Finance Final Exam-Chapter 9
Without flotation costs...
, F, the cost to the firm and the ror to the investor is the same
Capital structure Mix
- proportions of each source of financing used by the firm
Why do they differ?
A corporation's cost of capital is different than the investor's ror for two reasons: corporate taxes and floatation cost of new financing
What is the difference between Economic and Accounting profits?
A firm's economic profits is the net operating after-tax profits minus the product of invested capital (indirect or opportunity cost) and the cost of capital (direct cost or accounting cost or dollar cost)
Is MCC rising or declining?
Always rising. It is not the incremental return or the risk free rate and not the component cost of capital.
What happens when a firm increases their cost of capital?
By increasing the firm's cost of capital by restructuring the firm's financing resources, the firm is likely to reduce economic profits and hence not a wise move.
What two methods are used to estimate the cost of common stock?
CAPM & Dividend Growth Model
How does CAPM estimate the cost of equity?
CAPM estimates the cost of only internal equity or retained earnings or common stock with NO floatation cost
What is common stock also known as?
Common equity or simply equity
What is cost of debt and is it tax deductible?
Cost of Debt is also called yield to maturity and is tax deductible,
What is tax deductible for the issuing firm?
Cost of new or old preferred stock is not tax deductible for the issuing firm, dividend on preferred is also not tax deductible.
What is the relationship of ROR and cost of capital?
Differs from the company's cost of capital for two reasons: taxes and transaction or floatation cost,
Firms cost of capital is influenced by
Firm's cost of capital is influenced by a) risk free rate, b) business risk, and c) financial risk
What are the two major factors that the cost or required rate of return of common stock is influenced by?
From the CAPM, 1) risk free rate and 2) beta
Cost of Capital
Hurdle rate for new investment, weighted average cost of capital (WACC), Discount rate, Opportunity cost of funds, Required rate of return that must be earned on additional investment if firm value to remain unchanged.
Correlate beta and common stock
Larger the beta larger would be the cost of common stock whether it is a new common stock or old common stock,
Marginal Cost of Capital
MCC is defined as the average cost associated with each additional dollar of financing investment projects.
Cost of Common Equity
More difficult to estimate than cost of debt or cost of preferred stock because common stockholder's rate of return is not observable.
Why are no tax deductions made on the cost of RE and new common stock or equity?
No tax adjustment is made on these costs as these costs are not tax deductible to the issuing firm.
What effect does flotation cost have on RE and new common stock?
Notice, the cost of external or new common equity or stock (NPcs) is greater than the cost of RE for one reason: floatation cost.
Pecking order hypothesis:
Out of convenience and to minimize asymmetric information, the firm uses the RE first followed by debt, preferred stock and new issues of common stock,
What is old common stock also known as?
Retained earnings
When cost of debt is lowest and cost of new common stock is highest how can you rank the following?
Retained earnings Preferred stock New common stock Cost of debt
What involves flotation costs?
Retained earnings, also called internal equity: No flotation costs on retained earnings Sales of new common stock shares: involves floatation cost
In what order does firms finance projects using outside financing?
So in terms of cost, the firm finances the projects using outside financing by using debt, preferred stock, and lastly the new common stock issues.
what has highest cost to the firm>?
The cost of new common stock has the highest cost to the firm followed by cost of retained earnings, cost of preferred stock and cost of debt;
Does flotation cost make the cost of preferred stock bigger or smaller?
The cost of preferred stock with floatation cost would always be larger than the cost of preferred stock without floatation cost.
What is the goal of WACC?
WACC = (After tax cost of debt X proportion of debt financing) + (Cost of equity X proportion of equity financing)
Does flotation cost make the YTM bigger or smaller?
With a floatation cost, the YTM is always > than without the Floatation cost.
When is the cost to the firm larger than the for for investors?
With flotation costs
How can you increase economic profits?
a) operate machinery and equipment more efficiently, b) growing the firm's investment in projects that earn returns in excess of the firm's cost of capital, WACC, c) identify and improve economic efficiencies, d) increased sales, e) disposing of under-utilized or less utilized assets, f) reduce the cost of capital: WACC
Flotation costs
any transaction costs incurred when a firm raises funds by issuing a particular type of security
In terms of cost: from lowest cost to the highest cost
debt, preferred stock, RE, and new common stock,
What is used to determine the cost of old or new debt ?
risk free rate is not used, we use only the maturity or principal value or future value, market price and the number of years till maturity.
Investor's Required Rate of Return
the minimum rate of return necessary to attract an investor to purchase or hold a security.
