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Clemson FIN 3120 - Final Exam Study Guide
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FIN 3120 1st EditionFinal Exam Study Guide ChaptersChapter 12 – Cost of Capital- Weighted Average Cost of Capital:o If the new project is similar to existing projects within the firmo Average of the individual costs of capital based upon their percentage of existence in thecapital structureo    pfieakVPkVBkVEk o ka = wcke + wdki + wpkp - Costs and Risko Component costs should reflect the level of risko The risk free rate (Rf) is determined by: Supply and demand Inflation premiumso The risk premium is determined by: Business risk Financial risk Liquidity/Marketability risk Interest rate Seniority risko The Required Rate of Return = Rf + the risk premium- The Cost of Debto The rate of return on debt is determined by: The amount of the coupon payments The price of the bond *Coupon rate does not consider both of these factorso ki = kd (1 – T)o YTM is pre-tax- The Cost of Preferred Stocko Preferred stock dividends are fixed: perpetuity evaluation Cost = dividend / net price- The Cost of Equityo Can only be estimated - 3 approaches: Dividend Growth Model (DCF analysis)- Estimate future dividend growth rateo Past growth rateso Analysts’ forecastsThese notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.ogPDke01o g = retention rate * ROE Where retention rate = 1 – payout ratio Security Market Line (CAPM)- Uses the relation between the return on the stock and the return on themarket using the amount of systematic risk- fmferrrk ˆo Where Rm is the return on the market Rm – Rf = the risk premiumo Where beta is the relationship between the market and the stock If ß=1, stock moves the same as the market If ß<1, stock moves less than the market If ß>1, stock moves more than the market Risk Premium Approach- Straightforward but less accurate- Based on adding a risk premium to known required return on bonds (stocks are riskier than bonds)o Risk premium should be based on estimated project risk- ke= kd + risk premiumo Estimates from the models may differ due to differences in the assumptions of eacho Newly Issued Securities Issuance and Informational costs prevent a firm from receiving the full trading price of each stock Cost is best estimated by DCF analysis-gPDknete1o Where Pnet = stock price – flotation costs- Divisional Costso Firm divisions may have different risk profiles It is not always appropriate to use the same cost of capital for all divisions withina firm Each division should have its own beta and discount rate dependent on risko This method is also used to calculate the risk of privately held companies, which do not have “official” beta values- Marginal Costs of Capitalo The Required Rate of Return will increase as a firm raises a greater amount of capital in ashorter amount of timeo To determine the MCC: Calculate w’s and k’s (weights and costs) of debt, equity, and preferred stock (if any) Calculate breakpoints- Breakpoints are dollar amount changes in the Cost of Capital Calculate Marginal Costs of Capital Order projects by return, highest to lowest Calculate the sum of the projects’ costs Compare each projects return to the cumulative sum and the MCC associated with each respective cost levelo Cost of Capital is not consistent – can change based on a variety of factors: Interest rate changes Firm may run out of RE to use for a project Stock issueso *Stated rates for investors are pre-tax rateso *Since borrowing money can be expensed, the investors receive the stated rate while the firm does not experience the full cost of borrowingChapter 13 – Capital Structure Concepts- Capital Structure includes:o Permanent Short-Term Debto Long Term Debto Common Stocko Preferred Stock- Financial Structure includes all of the above + seasonal short-term debt- Capital Structure Terms:o Optimal Structure Minimize WACC Maximize firm value & shareholder wealth Generally unknown (incomplete information)o Target Structure Structure at which the firm plans to operate Aims for what the optimal structure is believed to be Normally close to wherever the current structure iso Debt Capacity The amount of debt in the optimal structure- Determining Optimal Capital Structureo Business risk Debt financing adds risk; equity financing is preferred for industries that are already risky Sources of risk:- Variability of sales volume within the business cycleo If a firm has volatile sales, using a low amount of fixed costs will result in lower variability in EBIT (business risk)- Variability of pricing- Variability of cost(s)- Market power- Extent of product diversification- Level and rate of growth- Degree of operating leverageo Use of assets with fixed costso The greater the amount of operating leverage, the more sensitive EBIT will be to changes in sales.- Systematic risk- Unsystematic risko Financial Risk Variability of EPS and increased probability of bankruptcy More debt = more risk Financial leverage is the use of fixed-cost financing sources (debt)- Firms employ financial leverage in order to increase returns for shareholders.- The greater the business risk, the less financial leverage will be used Factors indicating Financial Risk:- Debt-to-Assets ratio- Debt-to-Equity ratio- Times Interest Earned ratio- Fixed Charge Coverage ratio- EBIT-EPS analysiso Tax structureo Bankruptcy potential The higher the risk of bankruptcy, the less debt should be used (same idea as business risk) Risk of bankruptcy when cash flows are less than interest paymentso Agency costso Signaling effects Investors often view new stock sales as a negative signal- Capital Structure Theoryo Relationships between: Capital structure (debt to assets) Cost of capital Firm valueo Modigliani & Miller Assumptions:- No taxeso Capital structure is irrelevant If leverage increases, the cost of equity increases to exactly offset the benefits of additional debt financingo If using debt creates value, shareholders can make a riskless profit by creating their own homemade leverageo Value of U = DU/ keUo Value of L = DL/ keL + I/ kdLo The values of the levered and unlevered firms are identical due to arbitrage- No bankruptcy costs- No agency costs- No transaction costs (brokerage fees)- No person can affect


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Clemson FIN 3120 - Final Exam Study Guide

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