The nominal rate of interest for a security is

equal to the risk-free rate (consisting of the real rate of interest plus the inflation expectation premium) plus the risk premium. The risk premium varies with specific issuer and issue characteristics.

Which of the following is true regarding a bond?

A. The face value and coupon payments of a bond NEVER change

The correct portions of debt versus equity are always uncertain. The following comments can, however, be made.

Higher tax rates give preference to debt Higher business volatility gives preference to equity Greater operational leverage (fixed costs) gives preference to equity Greater information asymmetry* gives preference to debt *Potential shareholders do not understand the business. Therefore, they are only willing to pay a lower price per share, which is a higher rate of return.

capital budgeting process

Proposal generation. Proposals for new investment projects are made at all levels within a business organization and are reviewed by finance personnel. Review and analysis. Financial managers perform formal review and analysis to assess the merits of investment proposals Decision making. Firms typically delegate capital expenditure decision making on the basis of dollar limits. Implementation. Following approval, expenditures are made and projects implemented. Expenditures for a large project often occur in phases. Follow-up. Results are monitored and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.

DuPont model

ROE = NPM * TAT * FLM

Coupon Rates and Bond Prices

The low-coupon bond will have much more volatility with respect to changes in the discount rate. Why? Lower coupon bonds are proportionately more dependent on the face amount to be received at maturity

Cost of New Issues of Common Stock

The net proceeds from sale of new common stock, Nn, will be less than the current market price, P0. Therefore, the cost of new issues, rn, will always be greater than the cost of existing issues, rs, which is equal to the cost of retained earnings, rr. The cost of new common stock is normally greater than any other long-term financing cost.

premium

YTM<coupon

par

YTM=coupon

Bond Value Behavior

the value of a bond in the marketplace is rarely equal to its par value. Whenever the required return on a bond differs from the bond's coupon interest rate, the bond's value will differ from its par value. The required return is likely to differ from the coupon interest rate because either (1) economic conditions have changed, causing a shift in the basic cost of long-term funds, or (2) the firm's risk has changed. Increases in the basic cost of long-term funds or in risk will raise the required return; decreases in the cost of funds or in risk will lower the required return

Basic Common Stock Valuation Equation

the value of a share of common stock is equal to the present value of all future cash flows (dividends) that it is expected to provide P0 = D1/ (1+rs)^1.... P0 = value of common stock Dt = per-share dividend expected at the end of year t Rs= required return on common stock

Common Stock Valuation

-common stockholders expect to rewarded through periodic cash dividends and an increasing share value -some of these investors decide which stocks to buy and sell based on a plan to maintain a broadly diversified portfolio -other investors have a more speculative motive for trading - they try to spot companies whose shares are undervalued meaning that the true value of the shares is greater than the current market price -these investors buy shares that they believe to be undervalued and sell shares they think are overvalued (the market price is greater than the true value)

Issuing Common Stock

-initial financing for most firms typically comes from a firm's original founders in the form of a common stock investment -early stage debt or equity investors are unlikely to make an investment in a firm unless the founders also have a personal stake in the business -initial non-founder financing usually comes first from private equity investors -after establishing itself, a firm will often "go public" by issuing shares of stock to a much broader group

Sources of Long-Term Capital

-long-term debt - stockholders equity -preferred stock -common stock equity -common stock -retained earnings

Common Stock: Ownership

-the common stock of a firm can be privately owned by a private investors, closely owned by an individual investor or a small group of investors, or publicly owned by by a broad group of investors -the shares of privately owned firms, which are typically small corporations, are generally not traded; if the shares are traded, the transactions are among private investors and often require the firm's consent -large corporations are publicly owned, and their shares are generally actively traded in the broker or dealer markets

Common Stock: Dividends

-the payment of dividends to the firm's shareholders is at the discretion of the company's board of directors -dividends may be paid in cash, stock, or merchandise -common stockholders are not promised a dividend, but they come to expect certain payments on the basis of the historical dividend pattern of the firm -before dividends are paid to common stockholders any past due dividends owed to preferred stockholders must be paid

Your firm has 10-year bonds with a 10% coupon rate. These bonds currently sell at par. Your marginal tax rate is 35%. What is your cost of debt?

10% (10-.35)= 6.5%

Your firm issues debt with a YTM of 8%. Your estimated cost of equity is 12%. Your marginal tax rate is 25%. The Treasury department says you plan to finance with 50% debt and 50% equity in the future. What is your firm's WACC?

9%

yield curve

A graphic depiction of the term structure of interest rates can be normal, inverted, or flat

When a firm wishes to sell its stock in the primary market, it has three alternatives

A public offering, in which it offers its shares for sale to the general public. A rights offering, in which new shares are sold to existing shareholders. A private placement, in which the firm sells new securities directly to an investor or a group of investors.

Why WACC is so important

A weighted average cost of capital is the rate of return expected by all stakeholders. The shareholders (owners) of the firm are in last position, so they receive any residual return

Accept-Reject versus Ranking Approaches

An accept-reject approach is the evaluation of capital expenditure proposals to determine whether they meet the firm's minimum acceptance criterion. A ranking approach is the ranking of capital expenditure projects on the basis of some predetermined measure, such as the rate of return.

who issues bonds

Debt, issued by: Companies (Finance projects or general financing) Federal government (Finance deficit spending) State and local government (Finance schools, roads, prisons, etc)

Changes in Expected Dividends

Assuming that economic conditions remain stable, any management action that would cause current and prospective stockholders to raise their dividend expectations should increase the firm's value. Therefore, any action of the financial manager that will increase the level of expected dividends without changing risk (the required return) should be undertaken, because it will positively affect owners' wealth.

Outfit of a new Fed-Ex duplicating facility in the United States-Facility construction: $9M-NWC: $1M-Anticipated sales: $10M / year-Gross margin: 50%-Fixed operating expenses: $2M / year-Project lifespan: 6 years-Salvage value at end-of-life: $3M-Corporate tax rate: 21%-WACC: 15%

At the beginning of a project (CF0): -Capital Expenditures -$9M •Projects consist of the purchase of assets -machinery, buildings, companies, etc... -NWC outlay -$1M •An increase in sales causes an increase in Accounts Receivable, Inventory, and Accounts Payable. This is almost always a net use of cash. Recurring Cash Flows -OCFs •Revenues -$10M -Less CoGS-$5M -Less Op Ex -$1M -Less Depreciation -$9M / 6 years •Equals Pre-Tax Profit-Less Taxes (21%) •Equals After-tax profit-Plus Depreciation •Equals Operating Cash Flow

Why is depreciation added back to after-tax profits when calculating cash flow?

Because it was never a cash expense

covenants

Bonds contain provisions called covenants, that are designed to protect the bondholders' interests. The most common restrictive covenants do the following: Require a minimum level of liquidity, to ensure against loan default. Prohibit the sale of accounts receivable to generate cash. Selling receivables could cause a long-run cash shortage if proceeds were used to meet current obligations. Impose fixed-asset restrictions. The borrower must maintain a specified level of fixed assets to guarantee its ability to repay the bonds. Constrain subsequent borrowing. Additional long-term debt may be prohibited, or additional borrowing may be subordinated to the original loan. Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied. Limit the firm's annual cash dividend payments to a specified percentage or amount.

debtholders

Debtholders do not have general rights in the firm. Debtholders rely on the firm's contractual obligations in the bond covenants to be their voice. Interest payments to debtholders are treated as tax-deductible expenses by the issuing firm. The tax deductibility of interest lowers the corporation's cost of debt financing, further causing it to be lower than the cost of equity financing.

WACC Approach

Determine the cost of each capital component to the firm Debt After-tax Flotation costs Preferred Stock Flotation costs Common Stock - Retained earnings Common Stock - New Equity Flotation costs Determine the prospective weightings of each component

Which of the following should financial managers consider when making decisions ?

Expected dividends Expected dividend growth Risk

Bonds: The Five Elements of TVM

FV - Face value (terminal, maturity, par) PMT - Coupon payment Annual PMT =coupon rate * FV Divide by 2 for semi-annual pmts N - # of periods Remember that bonds are typically semi-annual N = Years *2 Rate - YTM, or rate of return We may have a required rate of return in mind. We then solve for the PV, the price that we would pay for the bond, if offered. PV - Price of the bond We may know the price of a bond in the market. We then solve for the Rate, revealing the YTM that the bond provides.

The most recent annual (2015) dividend payment of Warren Industries, a rapidly growing boat manufacturer, was $1.50 per share. The firm's financial manager expects that these dividends will increase at a 10% annual rate, g1, over the next three years. At the end of three years (the end of 2018), the firm's mature product line is expected to result in a slowing of the dividend growth rate to 5% per year, g2, for the foreseeable future. The firm's required return, rs, is 15%.

Find the present value of the dividends expected during the initial growth period...use NPV in Excel or the CF function on your calculator. Find value of the stock at the end of the initial growth period, P2018. Find D2019 by calculating DN+1 = DN x (1 + g2) D2019 = D2018 (1 + 0.05) = $2.00 (1.05) = $2.10 By using D2019 = $2.10, a 15% required return, and a 5% dividend growth rate, we can calculate the value of the stock at the end of 2018 as follows: P2018 = D2019 / (rs - g2) = $2.10 / (.15 - .05) = $21.00 b) The share value of P2018 = $21 from 3a) must be converted into a present value (end of 2015). P2018 / (1 + rs)3 = $21 / (1 + 0.15)3 = $13.81 Step 4 Adding the PV of the initial dividend stream (found in Step 2) to the PV of the stock at the end of the initial growth period (found in Step 3), we get: P2015 = $4.12 + $13.81 = $17.93 per share

what are bonds

Fixed promise-to-pay First position for cash flows and in case of liquidation Lower relative risk to the bondholder, therefore... Lower relative rate of return, since they are safer

Maturity and Bond Price Volatility

For bonds with a longer maturity, a small change in interest rates will lead to a substantial change in the bond's value. Bonds with a shorter maturity will not be as sensitive to interest rate changes.

Kait and Kasim Sullivan, a married couple in the 28% federal income-tax bracket, wish to borrow $60,000 for a new car. They can either borrow the $60,000 through the auto dealer at an annual interest rate of 6.0%, or they can take a $60,000 second mortgage on their home at an annual interest rate of 7.2%.

If they borrow from the auto dealer, the interest on this "consumer loan" will not be deductible for federal tax purposes. However, the interest on the second mortgage would be tax-deductible because the tax law allows individuals to deduct interest paid on a home mortgage. Because interest on the auto loan is not tax-deductible, its after-tax cost equals its stated cost of 6.0%. Because interest on the auto loan is tax-deductible, its after-tax cost equals its stated cost of 7.2%(1 - 0.28) = 5.2%.

Independent versus Mutually Exclusive Projects

Independent projects are projects whose cash flows are unrelated to (or independent of) one another; the acceptance of one does not eliminate the others from further consideration. Mutually exclusive projects are projects that compete with one another, so that the acceptance of one eliminates from further consideration all other projects that serve a similar function.

Several factors can influence the equilibrium interest rate

Inflation, which is a rising trend in the prices of most goods and services. Risk, which leads investors to expect a higher return on their investment Liquidity preference, which refers to the general tendency of investors to prefer short-term securities

Assume that Lamar Company, with a required return of 15%, announced a major technological breakthrough that would revolutionize its industry. Current and prospective stockholders expect that although the dividend next year, D1, will remain at $1.50, the expected rate of growth thereafter will increase from 7% to 9%. Changing the current price of the stock from $18.75 to

Po= 1.50/ (.15-.09)= $25 per share

Assume that Lamar Company manager makes a decision that, without changing expected dividends, causes the firm's risk premium to increase from 6% to 7% (the risk-free rate remains at 9%), so the new required return on Lamar stock will be 16% (9% + 7%).

Po= 1.50/ (.16-.07)= $16.67 per share

cost of preferred stock, rp

Preferred stock gives preferred stockholders the right to receive their stated dividends before the firm can distribute any earnings to common stockholders. the ratio of the preferred stock dividend to the firm's net proceeds from the sale of preferred stock. Rp= Dp/Np

Stockholders

Stockholders are owners of the firm. Stockholders have voting rights that permit them to express an opinion about the firm's directors and occasionally vote on very special issues, such as new share issuance. Stockholders' claims on income and assets are secondary to the claims of bondholders. Their claims on income cannot be paid until the claims of all creditors, including both interest and scheduled principal payments, have been satisfied. they expect greater returns to compensate them for the additional risk they bear' Dividend payments to a firm's stockholders are not tax-deductible.

Pros and Cons of Payback Analysis

The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firm's value. A second weakness is that this approach fails to take fully into account the time factor in the value of money. A third weakness of payback is its failure to recognize cash flows that occur after the payback period.

Why will a project with a positive NPV (if it turns out, in fact, to be positive) accomplish a financial manager's corporate objective?

The project will increase shareholder wealth

the risk free rate

The risk free rate can be represented as: RF = r* + IP The risk-free rate (as shown in the preceding equation) embodies the real rate of interest plus the expected inflation premium. The inflation premium is driven by investors' expectations about inflation—the more inflation they expect, the higher will be the inflation premium and the higher will be the nominal interest rate.

Unlimited Funds versus Capital Rationing

Unlimited funds is the financial situation in which a firm is able to accept all independent projects that provide an acceptable return. Capital rationing is 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.

Weighting Schemes

WACC is for future cash flows, therefore, the prospective cost of capital is the correct weighting* Equity - # of shares outstanding times market price per share Debt - During periods of stable interest rates, balance sheet debt approximates the market value

discount

YTM>coupon

corporate bond

a long-term debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms

security interest

a provision in the bond indenture that identifies any collateral pledged against the bond and how it is to be maintained. The protection of bond collateral is crucial to guarantee the safety of a bond issue.

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.

Outstanding shares

are issued shares of common stock held by investors, this includes private and public investors.

Issued shares

are shares of common stock that have been put into circulation. Issued shares = outstanding shares + treasury stock

Authorized shares

are the shares of common stock that a firm's corporate charter allows it to issue.

constant-growth model (gordon)

assumes that dividends will grow at a constant rate, but a rate that is less than the required return P0= D1/ (Rs-g) p0= value of common stock D1= per share dividend expected at the end of year one Rs= required rate of return on common stock g= constant rate of growth in dividends

The Zero Growth Model

assumes that the stock will pay the same dividend each year, year after year with zero growth, the value of a share of stock would equal the present value of a perpetuity of D1 dollars discounted at a rate rs. P0= D1/Rs

A conversion feature

benefits bondholders allowing them to change each bond into a stated number of shares of common stock. makes the bond more valuable (i.e. lowers the interest rate)

call feature

benefits issuers, allowing them to repurchase bonds at a stated call price prior to maturity. The call price is the stated price at which a bond may be repurchased, by use of a call feature, prior to maturity. The call premium is the amount by which a bond's call price exceeds its par value makes the bond less valuable (i.e. increases the interest rate)

when rates go up

bond prices go down there's an inverse relationship - price or rate could be the first thing then the other one moves oppositely

after-tax cost of debt, ri

can be found by multiplying the before-tax cost, rd, by 1 minus the tax rate, T, as stated in the following equation: ri = rd (1 - T)

Equity

consists of funds provided by the firm's owners (investors or stockholders) that are repaid subject to the firm's performance. voice in management, subordinate to debt in equity claims,no maturity or tax reduction

cost of a new issue of common stock, rn

cost of common stock, net of underpricing and associated flotation costs. New shares are underpriced if the stock is sold at a price below its current market price, P0. . If we let Nn represent the net proceeds from the sale of new common stock after subtracting underpricing and flotation costs, the cost of the new issue, rn, can be expressed as follows: Rn= (D1/ Nn) + G

capital asset pricing model (CAPM)

describes the relationship between the required return, rs, and the nondiversifiable risk of the firm as measured by the beta coefficient, b. rs = RF + [b X (rm - RF)] where RF = risk-free rate of return rm = market return; return on the market portfolio of assets

The variable-growth model

dividend valuation approach that allows for a change in the dividend growth rate, from g1 to g2. Step 1. Find the value of the cash dividends at the end of each year, Dt, during the initial growth period, years 1 though N. Dt = D0 × (1 + g1)t Step 2. Find the net present value of the dividends expected during the initial growth period. Step 3. Find the present value of the dividends expected during the 2nd growth period Find the value of the stock at the end of the initial growth period, PN = (DN+1)/(rs - g2), [which is the value of all dividends expected from year N + 1 to infinity at time N, assuming a constant dividend growth rate, g2]. Find the present value of PN. Step 4. Add the present value components found in Steps 2 and 3 to find the value of the stock, P0.

cost of capital

represents the firm's cost of financing, and is the minimum rate of return that a project must earn to increase firm value. Financial managers are ethically bound to only invest in projects that they expect to exceed the cost of capital. The cost of capital reflects the entirety of the firm's financing activities. Most firms attempt to maintain an optimal mix of debt and equity financing. To capture all of the relevant financing costs, assuming some desired mix of financing, we need to look at the overall cost of capital rather than just the cost of any single source of financing.

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 or cost of common stock equity. The constant-growth model does not look at risk; it uses the market price, P0, as a reflection of the expected risk-return preference of investors in the marketplace. The constant-growth valuation and CAPM techniques for finding rs are theoretically equivalent, though in practice estimates from the two methods do not always agree. Another difference is that when the constant-growth valuation model is used to find the cost of common stock equity, it can easily be adjusted for flotation costs to find the cost of new common stock; the CAPM does not provide a simple adjustment mechanism. The difficulty in adjusting the cost of common stock equity calculated by using CAPM occurs because in its common form the model does not include the market price, P0, a variable needed to make such an adjustment.

debt

includes all borrowing incurred by a firm, including bonds, and is repaid according to a fixed schedule of payments. no voice in management, senior to equity in claims and assets, stated maturity, interest deduction

cost of common stock equity, rs

is the rate at which investors discount the expected dividends of the firm to determine its share value. The cost of common stock is the return required on the stock by investors in the marketplace. There are two forms of common stock financing: retained earnings new issues of common stock Rs= (D1/P0) + g the cost of common stock equity can be found by dividing the dividend expected at the end of year 1 by the current market price of the stock (the "dividend yield") and adding the expected growth rate (the "capital gains yield

Treasury stock

issued shares of common stock held by the firm; often these shares have been repurchased by the firm.

Sinking fund requirements

restrictive provision often included in a bond indenture, providing for the systematic retirement of bonds prior to their maturity.

trustee

paid individual, corporation, or commercial bank trust department that acts as the third party to a bond indenture and can take specified actions on behalf of the bondholders if the terms of the indenture are violated.

WACC formula

rd*(1-T)*wd (after-tax cost of debt - net of flotation) D1/P0*wPS (preferred stock, P0 - net of flotation) (D1/P0 + g)*wCS (common stock, P0 - net of flotation, if new common stock)

weighted average cost of capital (WACC), ra

reflects the expected average future cost of capital over the long run; found by weighting the cost of each specific type of capital by its proportion in the firm's capital structure ra = (wi X ri) + (wp X rp) + (ws X rr or n) where wi= proportion of long term debt in capital structure wp= proportion of preffered stock in capital structure ws= proportion of common stock equity in capital structure Wi+Wp+Ws= 1

Net present value (NPV)

sophisticated capital budgeting technique; found by subtracting a project's initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital. NPV = Present value of cash inflows - Initial investment Decision criteria: If the NPV is greater than $0, accept the project. If the NPV is less than $0, reject the project. If the NPV is greater than $0, the firm will earn a return greater than its cost of capital. Such action should increase the market value of the firm, and therefore the wealth of its owners by an amount equal to the NPV.

nominal rate of interest

the actual rate of interest charged by the supplier of funds and paid by the demander. r1= Rf+ RP where RF is the risk free rate and RP is risk premium

par value, or face value

the amount borrowed by the company and the amount owed to the bond holder on the maturity date.

payback method

the amount of time required for a firm to recover its initial investment in a project, as calculated from cash inflows. The length of the maximum acceptable payback period is determined by management. 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

Interest rate risk

the chance that interest rates will change and thereby change the required return and bond value. Rising rates, which result in decreasing bond values, are of greatest concern. The shorter the amount of time until a bond's maturity, the less responsive is its market value to a given change in the required return.

yield to maturity

the compound annual rate of return earned on a debt security purchased on a given day and held to maturity.

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.

pretax cost of debt

the financing cost associated with new funds through long-term borrowing. Typically, the funds are raised through the sale of corporate bonds. Net proceeds are the funds actually received by the firm from the sale of a security. Flotation costs are the total costs of issuing and selling a security. They include two components: Underwriting costs—compensation earned by investment bankers for selling the security. Administrative costs—issuer expenses such as legal, accounting, and printing.

coupon interest rate

the percentage of a bond's par value that will be paid annually, typically in two equal semiannual payments, as interest.

Capital budgeting

the process of evaluating and selecting long-term investments that are consistent with the firm's goal of maximizing owner wealth.

yield to maturity (YTM)

the rate of return that investors earn if they buy a bond at a specific price and hold it until maturity. (Assumes that the issuer makes all scheduled interest and principal payments as promised.) The yield to maturity on a bond with a current price equal to its par value will always equal the coupon interest rate. When the bond value differs from par, the yield to maturity will differ from the coupon interest rate.

before-tax Cost of Long-Term Debt Rd

the rate of return the firm must pay on new borrowing. The before-tax cost of debt can be calculated in any one of three ways: Using market quotations: observe the yield to maturity (YTM) on the firm's existing bonds or bonds of similar risk issued by other companies Calculating the cost: find the before-tax cost of debt by calculating the YTM generated by the bond cash flows Approximating the cost

real rate of interest

the rate that creates equilibrium between the supply of savings and the demand for investment funds in a perfect world, without inflation, where suppliers and demanders of funds have no liquidity preferences and there is no risk. The real rate of interest changes with changing economic conditions, tastes, and preferences.

term structure of interest rates

the relationship between the maturity and rate of return for bonds with similar levels of risk.

cost of retained earnings, rr

the same as the cost of an equivalent fully subscribed issue of additional common stock, which is equal to the cost of common stock equity, rs. rr = rs