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FIN3204 Exam 4 – Chapters 14, 16, 17 Study GuideHow to Study:-Read over each part of this study guide and practice the problems in it.-Do these questions and problems in the textbook:Chapter 14: 3, 5, 7-10, 14-16Chapter 16: 4,6 (and the concepts and critical thinking questions- 1,3,4,5)Chapter 17: 1,4,5 (and the concepts and critical thinking questions- 1,2,3,5)-Familiarize yourself with the equation sheet. (attached)-Practice her review problems for exam 4 on blackboard. (attached with solutions)-For extra help, read over the textbook chapters, they help in content understanding.The In-Class Exam Review:-The Test: 13 conceptual12 problems3 bonus questions (NPV, IRR, Initial Cash Flows)-Ch. 14: 9 questions-Ch. 16: 8 questions-Ch. 17: 8 questions-know the chapter 17 textbook problems on stock splits-business risk and financial risk-homemade leverage definition-price adjustment on ex-dividend day-cash, special, extra dividends-different types of dates with dividends-how much time between the ex-dividend date and the day of record (2 business days)-chapter 14 the cost of equity can be found in 2 ways (dividend growth model and CAPM)-calculate the cost of debt and preferred stock-weighted average cost of capital equation-interest tax shield -don’t pay taxes on interest (tax deductible) -a firm that doesn’t care about this would be an all-equity (no debt) firm or a firm that doesn’t pay taxes-EBIT and breakdown calculations-which shareholders want low dividends and which want high dividends-weighted average cost of capital (the lower it is, the higher the firm’s value)-the lower the I/Y, the higher the NPV-capital structures (there isn’t a best, it varies across industries)-if given different cash flow, how to calculate WACC (get NPV by putting WACC as I/Y)Page 1CHAPTER 14: COST OF CAPITAL-the weighted average cost of capital (WACC) is the cost of capital for the firm as a whole-the required return on the overall firm14.1 The Cost of Capital: Some Preliminaries-the return an investor in a security receives is the cost of that security to the company that used it-our cost of capital provides us with an indication of how the market views the risks of our assets-knowing our cost of capital can help determine our required return for capital budgeting projects Required Return vs. Cost of Capital-when the return on the investment > the cost of capital, the NPV is positive-the required return is the smallest amount of return to compensate its investors for the use of capital needed to finance the project-required return = cost of capital = discount rate = interest rate = hurdle rate-the cost of capital for a risk-free investment is the risk-free rate-riskier projects have higher required returns-in other words, the cost of capital for riskier projects is greater than the risk-free rate-The cost of capital depends primarily on the use of the funds, not the source. Financial Policy and Cost of Capital-a firm’s cost of capital will reflect both its debt capital (to compensate its creditors) and its cost of equity (to compensate its shareholders)14.2 The Cost of Equity-cost of equity: the return that equity investors require on their investment in the firm given the business risk and financial risk of the cash flows from the firm-2 ways to determine the cost of equity1) The dividend growth model2) Security market line (SML) approach, or CAPM The Dividend Growth Model Approach- P0 = D0×(1+ g)RE−g = D1RE−g -P0 = price per share of the stock-g = the constant rate at which the dividend grows-D0 = the dividend just paid-D1 = the next period’s projected dividendD1 = D0 (1 + g)-RE = the required return on the stock (E stands for equity) ~ the firm’s cost of equity capitalPage 2RE = D1P0 + g-Dividend Growth Model Example: Suppose your company is expected to pay a dividend of $1.50 per share next year. There has been a steady growth in dividends of 5.1% per year and the market expects that to continue. The current price is $25. What is the cost of equity? RE = 1.5025+.051 = .111 = 11.1%-2 ways to estimate growth rate1) Use historical growth rates-find the dollar change in the dividends from year to year then divide that by the beginning years dividend to find the percent change to the next year-Ex. Year Dividend Percentage Change2005 1.23 -2006 1.30 (1.30-1.23) / 1.23 = 5.7%2007 1.36 (1.36-1.30) / 1.30 = 4.6%2008 1.43 (1.43-1.36) / 1.36 = 5.1%2009 1.50 (1.50-1.43) / 1.43 = 4.9%Average = (5.7 + 4.6 + 5.1 + 4.9) / 4 = 5.1%-advantages:-simple, easy to understand and use-disadvantages: -only applicable to companies currently paying dividends-not applicable if dividends aren’t growing at a reasonably constant rate-extremely sensitive to the estimated growth rate-an increase in g of 1% increases to cost of equity by 1%-does not explicitly consider risk2) Use analyst’s forecasts in the dividends The SML Approach (CAPM)-the required or expected return on a risky investment depends on 3 things:1) The risk-free rate, Rf2) The market risk premium, RE(¿¿m)−Rf¿3) The systematic risk of the asset relative to average, aka its beta coefficient, β- RE=Rf+βi(Rm−Rf)-RE = expected return-Rf = risk-free rate-βi = estimated beta-Rm = market risk-SML/CAPM approach Example: Suppose your company has an equity beta of .58, and the current risk-free rate is 6.1%. If the expected market risk premium is 8.6%, what is your cost of equity capital?RE = 6.1 +.58(8.6) = 11.1%-advantages: -explicitly adjusts for systematic risk-applicable to all companies, as long as we can estimate betaPage 3-disadvantages:-have to estimate the expected market risk premium, which does vary over time-have to estimate beta, which also varies over time-we are using the past to predict the future, which is not always reliable14.3 The Costs of Debt and Preferred Stock-in addition to ordinary equity, firms also use debt and preferred stock to finance their investments The Cost of Debt-cost of debt: the return that lenders require on the firm’s debt-the cost of debt is simply the interest rate the firm must pay on new borrowings, and we can observe interest rates in financial markets-ex. the yield to maturity on bonds outstanding is the market required rate on the firm’s debt-RD = cost of debt-we look at the yield on the debt in today’s marketplace-the cost of debt is NOT the coupon rate-Cost of Debt Example: Suppose we have a bond issue currently outstanding that has 25 years left to

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