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Intermediate Financial Mgmt

by: Timothy Kerluke II

Intermediate Financial Mgmt FIN 400

Timothy Kerluke II

GPA 3.53


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This 10 page Class Notes was uploaded by Timothy Kerluke II on Monday October 5, 2015. The Class Notes belongs to FIN 400 at California State University - Long Beach taught by Staff in Fall. Since its upload, it has received 13 views. For similar materials see /class/218736/fin-400-california-state-university-long-beach in Finance at California State University - Long Beach.


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Date Created: 10/05/15
Chapter 10 MINI CASE amp Problems 108 and 1011 During the last few years Harry Davis Industries has been too constrained by the high cost of capital to make many capital investments Recently though capital costs have been declining and the company has decided to look seriously at a major expansion program that had been proposed by the marketing department Assume that you are an assistant to Leigh Jones the fmancial vice president Your rst task is to estimate Harry Davis cost of capital Jones has provided you with the following data which she believes may be relevant to your task 1 2 Equot The flrm39s tax rate is 40 percent The current price of Harry Davis 12 percent coupon semiannual payment noncallable bonds with 15 years remaining to maturity is 115372 Harry Davis does not use short term interest bearing debt on a permanent basis New bonds would be privately placed with no otation cost The current price of the flrm39s 10 percent 100 par value quarterly dividend perpetual preferred stock is 11310 Harry Davis would incur otation costs of 200 per share on a new issue Harry Davis common stock is currently selling at 50 per share Its last dividend do was 419 and dividends are expected to grow at a constant rate of 5 percent in the foreseeable future Harry Davis beta is 12 the yield on t bonds is 7 percent and the market risk premium is estimated to be 6 percent For the bond yield plus risk premium approach the firm uses a 4 percentage point risk premium Harry Davis target capital structure is 30 percent long term debt 10 percent preferred stock and 60 percent common equity To structure the task somewhat Jones has asked you to answer the following questions Mini Case 10 1 a 1 What sources of capital should be included when you estimate Harry Davis weighted average cost of capital W ACC Answer The WACC is used primarily for making longterm capital investment decisions ie for capital budgeting Thus the WACC should include the types of capital used to pay for longterm assets and this is typically longterm debt preferred stock if used and common stock Shortterm sources of capital consist of 1 spontaneous noninterest bearing liabilities such as accounts payable and accruals and 2 short term interestbearing debt such as notes payable If the rm uses shortterm interest bearing debt to acquire xed assets rather than just to nance working capital needs then the WACC should include a shortterm debt component Noninterestbearing debt is generally not included in the cost of capital estimate because these funds are netted out when determining investment needs that is net rather than gross working capital is included in capital expenditures a 2 Should the component costs be gured on a before tax or an after tax basis Answer Stockholders are concerned primarily with those corporate cash ows that are available for their use namely those cash ows available to pay dividends or for reinvestment Since dividends are paid from and reinvestment is made with aftertax dollars all cash ow and rate of return calculations should be done on an aftertax basis a 3 Should the costs be historical embedded costs or new marginal costs Answer In nancial management the cost of capital is used primarily to make decisions which involve raising new capital Thus the relevant component costs are today39s marginal costs rather than historical costs Mini Case 10 2 Answer What is the market interest rate on Harry Davis debt and its component cost of debt Harry Davis 12 percent bond with 15 years to maturity is currently selling for 115372 Thus its yield to maturity is 10 percent 0 1 2 3 29 30 l l l l o o o l 1 115372 60 60 60 60 60 1000 Enter 11 30 PV 115372 pmt 60 and FV 1000 and then press the i button to nd rd2 i 50 Since this is a semiannual rate multiply by 2 to nd the annual rate rd 10 the pretaX cost of debt Since interest is taX deductible Uncle Sam in effect pays part of the cost and Harry Davis relevant component cost of debt is the aftertax cost rd1 T 1001 040 100060 60 Optional Question Should otation costs be included in the estimate Answer The actual component cost of new debt will be somewhat higher than 6 percent because the rm will incur otation costs in selling the new issue However otation costs are typically small on public debt issues and more important most debt is placed directly with banks insurance companies and the like and in this case otation costs are almost nonexistent Optional Question Should you use the nominal cost of debt or the effective annual cost Answer Our 10 percent pretaX estimate is the nominal cost of debt Since the rm s debt has semiannual coupons its effective annual rate is 1025 percent 1052 10 11025 10 01025 1025 However nominal rates are generally used The reason is that the cost of capital is used in capital budgeting and capital budgeting cash ows are generally assumed to occur at yearend Therefore using nominal rates makes the treatment of the capital budgeting discount rate and cash ows consistent Mini Case 10 3 P p t What is the rm39s cost of preferred stock Answer Since the preferred issue is perpetual its cost is estimated as follows iDpsi 01100 7 10 Pn 13310 200 11110 Note 1 that otation costs for preferred are signi cant so they are included here 2 that since preferred dividends are not deductible to the issuer there is no need for a taX adjustment and 3 that we could have estimated the effective annual cost of the preferred but as in the case of debt the nominal cost is generally used c 2 Harry Davis preferred stock is riskier to investors than its debt yet the preferred39s yield to investors is lower than the yield to maturity 0n the debt Does this suggest that you have made a mistake Hint think about taxes Answer Corporate investors own most preferred stock because 70 percent of preferred dividends received by corporations are nontaxable Therefore preferred often has a lower beforetax yield than the beforetax yield on debt issued by the same company Note though that the aftertax yield to a corporate investor and the aftertax cost to the issuer are higher on preferred stock than on debt d p t What are the two primary ways companies raise common equity Answer A firm can raise common equity in two ways 1 by retaining earnings and 2 by issuing new common stock d N Why is there a cost associated with reinvested earnings Answer Management may either pay out earnings in the form of dividends or else retain earnings for reinvestment in the business If part of the earnings is retained an opportunity cost is incurred stockholders could have received those earnings as dividends and then invested that money in stocks bonds real estate and so on d 3 Harry Davis doesn t plan to issue new shares of common stock Using the CAPM approach what is Harry Davis estimated cost of equity Answer rs 007 006l2 142 Mini Case 10 4 What is the estimated cost of equity using the discounted cash ow DCF approach A D D 1 Answer rs 71 Mg w005 138 P0 P0 50 e 2 Suppose the firm has historically earned 15 percent on equity ROE and retained 35 percent of earnings and investors expect this situation to continue in the future How could you use this information to estimate the future dividend growth rate and what growth rate would you get Is this consistent with the 5 percent growth rate given earlier Answer Another method for estimating the growth rate is to use the retention growth model g 1 Payout Rati0ROE In this case g 035015 525 This is consistent with the 5 rate given earlier e 3 Could the DCF method be applied if the growth rate was not constant How Answer yes you could use the DCF using nonconstant growth You would nd the PV of the dividends during the nonconstant growth period and add this value to the PV of the series of in ows when growth is assumed to become constant f What is the cost of equity based on the bond yield plus risk premium method Answer rs company s own bond yield risk premium First nd the YTM of the bond Enter n 30 PV 115372 pmt 60 and FV 1000 and then press the i button to nd r2 i 5 Since this is a semiannual rate multiply by 2 to nd the annual rate r 10 The assumed risk premium is 4 thus rs 010 004 14 Mini Case 10 5 g What is your f39mal estimate for the cost of equity rs Answer The nal estimate for the cost of equity would simply be the average of the values found using the above three methods CAPM 142 DCF 138 BOND YIELD RP 140 AVERAGE 140 h What is Harry Davis weighted average cost of capital W ACC Answer WACC wdrd1 T wpsrps wcers 0301006 01009 060 14 0111 111 i What factors in uence Harry Davis composite WACC Answer There are factors that the rm cannot control and those that they can control that in uence WACC Factors The Firm Cannot Control Level Of Interest Rates Tax Rates Market Cond1t10ns Factors The Firm Can Control Capital Structure Policy Dividend Policy Investment Policy j Should the company use the composite WACC as the hurdle rate for each of its projects Answer No The composite WACC re ects the risk of an average project undertaken by the rm Therefore the WACC only represents the hurdle rate for a typical project with average risk Different projects have different risks The project s WACC should be adjusted to re ect the project s risk Mini Case 10 6 What procedures are used to determine the risk adjusted cost of capital for a particular division What approaches are used to measure a division s beta Answer The following procedures can be used to determine a division s riskadjusted cost of capital 1 Subjective adjustments to the rm s composite WACC 2 Attempt to estimate what the cost of capital would be if the division were a standalone rm This requires estimating the division s beta The following approaches can be used to measure a division s beta 1 Pure play approach Find several publicly traded companies exclusively in the project s business Then use the average of their betas as a proxy for the project s beta It s hard to nd such companies 2 Accounting beta approach Run a regression between the project s ROA and the SampP index ROA Accounting betas are correlated 05 06 with market betas However you normally can t get data on new project ROAs before the capital budgeting decision has been made 1 Harry Davis is interested in establishing a new division which will focus primarily on developing new internet based projects In trying to determine the cost of capital for this new division you discover that stand alone firms involved in similar projects have on average the following characteristics 0 Their capital structure is 10 percent debt and 90 percent common equity 0 Their cost of debt is typically 12 percent I The beta is 17 given this information what would your estimate be for the division s cost of capital Answer rs DIV rRF TM rRFbDIV 7 617 172 WACCDN wdrd1 T wcrs 011206 09172 162 The division s WACC 162 vs The corporate WACC 111 The division s market risk is greater than the rm s average projects Typical projects within this division would be accepted if their returns are above 162 percent Mini Case 10 7 Hi What are three types of project risk How is each type of risk used Answer The three types of proj ect risk are StandAlone Risk Corporate Risk Market Risk Market risk is theoretically best in most situations However creditors customers suppliers and employees are more affected by corporate risk Therefore corporate risk is also relevant Standalone risk is the easiest type of risk to measure Taking on a project with a high degree of either standalone or corporate risk will not necessarily affect the firm s market risk However if the project has highly uncertain returns and if those returns are highly correlated with returns on the firm s other assets and with most other assets in the economy the project will have a high degree of all types of risk n Explain in words why new common stock that is raised externally has a higher percentage cost than equity that is raised internally by reivesting earnings Answer The company is raising money in order to make an investment The money has a cost and this cost is based primarily on the investors required rate of return considering risk and alternative investment opportunities So the new investment must provide a return at least equal to the investors opportunity cost If the company raises capital by selling stock the company doesn t get all of the money that investors put up For example if investors put up 100000 and if they expect a 15 percent return on that 100000 then 15000 of pro ts must be generated But if otation costs are 20 percent 20000 then the company will receive only 80000 of the 100000 investors put up That 80000 must then produce a 15000 profit or a 1580 1875 rate of return versus a 15 percent return on equity raised as retained earnings Mini Case 10 8 Harry Davis estimates that if it issues new common stock the otation cost will be 15 percent Harry Davis incorporates the otation costs into the DCF approach What is the estimated cost of newly issued common stock taking into account the otation cost Answer Do1g P0139F 7 419105 7 501015 440 4250 g 50 50 154 o Equot Answer Suppose Harry Davis issues 30 year debt with a par value of 1000 and a coupon rate of 10 paid annually If otation costs are 2 percent what is the after tax cost of debt for the new bond Using a nancial calculator n 30 PV l0021000 980 pmt l040100 60 FV 1000 The resulting i is 615 which is the aftertax cost of debt Answer What four common mistakes in estimating the WACC should Harry Davis avoid 1 Don t use the coupon rate on a firm s existing debt as the pretax cost of debt Use the current cost of debt 2 When estimating the risk premium for the CAPM approach don t subtract the current longterm tbond rate from the historical average return on stocks For example the historical average return on stocks has been about 127 If in ation has driven the current riskfree rate up to 10 it would be wrong to conclude that the current market risk premium is 127 10 27 In all likelihood in ation would also have driven up the expected return on the market Therefore the historical return on the market would not be a good estimate of the current expected return on the market 3 Don t use book weights to estimate the weights for the capital structure Use the target capital structure to determine the weights for the WACC If you don t have the target weights then use market value rather than book value to obtain the weights Use the book value of debt only as a last resort 4 Always remember that capital components are sources of funding that come from investors If it s not a source of funding from an investor then it s not a capital component Mini Case 10 9 amp 214 108 a r 5 P0 g 23 7 93 7 163 b rs rRF rM rRFb 9 13 916 9 416 9 64 154 c rs Bond rate Risk premium 12 4 16 3 1 The bondyieldplusriskpremium approach and the CAPM method both resulted in lower cost of equity values than the DCF method The rm39s cost of equity should be estimated to be about 159 percent which is the average of the three methods 1011 a Common equity needed 0530000000 15000000 b Cost using rs AfterTax Percent gtlt Cost Product Debt 050 48 24 Common equity 050 120 60 WACC Q 81 T 806 48 c rs and the WACC will increase due to the otation costs of new equity Mini Case 10 10


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