Final Exam Study Guide
Final Exam Study Guide FIN 301
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This 26 page Study Guide was uploaded by Blair O'Brien on Monday February 2, 2015. The Study Guide belongs to FIN 301 at University of Miami taught by Dana Manner in Fall2013. Since its upload, it has received 121 views. For similar materials see Fundamentals of Finance in Finance at University of Miami.
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Date Created: 02/02/15
Exam 2 Chapters 7I 8 9 and 10 Chapter 7 Stock Valuation Dividend Discount Model 0 General D1 0 Equatlon P0 r 0 D1 next dividend O I required rate of return Dividend Growth Model Constant Growth D1 0 Equatlon P0 r8 0 r g constant growth rate in dividends D4 0 EX P3 rg SuperNormal Growth Model NonConstant Growth Components of Required Return D1 0 r x g P0 11 Dividends Yield P0 39 8 Capital Gains Yield Common vs Preferred Stock quotjust paid D0 quotnext dividend D1 quotPricequot of anything 2 PVFCF Chapter 8 Net Present Value NPV Net Present Value NPV 0 Z PVFCF cost NPV 20 Internal Rate of Return IRR Payback Period yrs Average Accounting Return AAR Mutually Exclusive Projects Conventional Projects NonConventional Projects NPV Pro le Decision Rules NPV 2 0Accept IRR 2 rAccept NPV Z OReject IRR Z rReject If ZPVFCF Lcost increaser If ZPVFCF z cost decreaser Chapter 9 Capital Investment Decisions Chapter 10 Lessons from Capital Marketing History Chapter 1 Introduction Goal of Financial Management Make money gt relative to situation e g nonpro t Shareholders happy best decisions riskreward long term short term MAXIMIZE SHAREHOLDER VALUE or wealth Decisions 1 Capital budgeting Spending gt Investing Decision 2 Capital Structure gt Financing Decision 3 Working Capital Management gt Working Capital Current Assets Current Liabilities Legal Forms 1 Sole Proprietorship gt Natural person unlimited up and downside liability 2 Partnership JV gt not double taxed 3 Corporation LLC gt legal entity corporations have eternal life Agency Relationship 0 Principal gt Shareholders 0 Agent gt Board of Directors they hire and fire highupper management management Agency Problem gt nancial self interests that start to collide Chapter 2 Financial Statements Taxes and Cash Flows Books vs Market Value Income vs Cash Flow Average vs Marginal Tax Rates EBIT Earnings before interest and taxes NBT Net Before Tax NAT Net After Tax Retained Earnings Net Income Dividends Earnings Per Share Net IncomeTotal Shares Outstanding Dividends Per Share Total DividendsTotal Shares Outstanding Noncash Items ex gt depreciation Marginal Tax Rates how much is taxed on each incremental dollar Average Tax Rate Calculations total taxes paid divided by total taxable income Blended or Weighted Average Rate Average Tax Rate Marginal Tax in Taxable Income 1 Cash Flow from Assets Cash Flow of Creditors Cash Flow to Stockholders 2 Cash Flow from Assets Operating Cash Flow Net Capital Spending Change in NWC a where OCF EBIT Depreciation Taxes NCS Ending NFA Beginning NFA Depreciation Change in NWC Ending WC Beginning NWC Cash Flow to Creditors Bondholders Interest Paid Net New Borrowing 4 Cash Flow to Stockholders Owners Dividends Paid Net New Equity Raised 9 Ex Dole Cola pg 39 Net Sales 600 Cost of Goods Sold 300 Depreciation m EBIT 150 Interest Paid Taxable Income120 Taxes Net Income 79 Dividends 30 Add RE 49 Chapter 4 Time Value of Money FV PV x lrn gt lrn Future Value Interest Factor PV FV 1rn gt llrn Present Value Interest Factor Interest Rate Discount Rate Relationship between PV and Interest Rate Inverse Relationship 0 Rate increases gt PV decreases 0 Rate decreases gt PV increases Relationship between FV and Interest Rate Not Inversely Related 0 Rate increases gt FV increases 0 Rate decreases gt FV decreases Switching from BGN to END mode 2nd gt BGN above PMT gt 2nd gt Set gt 2nd gt Quit Ex Due to global warming the ice caps are melting at 3 per year how long will it take to behalf its size Answer PV 2 PV 1 IY IY 3 PMT PMT 0 FV 2 EV 12 N N 2276 years NOTE if you put 0 as your F V you will get an error gt it is an asymptote gt it will never reach 0 Chapter 5 Discounted Cash Flow Valuation DCF Ordinary Annuity a series of future cash ows have certain characteristics 1 Series of equal payments in amount and frequency 2 First FCF occurs at t1 gt end of rst period 3 Beginning and ending de nite beginning and end Ex T he Lottery If you win the lottery and they are either going to pay you 1million per year for 20 years or a lump sum of 1 1500000 today what discount rate would you apply for these to be equal what is their borrowing costwhat discount rate they re going to apply to it Note borrowing cost relevant discount rate PMT N IY FV PV ANSWER PMT 1000000 N 20 IY 597 FV 0 PV 11500000 If your relative rate of return is 0 Higher than discount rate take lump sum 0 Lower than discount rate take 1 million per year Annuity Due violates characteristic 2 of ordinary annuities gt rst cash ow occurs at t0today EX RENT SHIFT CALC INTO BGN MODE Ex Rent Your rent is 400 and is due on the rst of every month If your interest rate is 10 and you must pay your rent for 5 months how much money do you need in your account today PMT N IY FV PV ANSWER PMT 400 N 5 IY 10 FY 0 PV 166795 NOTE remember to change to BGN mode gt if you do not want to do so gtjust change N to 4 rather than 5 If your relative rate of return is 0 Higher than discount rate take lump sum 0 Lower than discount rate take 1 million per year Special Case has characteristic 1 and 2 but violates 3 in that it has a beginning but no end This means it is in perpetuity ordinary annuity that goes on forever PVperp CFr Ex 1000 in perpetuity r12 Esum of the a how much is the EPV for years 150 PMT N IY FV PV b How much is the EPV for years 51 to in nity ANSWER a PMT 1000 N50 IY 12 FV 0 PV 830450 b PVperp answer from a gt 100012 830250 2783 Loan Amortization 0 Fully Amortizing Loan paying off over time until 0 is owed 0 Pure Discount Loan no payments are made loan the way all paid in one lump sum at a certain time o Balloon Payment Loan payments don t fully reduce balance to 0 at the end you must pay off a large sum in the end gt not a fully amortizing loan Ex How much is the initial value of a pure discount loan if you pay back 1000 in one year with a discount rate of 10 PMT N IY FV PV ANSWER PMT 0 N 1 IY 10 FV 1000 PV 90909 Ex Balloon Loan doesn t fully amortize You took a loan out to buy a car You borrowed 3327650 It was a 5 year loan that you will make monthly payments of 500 on You have a 6125 APR What will your ending payment be PMT N IY PV FV ANSWER PMT 500 N 5X12 60 lY 612512 PV 3327650 FV 1016769 Amortization Schedule A business takes out a 5000 veyear loan at 9 gt fully amortized pg 148 To nd the total payment each year use the ordinary annuity equation 5000 PMT X 11109509 gt C 500038897 gt C 128546 CALC PMT 128546 N 5 IY 9 FV 0 PV 5000 Beginning Balance PMT INT Principal Ending Balance 1 5000 128546 450 83546 416454 2 416454 128546 37481 91065 324388 3 324388 128546 4 226127 128546 5 117932 128546 000 If you want to pay if off early how much Will you have to pay If you want to pay it off at year 3 1st PMT N IY FV PV 2 2nd PMT N IY FV PV 2 ANSWER 1st gt nding balance of loan at end of year 3 PMT 128546 N 5 IY 9 FV 0 PV 5000 2nd gt really asking FV3 gt solve for FV PMT 128546 N 3 IY 9 FV 226128 PV 5000 EX Buying a House You bought a house for 500000 You made a down payment of 20 of the price and you have a 30 year Xed rate mortgage at 295 APR How much is your monthly payment PMT N IY FV PV ANSWER PMT 166565 N 30 X 12 360 IY 29512 FV 0 PV 400000 Special Financing ys Cash Back gt Look at Handout APR annual rate gt interest rate charged per period x of periods per year EAR e ectiveequivalent annual rate gt always going to be higher than APR except when you have annual payments EX 10 APR a Daily compounding EAR b Monthly compounding EAR ANSWER a 105153 b 104713 If you pay 200month for 10 years how much is your FV With a 6 EAR b 9 APR daily compounding ANSWER a APR 58411 PMT 200 N 10 x 12 IY 5841112 PV 0 FV 324946885 b 1st gt NOM 9 N 365 EFF 94162 2nd gt EFF 94162 N 12 NOM 90327 PMT 200 N 10 X 12 IY 9032712 PV O FV 3877452 Chapter 6 Interest Rates and Bond Valuation US Treasury issues bonds 3 kinds 1 TBills gt short in maturity max 2 years 2 Treasury Notes gt about 10 years 3 Treasury Bonds gt 25 years Bond Features 0 Par Value Face Value 0 Maturity Date 0 Coupon Rate gt term for interest rate When it comes to bonds 0 If the market rate is less than the coupon rate you Will pay a premium 0 If the market rate is greater than the coupon rate you Will at a discount 0 At value means When the coupon and market rate required rate of return in market are equaL ASSUMPTIONS MEMORIZE 1 2 3 4 Par Value if not stated par value 1000 Pay Interest semiannually twice a year Yield to Maturity is expressed as an APR Quoted Price is expressed as a percentage of par value Relationship between Price and Yield to Maturity gt Inversely Related these are also the only two things that can change in a bond because they don t appear on the bond Ex Finding the PV of a Bond A 10 year bond has an 8 annual coupon rate What is the present value of this bond if the market rate is 105 PMT N IY FV PV ANSWER PMT 40 N 10 X 2 20 IY 1052 FV 1000 PV 84747 Ex Solving for an unknown Coupon Rate Give a market value of the bond is 84747 the market rate is 105 and the bond matures in 10 years what is the coupon rate of interest PMT N IY FV ANSWER Ist solveforpayment gt PMT 40 N 10X220 lY 1052 FV 1000 PV 84747 2nd PMT 40 is the semiannual cash ow gt 40x2 80 annually gt 801000 08 coupon rate of interest gt 8 NOTE When asked what is the coupon rate of interest REMEMBER to x2 and divide by par value gt that will give you the annual coupon rate Ex Unknown maturity in years Given a market value of the bond is 84747 the market rate is 105 and a coupon rate of 8 how many years does it take for this bond to mature PMT N IY FV PV ANSWER PMT 40 N 202 10yrs lY 1052 FV 1000 PV 84747 Ex Unknown Yield to Maturity Given a market value of the bond is 84747 it matures in 10 years and a coupon rate of 8 What is the yield to maturity PMT N IY FV ANSWER PMT 40 N 10X2 20 IY 525X2 105 FV 1000 NOTE Multiply the IY by 2 because Y T M is expressed as an APR PV 84747 Ex Quoted Price Your broker says that the quoted price of a stock is 10075 What is the real price ANSWER 10075 means par 75 of 1000 gt Real Price move the decimal place over 1 Real Price 100750 Zero Coupon Bonds buy low sell high Pure Discount Bonds gt eX US Treasury Bonds bc of Assumption 3 EX Find the YTM If the market price is 50835 and the bond matures in 5 years What is your yield to maturity PMT N IY FV ANSWER PMT 0 N 5X2 10 lY 7 X 2 14 FV 1000 PV 50835 Floating Rate Bonds gt coupon rate oats With market rate of return Interest Rate Risk graph gure 62 pg 171 1 2 o o All other things being equal the longer the time to mature the greater the interest rate risk All other things equal the lower the coupon rate the greater the interest rate risk if rate increase bond price decreases if rate decreases bond price increases 30 year bond is much more sensitive to change in rate When you have 2 bonds with the same coupon rate the one with the longer maturity is more of a risk If you think rates are going to decrease gt buy long term bonds If you think rates are going to increase gt buy short term bonds Default Risk break their promise to pay higher risk higher yeild Government Bonds pay taXes on them Municipal Bonds states cities etc gt taX free gt interest you earn on them is not taXed Fisher Effect 1 R 1 X r X 1 X h R nominal rate r real rate gt rate of return adjusted for in ation h in ation rate r is about equal to R h Term Structure of Interest Rates pg 194 and 195 eX 64 and 65 0 Rate of return that you require increases with the longer maturity of bond 0 Rate of return that you require decreases with the shorter maturity of bond Chapter 7 Stock Valuation Price of anything EPVFCF where E sum of the just paid D0 neXt dividend D1 Dividend Discount Model General assumes that the dividend stays the same forever similar to perpetuity formula Dividend Growth Model Constant Growth eX grow 5 per year SuperNormal Growth Model NonConstant Growth EX Year EXp Growth 1 100 2 200 3 250 What is the price of this stock if your required rate of return is 10 and in year 4 the growth rate is 5 D 1 D2 D3 P3 FV N PMt PV ANSWER D1 D2 D3 P3 FV 1 2 250 5250 N 1 2 3 3 PMT O 0 0 0 I 10 10 10 10 PV 91 165 188 3944 EPVFCF 4388 P0 P3 found by gt P3 D4rg gt P3 2501grg gt P3 2501051005 5250 REMAIN CONSTANT gt DON T NEED TO CHANGE THEM IN YOUR CALCULATOR Components of Required Return r DIP0 g WHERE o D1PO Dividend Yield 0 g Capital Gains Yield Common Stock 0 Have voting rights 0 Take all of the tisk but also can get higher reward 0 Two forms 0 Cummulative voting easier for you to take a seat on the board 0 Straight voting Preferred Stock Get dividends paid 1st Dividend has a particular dividend payment Don t have voting rights typically but not always RiskReward Ratio is different O Higher return on debt To get a higher price you will have to lower the rate of return If you have a higher price but the same rate of return gt you probably have higher prediction for dividends F CF To INCREASE price gt DECREASE rate of return Chapter 8 Net Present Value NPV the rule you want to use in every case when making an investment decision helps you know how an investment will affect shareholder value General Valuation Model EPVFCF cost NPV Z O Esum of the r is consideredbuilt into EPVFCF NPV DECISION RULE NPV 0 Accept why buy if NPV 0 you are earning your exact r NPV lt O Reject costs more than it s worth 100 gt if you have 100 shares each share will increase by 1 same happens in reverse if NPV is 100 IR is the rate that makes the NPV 0 IR DECISION RULE NPV 0 gt IR 2 r Accept NPV lt 0 gt IRRlt r Reject Payback Period expressed in years PP DECISION RULE accept or reject based on an arbitrary hurdle EX The cost of an investment is 1000 and you have future cash ows of 250year for 5 years Let s say the hurdle is 3 years gt you would reject it because it would take 4 years to pay back gt it would be wrongfully rejected PP ignores the TVM and FCF after the hurdle AAR Average Net IncomeAverage Book Value AAR AAR Decision Rule based on arbitrary hurdle rate AAR Z Accept AAR lt Reject EX Find the NPV pg 241 Figure 81 The initial investment of a project costs 30000 You will make 6000 each year from this project and you can sell the equipment at the end of the 8 year time period of the project for 2000 Your required rate of return is 15 What is the NPV How will this project affect your share price assuming you have 1000 outstanding shares PMT N IY FV PV ANSWER PMT 6000 N 8 IY 15 FV 2000 PV 2757773 PV cost 2757773 30000 2422271000 242share EX Find the Payback Period pg 244 eX 82 The cost of a project is 500 How long will the payback period be if the future cash ows are as follows YR 1 100 YR 2 200 YR 3 500 ANSWER Payback Period 24 years about 2 years and 5 months EX Find the AAR pg 247 The cost of this investment is 500000 and will be depreciated over 5 years on a straightline basis Would you accept or reject based on the AAR decision rule if your r15 Year 1 2 3 4 5 Net Income 10000015000050000 0 50000 ANSWER Avg NI 50000 Avg BV 25000 AAR 20 If rl 5 the rule says accept but this would be a bad decision because your total NI CF never equaled how much you spent on the initial investment NOTE this is very distorted and not a good decision maker particularly deceptive If EPVFCF Z cost gt increase r If EPVFCF lt cost gt decrease r NPV Pro le quotiii39F39Elt I ll351539 rial 11 FIE LII NonConventional Projects EX on pg 253 Figure 86 You get 2 IRS when you have ONE change from to You get 3 IRS when you have TWO change from to You get 4 IRS when you have THREE change from to etc I39quotE I iiiEIII fE HF U r aga 39i E ii IHH IGNORE IRR DECISION R ULE WHEN DOING N ONC 0N VEN T I ONAL PROJECTS Mutually Exclusive Investments if you invest in A you can t invest in B and vice versa EX Drawn an NPV Pro le Which project would you prefer to invest in Over what range of r would you accept A Over what range of r would you accept B What is the r in which you are indifferent IRRcrossover After what r would you reject both Year Investment A Investment B 0 100 100 1 50 20 2 40 40 3 40 50 4 30 60 ANSWER Calculator Entries A B Difference CFO 100 100 0 C01 50 20 30 F01 1 1 1 C02 40 40 0 F02 1 1 1 C03 40 50 10 F03 1 1 1 C04 30 60 3O F04 1 1 1 Totals 160 170 NPV 60 70 HIPu 41 Filva 3 HPM E crueeuwr mints NFVE NFVE g IHReru eu ver quot111 new 2 MW l 1 r 5 I l b21 55quot quotREE 3 1u Accept B from 0 to 111 Acceptl from 111 to 24 indi erem at 111 Reject bath if rgt24 111 Chapter 9 Marking Capital Investment Decisions Relevant Cash Flows Incremental Cash Flows Sunk costs a cost that has already been incurred and cannot be recouped and therefore should not be considered in an investment decision Not relevant because decision was already made the money was spent and you can t get it back 0 Ex a consulting fee marketing research costs etc Opportunity Costs the most valuable alternative that is given up if a particular investment is undertaken If you do something versus doing something else there are costs associated with each decision We give up the valuable opportunity to do something else with it Side Effects 0 Ex erosion the cash ows of a new project that come at the expense of a rm s existing projects for example VHS and BetaMax Pro tability Index PVFCFCFO NPVCFO 1 Biggest P1 ones you want to invest in gt ex P1 12 you ll get 120 for every 1 you put in Pro Forma Financial Statements nancial statements projecting future years operations Ex on pg 279 Project Operating Cash Flow pg 281 Table 94 Project OCF EBIT Depreciation Taxes Ex You are considering an investment that s initial cost Will be 90000 and you need an initial Net Working Capital investment of 20000 that Will be fully returned to you at the end of the project life Which is 3 years Each year the operating cash ow Will be 51780 and you have a required return of 20 for neW projects Find the NPV of this project ANSWER PV Cost NPV gt 120648 110000 10648 PMT 51780 N 3 IY 20 FV 20000 PV 120648 NOTE you could also nd it through the CF worksheet or rolling back each individually The Tax Shield Approach MEMORIZE useful for cost saving projects Without revenue gains Ex is it effective to buy a neW printercopier Wording Ex retiring and old machine OCF SalesCosts x lTc Depreciation x Tc SalesCosts x 1Tc CF Without Depreciation Depreciation x Tc Depreciation Tax Shield If you buy equipment for 10000 and depreciate it using a straight line method It Will have a salvage value of 2000 and its useful life is 4 years Your tax rate is 40 If you sell it for 3000 more than salvage value you Will have to pay a tax FMV 3000 FMV 3000 NBV M Tax gain 1000 ATCFSV2600 Tax w 400 gt owe to the government due to recapture of excess depreciation Could go the other way FMV 1000 FMV 1000 NBV 2000 TaX 400 loss 1000 ATCFSV1400 TaX X 40 400 Capital Rationing the situation that exists if a rm has positive NPV projects but cannot obtain the necessary nancing 0 Soft Rationing the situation that occurs When units in a business are allocated a certain amount of nancing for capital budgeting 0 Hard Rationing the situation that occurs When a business cannot raise nancing for a project under any circumstances Chapter 10 Some Lessons from Capital Market History Dollar Returns if you buy an asset of any sort your gain or loss from that investment is called your return on investment Total Dollar Return Dividend Income Capital Gain or Loss Dividend Income dividend share X of shares you own Capital GainLoss stock price at end of year stock price at beginning of year Total Cash if Stock is Sold Initial Investment Total Return Initial Investment price of stock at beginning of year X of shares you buyown Percentage Returns Dividend Yield Capital Gains Yield Dividend Yield Dt1Pt CGY Pt1 PtPt EX 37share dividend paid 185 Return 18537 40333737 05 09 14 gt 14 or 14 cents If you bare more risk return Will be higher If you bare less risk return Will be lower Investing in something with lower risk ie Treasury Bill you basically only gain a little more than in ation All you re really doing is maintaining your purchasing power Risk Premium the eXcess return required from an investment in a risky asset over that required from a riskfree investment Risk Return how much additional return that you earn for taking on a risk above and beyond the riskfree asset available in the market MILLIONAIRE EXAMPLE You invest in a portfolio that gives you 12 annually How much do you need to invest each year in order to retire at 20 years from now PV FV N I PMT ANSWER PV 0 FV 1000000 N 20 I 12 PMT 1387878 Standard Deviation how we measure riskvolatility Arithmetic Average Return the return earned in an average year over a multiyear period change 1 change 2 change n of years Geometric Average Return the average compound return earned per year over a multiyear period r 1R1X1R2X1RT1T 1 Ex mutual funds are advertised this way Calculate the Arithmetic and Geometric Average Returns on this investment portfolio YR change 0 100 1 50 50 2 100 100 Arithmetic 50 102 52 25 25 Geometric 15X110Al2 1 11 0 gt more accurate on a multiyear period Effective Market Hypothesis EMH the hypothesis that actual capital markets such as the NYSE are efficient o In a nutshell every trade in the market hasresults in NPV O gt implies that you are getting your required rate of return Basically says you can never beat the market Every trade in market you will get exactly what you paid for EPVFCF Market Price gt in a perfectefficient market Capital Market Ef ciency 1 Strong says that all investors have ALL information includes inside nonpublic info 2 SemiStrong all investors have all PUBLIC information 3 Weak all we know is from history Chapter 11 Risk and Return EXpected Returns return on a risky asset eXpected in the future Risk Premium EXpected Return RiskFree Rate Rp ER Rf EX pg 352 Table 111 State Prob Recession 5 Boom 5 Stock L Stock UER L M 20 30 10 15 70 10 i 5 25 20 ERL 5020 5070 25 ERU 5030 50 10 20 State Prob Stock L R 05 B 05 10 Stock U R 05 B 05 10 Expected Return ER Variance Standard Deviation m 202545 702545 302010 102010 M 25 2025 45 Risk Premium if Rf 8 25 8 17 20 8 12 Deviation 2 Prob X Deviation 2 452 2025 10125 45 22025 10125 Variance 2025 Std Dev45 1002 01 00500 10201 00500 Variance 0100 Std Dev10 Stock U 20 0100 10 Stock L is riskier because it has a higher standard deviation Portfolio a group of assets such as stocks and bonds held by an investor a basket of investments Portfolio Weight of a portfolio s total value in a particular asset Portfolio Expected Return EX Let s say you invest half in Stock U and half in Stock L from above ERp 50ERL 50ERU ERp 5025 5020 225 Variance and standard deviation of this portfolio from Table 116 State R B ER 5 40 Deviation 2 Probabilitv X Deviation A2 05225A2030625 0153125 40225A2030625 0153125 Variance03 0625 Std Dev175 M Expected Return ER 225 Variance 03 0625 Standard Deviation 175 0 risk in your return from portfolio because you will always have a return between 20 and 25 Only Taken on another 75 of risk in comparison to just investing in Stock U PRINCIPAL ADVANTAGE OF A PORTFOLIO gt Come hell or high water you ll get that return Risk Systematic Risk a risk that in uences a large number of assets Also market risk Unsystematic Risk a risk that affects at most a small number of assets Also unique or asset speci c risk Return ER Systematic Portion Unsystematic Portion gt R ER ERm ERe Diversi cation not putting all your eggs in one basket Principle spreading an investment across many assets Will eliminate some of the risk 0 The market only compensates for diversi ed investors Unsystematic Risk is essentially eliminated by diversi cation so a relatively large portfolio has almost no systematic risk Systematic Risk Principle the eXpected return on a risky asset depends only on that asset s systematic risk 0 The eXpected return on an asset depends only on that asset s systematic risk Beta Coef cient amount of systematic risk present in a particular risky asset relative to that in an average risky asset Looks at how does an individual security moves in comparison to the market as a Whole Ex if the market moves up a notch does the security move up that notclz too And same with decreasing If so Beta Coe icient I Bm Beta of Market 10 Bi Beta of an individual security gt if it 10 it is as risky as the average risky security in the market gt lt 10 less risky than average risky security in market gt gt 10 riskier than average risky security in market Portfolio Beta Bp a invested XBa b invested X Bb n X Bn Security Market Line SML eta Addii tisnall Systematic R151 Rm EMIL 1 51an E Risef un E39Wine 1quot risk 1 Bm SMleope Rm RfBm Rm Rf1 Rm Rf Market Risk Premium Capital Asset Pricing Model CAPM Ri Rf Rm RDBi Ri how do we nd the right required return for a risky asset Rf riskfree return Pure TVM Rm Rf Market Risk Premium Bi amount of systematic risk EX If Rf 05 Rm 14 and the amount of systematic risk Bi 12 What is your required return for the risky asset ANSWER Ri 1580 Chapter 12 Cost of Capital Cost of Capital depends on the USE of the funds NOT the source Cost of Equity Re the return that equity investors require on their investment in a rm Dividend Growth Model Approach DGM P0 D0 X 1gReg gt P0D1Reg Re DlPO g Security Market Line SML gt Re Rf Rm RfBe CAPM gt Ri Rf Rm 11an Weighted Average Cost of Capital WACC we X Re Wp X Rp Wd X Rd1T gt we weight of equity gt wp weight of preferred gt wd weight of debt gt I T is included because interest is tax deductable EX18pg415 Debt 10000 Bonds Stock 275000 Preferred 8000Market 15 yrs 6850 49 Rm 12 69 CPN B 85 94 Rf 35 Quoted Price 104 D1 325 t 35 g 5 ANSWER 1st Re DGM Re 3256850 05 0974 gt Re 974 2nd CAPM Re 035 12 03585 gt Re 10725 3rd Average ofDGM and CAPM gt 0974 107252 1023 Re 4th Risk of Preferred preferred has an assumed par value of 100 Rp 49094 521 5th Risk of Debt Rd YTM 647 pretaX Get this by FV IOOON 15x2 30 PMT 6923450 PV 1040 I 32396x2 647 6th WACC WACC 62311023 02510521 34680647135 WACC 0802 802 Chapter 13 Capital Structure and Leverage Ways to Finance 1 100 With equity least risky gt won t get into nancial distress disadvantage can you raise as much capital as you need Most in debt bank some in equity more risky because they have to pay initial and interest to debt bank gt 5050 between capital and equity 3 100 debt most risky gt advantage cheapest form of capital gives the lowest WACC disadvantage bankruptcy NO EQUITY BANKRUPT Equity most expensive form of capital because it is risky Completely UNleveraged 100 equity completely LEveraged 100 debt Somewhere in between Optimal Capital Leverage You want to nd the capital structure that minimizes the WACC gt maximizes value of NPV of each project gt increases to shareholders MampM Proposition I The Pi Model gt Value of Firm is independent of Capital Structure 0 Doesn t matter size of pizzahow you slice because capital structure has no impact on value of rm VL VU gt Value of Leveraged Firm Unleveraged Value of Firm MampM Proposition II a rm s cost of equity capital is a positive linear function of its capital structure 0 more debt added to capital structure gt required rate of return on equity will increase Cost of Equity Return on Assets Ra Return on Debt x DebtEquity Ratio Leverage Re Ra RaRaprE MampM Proposition I with Taxes you see that value of rm is impacted by capital structure VL VU T x Debt Bankruptcy aka Financial Distress or insolvent Value of Liabilities 2 Value of Assets 0 Direct Bankruptcy Costs the costs that are directly associated with bankruptcy such as legal and administrative expenses 0 Ex late fees penalty interest rate cost of borrowing increases etc 0 Indirect Bankruptcy Costs the costs of avoiding a bankruptcy ling incurred by a nancially distressed rm harder to measure 0 Ex not paying vendors so they cut off your credit supplyterms Types of Bankruptcy Filings 0 Chapter 7 Liquidation corporation or individual 0 Everything is sold gt all 3533 made from it goes to paying back 0 Total discharge of debt WHO GETS PAID FIRST 1 The attorneys accountants etc Other expenses from bankruptcy ling etc Employees Bene t Plans Consumer Claims Government Creditors Preferred Stockholders Common Stockholders QWNQQPFDN 0 Chapter 11 Reorganization just corporations 0 The debtor is allowed to get a mulligan aka a doover 0 2nd change to change balance sheet etc Must make a plan to present to show that they can change capital structure and eventually repay their debt 0 Chapter 13 Reorganization Personal just individuals 0 If you have more than 15 in assets and you fail the means test for Ch 7 you must le a Ch 11 Optimal Capital Structure 0 Static Theory gt pg 434 Figure 135 pg 435 Figure 136
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