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USC / Finance / FIN 365 / emarket usc

# emarket usc Description

##### Uploaded: 04/25/2017
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## What weights should Kenai use in calculating WACC?

Final Exam Study Guide Tuesday, April 25, 2017 2:56 PM Market value of equity v+ market value of debt = market value of assets Leverage: relative amount of debt on a balance sheet Unlevered: firm that doesn't issue debt Levered: some of a firm's financing comes from debt Unlevered firm: WACC = equity cost of capital Levered firm: WACC = fraction finaDon't forget about the age old question of o How long have you worked there?
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nced by equity * equity cost of capital + fraction financed by  debt*debt cost of capital = asset cost of capital Kenai corporation has debt with book value of 10 million, trading at 95% of face value. It has  book equity of 10 million and 1 million shares of common stock trading at 30\$ per share. What  weights should Kenai use in calculating WACC?  9.5 million debt market value, 30 million in market value of stock 9.5+30 = 39.5 million total value Debt: 9.5/39.5 = 0.2405 , 24.1% Equity: 30/39.5 = 0.7595 , 75.9% Cost of Debt Capital -yield to maturity and the cost of debt YTM is the yield that bond purchasers would earn if they held the debt to maturity and received  all payments Taxes and the cost of debt: Effective cost of debt: rD(1-TC) Tc is corporate tax rate DuPont Corp has cost of debt of 2.81%. Its tax rate is 35%. What is the effective cost of debt? .0281*(1-.35) = 0.0183 , 1.83% Cost of Preferred Stock Capital = preferred dividend/preferred stock price = Div/P Preferred stockholders are promised a fixed dividend which must be paid before dividends are  paid to common stockholders.  DuPont's class A preferred stock has a price of 85.83 and dividend of 3.50. Cost of preferred  stock is: 3.50/85.83 = 0.0408 , 4.08% Cost of Common Stock Capital Estimate beta of equity and risk free rate and apply CAPM.  Cost of equity = risk free rate + equity beta*market risk premium DuPont has a beta of 1.6, yield on T notes is 3%, and market risk premium is 6%. Cost of equity  is: 3+1.6*6 = 12.6 %  Final Exam Stud Guide Pae 1 is: 3+1.6*6 = 12.6 % Constant dividend growth model:  Cost of equity = dividend/current price + dividend growth rate Div/P + g The forecast for DuPont earnings growth rate is 7.9%. Dividend is going to be 1.80 and price is  57.66. Cost of equity: div/P + g = 1.80/57.66 + .079 = 0.1102 , 11% Different that outcome from CAPM model Equity beta for J and J is .55. Yield on T notes is 3%. Risk premium is 6%. Dividends are 2.81.  Stock price is 92.00. Dividends will increase at 4% a year.  Estimate cost of equity in two ways:  CAPM: 3+.55*6 = 6.3 % 2.81/92 + .04 = 0.0705 , 7.05% To reconcile, solve for the growth rate that equalizes both approaches.  .063 - 2.81/92 = 0.0325  If dividends grow by 3.25%, the two approaches produce same cost of equity estimate. WACC equation: rEE% + rpfdP% + rD(1-Tc)D% = rwacc E,P,D% = weights of equity capital, preferred stock, and debt rE, rpfd, rD= returns  Tc= tax rate DuPoint has common stock: 53240 million, preferred stock: 221 million, debt: 14080 million Total value: 53240+221+14080 = 67541 million (67.541 billion) WACC = 12.6%*(53240/67541) + 4.08%*(221/67541) + 2.81%*(1-.35)*(14080/67541) = 0.1033 ,  10.33% Target has return on equity of 11.5%, YTM on debt of 6%. Debt accounts for 18% and equity is  82% of total market value. Tax rate is 35%. What is Target's WACC? .115*.82 + .06*(1-.35)*.18 = 0.1013 , 10.1% Net debt = Debt - cash - risk free securities rWACC= rE (market value of equity/enterprise value) + rD(1-TC)(Net Debt/Enterprise value) Risk free interest rate: use yields on long term treasury bonds Levered value: value of investment, including benefit of interest tax deduction WACC Valuation Method: discounting incremental free cash flows using the firm's WACC Levered value: VL0 = FCF0 + FCF1/1+r + FCFn/(1+r)n Anheuser-Busch InBev is introducing BudZero. The cost to bring to market is 200 million, first  year FCF will be 100 million and will grow at 3% afterwards. WACC is 5.7%, should they go forth  with the project?  Final Exam Stud Guide Pae 2 with the project? -200 + 100/(.057-.03) = 3,503.7037 million (3.5 billion) Want to issue new equity or bonds. Issuing costs are treated as cash outflows.  DuPont offers 65 billion as the purchase price for Nike. Issuance costs for debt will be 800  million. FCF will be 3.3 billion in the first year and will grow at 3% thereafter.  PV = 3.3/(.079-.03) = 67.3469 billion NPV = -65 - .8 + 67.3469 = 1.5469 billion Chapter 14 Sources of funding: funds of founder, outside capital -angel investors Individual investors who buy equity in small private firms Get a substantial stake in the company -venture capital firms Limited partnerships that specialize in raising money to invest in private equity of  young firms -institutional investors Pension fund, insurance companies, endowments, foundations May invest directly or indirectly by becoming limited partners in venture capital  firms -corporate investors Many established corporations purchase equity in younger, private companies -corporate strategic objectives -desire for investment returns You founded your own firm two years ago. Initially contributed 100,000 of your money and  received 1500000 shares of stock. This is .067 per share.  You have sold an additional 500,000 shares to angel investor, total is now 2,000,000. Now you  are considering raising more capital from a venture capitalist. VC would invest 6 million and would receive 3 million newly issued shares. What is the post  money valuation? -post money valuation is the valuation of the whole firm (old + new shares) at the funding  round price -post-money valuation = pre-money valuation + amount invested What percentage will VC own? What percentage will you own? What is the value of your  shares? 1,500,000 + 500,000+ 3,000,000 = 5,000,000 total shares outstanding VC is paying 6 million/3 million shares = \$2 a share Post-money valuation = 5,000,000*2 = 10,000,000 \$ Percentage of firm owned by VC = 3,000,000/5,000,000 = 0.6 , 60% Percentage you own is 1,500,000/5,000,000 = 0.3 , 3% Angel investors own 500,000/5,000,000 = 0.1 , 10% Underpriced IPOs -underwriters benefit and pre-IPO shareholders lose Hot and Cold Markets Not solely driven by demand for capital During periods of growth, more IPOs  Final Exam Stud Guide Pae 3 During periods of growth, more IPOs Interest rates High Cost of IPO -fee is large, 7% to underwriter Poor post IPO Performance -is the company not worth as much as people think SEO: seasoned equity offering (already had IPO) -doesn’t needs to set price because it is already trading -tombstones: how investors were made aware of offerings Two types: Primary: new shares Secondary: shares sold by existing shareholders (founder, venture capital, etc.) Two kinds of offerings:  Cash offer: firm offers shares to investors Rights offer: firm offers shares to only existing shareholders Company has market cap of 1 billion and firm has 100 million shares. Shares are trading at 10\$  a price. Need to raise 200 million. Each shareholder is sent one right for every share they own. You will require either four rights to purchase one share at 8\$ a share or 5 rights to purchase 2  new shares at a price of 5\$ a share. Which approach will raise the most money? 100 million/4 = 25 million  25 million *8\$ = 200 million dollars 100 million/5 = 20 million 20 million*2*5\$ = 200 million dollars  Want to open a coffee shop: 24,000 start-up costs Cash flow at year 1: 34,500 Discount rate 15%, 5% risk free rate, 15% market premium NPV is -24,000 + 34,500/1.15 = 6,000 Finance with equity costing 30,000 because 30,000 = 34,500/1.15 (present value of cash flows) 30,000 = unlevered equity in the company (company has no debt) Let's use 15,000 debt Interest rate is 5%: 1.05*15,000 = 15,750 to payback at end of year How much capital can I raise now?  34500-15750 = 18750  Levered equity: company has debt What discount rate is used to value levered equity? Modigliani Miller Model -unlevered firm, cash flows to equity equals free cash flows from firm's assets -in a levered firm, same cash flows are divided between debt and equity holders -total to all investors equals free cash flows generated by assets -VL = E+ D = VU Value of unlevered firm and levered firm are the same 34,500/1.15 = 30,000.0  18,750+15,750 = 34,500 ; 34500/1.15 = 30000.0   Final Exam Stud Guide Pae 4 18,750+15,750 = 34,500 ; 34500/1.15 = 30000.0  If you borrow 6000, 6000*1.05 = 6300  34500-6300 = 28200  Return: 28200/24000 -1 = 0.175 , 17.5% WACC rU = D/(D+E)rD + E/(D+E)rE .05*(15000/30000) + .25*(15000/30000) = 0.15  rE = rU + D/E(rU -rD) Cost of levered equity equals cost of unlevered equity plus a premium proportional to the  debt:equity ratio Safeway Inc. EBIT of 1.13 billion Interest expense of 300 million Tax rate is 35% With leverage: 1130-300 = 830  830*.65 = 539.5, net income after taxes Without leverage: 1130*.65 =734.5 , income after taxes With leverage: 300\$ interest paid 300+539 net income = 839 available to investors Without leverage: 734 available to investors Tax deduction on 300 million interest expense Shield: 300*.35 = 105.0 million Suppose ECB borrows 2 billion by issuing bonds Cost of debt is 6%, will pay \$120 million in interest each year for 10 years Repay 2 billion in year 10 Interest shield? Tax rate is 35% 10 year annuity .35*120 million = 42 million 42*1/.06*(1-1/1.06^10) = 309.1237 million Final repayment of principal is not deductible Only interest is deductible Level of interest payments impacts tax savings due to changes in debt outstanding, changes in  interest rate, change in tax rate, risk of default Market value of debt = D = PV(future interest payments) PV(interest tax shield) = PV(tax*future interest payments) = T*PV(Future interest payments) =  T*D rwacc = rE * E/(E+D) + rD*(1-T)*D/(E+D) Reduction in WACC increases with the amount of debt financing Higher the leverage, lower WACC, more tax advantage of debt  Final Exam Stud Guide Pae 5 Higher the leverage, lower WACC, more tax advantage of debt WACC with taxes decreases as debt to value ratio increases However, more debt, higher risk of default VL = VU + PV(interest tax shield) -PV(financial distress costs) Genron has 20 million in excess cash, no debt Firm expects to generate additional Free cash flows of 48 million a year If unlevered cost of capital is 12%, Enterprise value is: EV: PV(future FCF) = 48million/12% = 400 million Three options to pay out 20 million in excess cash -with 10 million shares outstanding, pay a 2\$ dividend Anticipates paying 4.80 per share each year thereafter Value of share before it pays dividend: Pcum = Current dividend + PV(Future Dividends) = 2+4.80/.12 = 42.0  Just after dividend paid: Pex = PV(future dividends) = 4.8/.12 = 40.0  -share repurchase -share price remains the same Share repurchase may seem more attractive b/c have to pay taxes on dividends Dividend Tax Rate Factors -income level -different income, different income tax bracket -Investment horizon -capital gains on stock held less than 1 year and dividends on stocks held less than 61 days  are taxed as ordinary income -Tax jurisdiction -state taxes differ by state -type of investor/investment account -stocks held by individual investors/retirement accounts are not subject to taxes on  dividends of capital gains  Final Exam Stud Guide Pae 6

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