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by: Daren Beatty Jr.


Daren Beatty Jr.
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Class Notes
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This 58 page Class Notes was uploaded by Daren Beatty Jr. on Thursday October 22, 2015. The Class Notes belongs to ME 12 at University of California Santa Barbara taught by Staff in Fall. Since its upload, it has received 17 views. For similar materials see /class/227088/me-12-university-of-california-santa-barbara in Mechanical Engineering at University of California Santa Barbara.

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Date Created: 10/22/15
UCSB ECON 134A Introductory Finance Lecture 12 Risk cost of capital and capital budgeting Corresponds to Ch 12 in textbook Spring quarter 2009 Instructor Ragnar Arnason Cost of capital Cost of capital The annual interest cost appropriate for the capital raised The same as the rate of discount Crucial for capital budgeting Present value of projects depends on rate of discount that is used IRR is compared to the cost of capital 0 Wrong cost of capital gt wrong investments The Cost of Equity Capital Basic Principle A rm with excess cash can either pay a dividend or make a capital investment Shareholder Pay cash dividend invests in cial Firm with excess cash Shareholder s Terminal Value Invest in project Principle Because stockholders can reinvest the dividend in nancial assets the return on a capitalbudgeting project should be at least as great as the return on a nancial asset of comparable risk An equity financed firm For an equity based firm its cost of capital is the Cost of Equity Capital o VVhy 39 To calculate the firm s cost of equity capital we need to know three things 1 The riskfree rate RF 2 The market risk premium RM RF C0vRlRM 0W 3 The company beta VarltR 02 M M Example Suppose the stock of Stansfield Enterprises a publisher of PowerPoint presentations has a beta of 25 The firm is 100 equity financed Assume a riskfree rate of 5 and a market risk premium of 10 What is the appropriate discount rate for an expansion of this firm Y2RF ltRM RFgt R525gtlt10 Y230 Example Suppose Stansfield Enterprises is evaluating the following independent projects Each costs 100 and lasts one year Project Project B Project s IRR Estimated Cash Flows Next Year A 25 150 50 B 25 130 30 C 25 110 10 Which projects if any should Stansfield pick NPV at 30 1538 0 1538 Using the Security Market Line g G 9d iA SM 9 H prOJect 5 m 30 5W Bad project 039 E i gt Firm s risk beta 25 An allequity firm should accept projects whose PVcost of equity capital caICUIated at the cost of equity capital is positive or whose IRRS exceed the cost of equity capital and reject others So beta is crucial To calculate the firm s cost of capital To draw the SML The question is how to estimate beta Estimation of Beta C0vR7RM 20 2 1 VarRM 0 Have to get data on RM and R Calculate the variances or covariances Or do an OLS regression of R on RM Estimation problems Betas may vary over time The sample size may be inadequate Betas are in uenced by changing nancial leverage and business risk Solutions Problems 1 and 2 can be moderated by more sophisticated statistical techniques Problem 3 can be lessened by adjusting for changes in business and nancial risk Stability of Beta Most analysts argue that betas are generally stable for firms remaining in the same industry That is not to say that a firm s beta cannot change Changes in product line Changes in technology Deregulation Changes in financial leverage Evidence GE Beta85 9119 beta90 4119 beta95 9115 Beta2000510 Using an Industry Beta It is frequently argued that one can better estimate a firm s beta by involving the whole industry If you believe that the operations of the firm are similar to the operations of the rest of the industry you should use the industry beta If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry you should use the firm s beta Do not forget about adjustments for financial leverage Determinants of Beta Business Risk Cycicaity of Revenues Operating Leverage Financial Risk Financia Leverage Cyclicality of Revenues Highly cyclical stocks have higher betas Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle Transportation firms and utilities are less dependent upon the business cycle Note that cyclicality is not the same as variability stocks with high standard deviations need not have high betas Movie studios have revenues that are variable depending upon whether they produce quothitsquot or quotflopsquot but their revenues may not be especially dependent upon the business cycle Operating Leverage The degree of operating leverage measures how sensitive a firm or project is to its fixed costs Operating leverage increases as fixed costs rise and variable costs fall Operating leverage magnifies the effect of cyclicality on beta Operating Leverage Total costs Higher operating leverage ota1 costs Fixed costs Jixed costs Sales gt Operating leverage increases as xed costs rise and variable costs fall Why More risk more xed costs Financial Leverage and Beta Operating leverage refers to the sensitivity to the firm s fixed costs of production Financial leverage is the sensitivity to a firm s fixed costs of financing The relationship between the betas of the firm s debt equity and assets is given by 6 2 Debt Equity Asset Debt Equity Debt Debt Equity Equity 0 Financial leverage always increases the equity beta relative to the asset beta Example Consider Grand Sport Inc which is currently allequity financed and has a beta of 090 The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity Since the firm will remain in the same industry its asset beta should remain 090 However assuming a zero beta for its debt its equity beta would become twice as large 1 Assel 1 1 Equz39ly Eqy 2 090180 Extensions of the Basic Model The Firm versus the Project The Cost of Capital with Debt The Firm versus the Project Any project s cost of capital depends on the use to which the capital is being put not the source Therefore it depends on the risk of the project and not the risk of the company Illustration E SML e Incorrectly accepted D negative NPV projects o o 0 RF FIRM RF Incorrectly rejected r f positive NPV projects Firm s risk beta FIRM Capital Budgeting amp Project Risk An example The Conglomerate Company has a cost of capital based on the CAPM of 17 The risk free rate is 4 the market risk premium is 10 and the firm s beta is 13 17 4 13 10 This is a breakdown of the company s investments 13 Automotive Retailer 3 20 13 Computer Hard Drive Manufacturer 3 13 13 Electric Utility 3 06 Average 3 of assets 13 When evaluating a new electrical generation investment which cost of capital should be used Capital Budgeting amp Project Risk SML g 24 Investments in hard drives or auto retailing should have E 17 higher discount rates 10 Q t Project s risk 3 06 13 20 r406 14 410 10 re ects the opportunity cost of capital on an investment in electrical generation given the unique risk of the project The Cost of Capital with Debt The Weighted Average Cost of Capital is given by Equity Debt rWACC rEquily rDebt X0 TC Equlty Debt Equlty Debt S B X 1 T rWACC 53 rs 53 B C 0 Because interest expense is tax deductible we multiply the last term by 1 TC Example International Paper The debt to value ratio is 32 The interest on the company s debt is 8 The firm has a 37 marginal tax rate The industry average beta is 082 The risk free rate is 3 and the market risk premium is 84 What is the firms WACC Example cont The cost of equity capital is rSZRF Bi RM RF 3 082 84 989 The cost of borrowed capital is 8 The WACC is S B rWACC 53 rs 53 068 989 032 8 1 037 834 VB X1TC Liquidity and the Cost of Capital The cost of trading an illiquid stock bonds reduces the return to the investor Larger spread More waiting time Market price less certain 3 Investors demand a higher return when investing in stocks with low liquidity 0 This higher return implies a high cost of capital to the firm Liquidity and the Cost of Capital Cost of Capital Liquidityr What the Corporation Can Do The corporation has an incentive to lower trading costs since this would result in a lower cost of capital There are a few things the company can do Provide full information reduces uncertainty and asymmetric information Attempt to increase the number of small investors stock Facilitate trades by buying and selling itself stocks and bonds A stock split might increase the liquidity of the shares WHAT IS A LONGTERM LIABILITY Present obligation payable by sacrIfice of economic benefit in the future Settled gt12 months or operating cycle whichever is longer IMPORTANT LIKELY CHARACTERISTICS Interest LONG TERM LIABILITIES l g lLOquot 39Term L39ab39l39t39es Covenants or restrictions Notes payable and Bonds payable Why issue bonds Bob Anderson UCSB 2004 141 3 Bub Andaman 2mm 0749 Bond Indenture TVDes 0f Bonds l Contract representing a promise to pay Debenture boncl 1 a sum of money at a designated No collateral securlty maturity date plus secured bonds 2 periodic interest at a specified rate BaCked bY Pledge 0f COHateral Mortgage Generally a fixed rate Stated Term bonds nominal or coupon rate Maturity in lumpsum l Generally pay interest semiannually Serial bonds Matures in installments Types of Bonds Callable bonds Issuer has right to retire bonds before maturity at a specified price Registered bonds Record maintained of debt holders Bearer bonds Unregistered holder clips coupons to receive interest Bub Andasm 2mm Types of Bonds Convertible bonds Convertible to common stock at option of the investor Deep discount bonds Sold at a discount that provides the buyer s total interest payoff at maturity Revenue bonds Interest paid from specified revenue sources Income bonds Pays no interest unless the issuing company is profitable Bub Anderson 2mm 0749 BONDS FAIR VALUE CONCEPT The value the purchaser gets is what they pay based on the interest rate in effect on the date the bond is purchased This is why there are premiums and discounts If today s rate is 25 and I can go buy a bond that pays me 12 would I pay the same for a bond that pays me 12 as I would for one that pays me 2 o NO I would not I would be willing to pay a premium39for the 12 bond IfI buy a bond today that pays interest at 5 and the market rate subsequently declines to 2 would the fair value of the bond be impacte YES I could sell it for more than I paid for it I would be able to sell it or a premium Two Interest Amounts What is the interest rate called that is written in the terms of the bond indenture agreement Stated Coupon or Nominal rate What is the interest rate called that represents the rate actually earned by the bondholders Market or Effective rate 7 Bob Anderson 2mm Two Interest Amounts Selling Price of Bond How do you calculate the amount of interest that is actually paid to the bondholder each 1 Depends fm Market Rate of mterest period 2 Computation of selling price Stated rate x Face Value of the bond 39 PV of maturitY value Plus How do you calculate the amount of interest 39 PV of mere P Yment5r at What rate that is actually recorded as interest expense 39 Market rate Df39merest by the issuer of the bonds 3 Semiannual interest paying bonds Market rate x Carrying Value of the bond 39 ReqUire dOUbling the PeriOdS Halving the interest rate Bub Andasm 2mm 1 Hub Anderson 2mm 0749 o Discount and Premium Assume Stated Rate 8 Discount Market Interest Bonds Sold At When the market rate is gt the stated rate Premium When the market rate is lt the stated BBB BBB 15 sub Anderson 2mm E Assume Stated Rate 8 I Assume Stated Rate 8 I Market Interest Bonds Sold At Market Interest Bonds Sold At gt BU BEE Bub Andasm 2mm LESquot Bub Andaman 2mm 0749 Assume Stated Rate 8 I Assume Stated Rate 8 I Market Interest Bonds Sold At Market Interest Bonds Sold At gt gt IU EUE 10 gt 3 Hub Andaman 2mm o Assume Stated Rate 8 Market Interest Bonds Sold At gt gt EUE Bub Andasm 2mm o Assume Stated Rate 8 Bonds Sold At Face Value Market Interest gt gt gt LL15quot aub Anderson 2mm W 0749 Illustration 143 Bonds Selling Price w 6 Mkt Rate Three 3 year bond Face Value 100000 8 coupon rate 10 yield rate Interest is payable semiannually on June 30 and Dec 31 assume semi annual compounding PV of Principle 100000 x 8375 83748 PV of Interest 4000 x 5417 21669 Selling price 105 417 15 sub Anderson 2mm m Selling Price w 8 Mkt Rate Selling Price w 10 Mkt Rate PV of Principle PV of Principle 100000 x 7903 79031 100000 x 7462 74622 PV of Interest PV of Interest 4000 x 5242 20969 4000 x 5076 20303 Selling price 100000 Selling price 94 924 aub Andasm 2mm m1 1 aub Anderson 2mm 0749 sell39n Pr39 ggummar Premium Discount Amortization Market rate 6 2 fryquotnquot 1353 The premium or discount must go away over the life of the bonds Think about it on the last day in some entry to record he sale of each our example we owe 100000 The debits and E aim IDs 43917 credits work out nicely if the premium or discount is Bond Payable 100000 not there anymore If it is then whatcha gonna Bond Premium 5417 do 8 Bonds Cash 100000 Bond Payable 100000 We amortize the premium or discount over the life of 01 SW 94 924 the bonds PREFERRABLY using an effective as Bond Payable 100000 Interest method can use straight line If produces Bond Discount 5076 materially conSIstent results r91 m Andasm 2mm m Bub Andaman 2mm Effective Interest Method Discount and Premium Bond interest expense is increased by Each period we record interest expense of the amortization of a net value of the bonds using the fair value quotquotquot quot rate Discount In other words we ignore the stated rate and and decreased by amortization of a u face value and instead we record interest expense based on the adjusted bond amount Premlum Bond payable net of premium or discount and apply the market rate of interest It s really quite simple Bub Andasm 2mm m 7 Bub Anderson 2mm 0749 Illustration 143 Bonds Three year bond Face Value 100000 8 coupon rate 10 yield rate Bonds issued on January 1 2004 Interest is payable semiannually on July 1 and January 1 L Bub Anderson 2mm WANNA SEE IT Discount and Premium Stated Rate 8 39 39 39 39 W Rm m Wumnm LS awnLE mm mm On the balance sheet the face value is reported as a liability Semirannual payment 4min PV annuity at 55 peiiuds znana With the discount being piasamw Discnunt Discuun 5mg Deducted Payment Interest Amnrtiz Balance Face Va iEIEILIEIEI OPENING 94324 and the premium being i ALIEIEI AJAE 74E BEEN 2 ALIEIEI 4784 784 95454 3 mm 4823 623 97277 to the Face Value of the Bond 4 ALIEIEI AEEA EA 98141 5 ALIEIEI 49EI7 8W BBLIAE E A EIEIEI A 952 52 iEIEI EIEIEI 75 IN OTHER WORDS THE BOND APPEARS ON THE FACE OF ause we always iecugnize a little muie interest than paid we are amurtizing m macaw AND m ending balance ends up We same as We face value upun atuiityi 1430 ExtinguiShment Of Debt Lon Term Notes Pa able APB Opinion No 21 insures proper accounting From 19752003 all early egtlttinguishments of debt where the form does not reflect the economic that resulted in a gain or loss were treated as an substance extraordinary item under SFAS No4 In 2003 the 39 FASB issued FASB No 145 Rescission of FAs Followmg categories are conSIdered EESESESRESNVZOl g rl Hfil gc fc p gr g nc gtngf FASB Zero InterestBea ring Notes Issued for Cash Regarding early e lttinguishment of longterm39debt I InteFeSt39Bearing NOteS With an Effective Rate Different than the Stated Rate Gain or loss is reflected as an extraordinary item if Imputing an interest rate The rate that would 39t 395 bOth Unusual and Infrequent OW SUbJGCt to have resulted if an independent borrower and same mm as other ex Items lender had negotiated a similar transaction 91 sub Andastm 2mm ml 3915 1432 Exercise Exercise o J 1 2002 Ell G c k th tw quot0723222 amusingquot quotme my quot393 as 9 How was the 337012 calculated 1 Purchases land having a fair market value of 200000 by issuing a 5year noninterestbearing promissory note in the Falr value Of Land face a39quot quot quot33739 12 Future value factor x 168506 2 Purchases equipment by issuing a 6 8year promissory note having a maturity value of 250000 interest payable Future Value annuall The Company has to pay 11 interest for funds from its bank Instructions a Reoord the two journal entries that should be reoorded by Ellen Greene Company for the two purchass on January 1 b Record the interest at the end of the first year on both notes using the effective interst method m 1434 Exercise Exercise Journal ent What value should be recorded for equipment rY Land 200 000 Face value 250000 39 Present value factor x 43393 Discount on notes payable 137012 108482 Notes payable 337012 Interest paid 15000 Present value factor x 514612 Interest 77 192 Interest expense 22000 Total present value 185 674 Discount on notes payable 22000 This will amortize the discount to zero over life of loan 91 m 15 1436 What is it made from Metals Plastics Ceramics Composites Wood natural fibers Silicon other semiconductors How many Mass produced and custom products are made differently Why is it made this way Pay attention to the things that you see What forces and environmental conditions does the part see Is this the least expensive way to make a part that meets these requirements What materials are used Why How was it made Mass produced or custom made It s What Makes Us Human Copper axehead Ancient Egypt 199171786 BC Musmal Instruments What problems do you want to solve Environmental Transportation Energy Building and construction Defense Educa on Medical care Agriculture Coalfired power plant What problems do you want to solve Safe water supply Shelter Medical treatment Roads Bridges Agricultural technology Business development microcredit Goals 1 Learn to identify the manufacturing processes that are used to make products 2 Learn to identify the materials that they are made from 3 Learn why those processes and materials were chosen 4 Have fun learning something practical and useful Process Hierarchy I Manufacturing Processes I I I I I Mass Reducing Mass Conserving Joining Finishing Conditioning Sand I llnvestmentl I Die Material Hierarchy I I I I Metals Polymers Ceramics Composites and Others From Kalpakjian Casting Video Casting Basic principles Part is made by lling a hollow mold with molten metal and letting it solidify there Mold may be reusable die casting or destroyed when removing the part sand or investment casting Mold is made from a pattern which can be reused sand casting or expendable foam wax Metal shrinks when it cools so the mold must be made larger than the nished part Planning for the uid ow in the mold is a critical part of mold design Casting Basic principles Recrystalization of molten metal in the mold determines microstructure and therefore the mechanical properties of the cast part Recrystalization can only be partially controlled hence some variability in cast part properties Impurities may be cast in especially with sand cast parts Machining after casting is usually required blip WWW glob alspec comFeaturedProductsDelmlGrobPrecisionicddiRolling229120 Casting Advantages and Disadvantages Geometrical exibility Reduced number of components Very large parts can be cast Economical Generally lower strength to weight than forged parts Control of microstructure can be dif cult Casting Processes Expendable mold Permanent mold Sand Pressure Shell Die Expandable pattern Centrifugal Plaster Squeeze Ceramic Investment Single crystal Sand Casting Make pattern halves Impress pattern and lling passages in sand Assemble the cope and drag Fill with molten metal Breallt away sand cut off runner and riser Machine if needed CORED SAND CASTING x RISER BINDS i 5 MOLTEN METAL smue Core h RUNNER MOLD CAVITY GATE httpclassetbyuedumfgl V J 39 39 quot 39 39 htm Investment Casting a 393 Cast wax pattern Fire ceramic Assemble wax patterns Fill mold Dip in ceramic slurry Melt wax Remove separate and finish parts Fi guresL WWW vainvestmentc ast com Die casting Machine reusable steel die cmquot CORE EJECTDR PINS Clamp die halves together mama 3 Inject molten metal 20 MPa 100 MPa Separate mold halves N HECTOR mE K 39 Eject part all COVER mg L MOLTEN METAL Low melting point metals are die cast e g aluminum magnesium and zinc Die casting 1 SETUP 8x EQUIPMENT COLD CHAMBER DIE CASTING MACHINE Die casting 2 PROCESS SCHEMATIC DIE CASTING COLD CHAMBER


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