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FIN3204 Exam 4 Chapters 14 16 17 Study Guide How 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 16 Chapter 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 conceptual 12 problems 3 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 1 CHAPTER 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 firm 14 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 equity 1 The dividend growth model 2 Security market line SML approach or CAPM The Dividend Growth Model Approach P0 D 0 1 g R E g D1 R E g price per share of the stock P0 g the constant rate at which the dividend grows D0 D1 the dividend just paid the next period s projected dividend D1 D0 1 g Page 2 R E the required return on the stock E stands for equity the firm s cost of equity capital R E g D1 P0 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 R E 051 111 11 1 1 50 25 2 ways to estimate growth rate 1 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 Change 2005 1 23 2006 1 30 2007 1 36 2008 1 43 2009 1 50 Average 5 7 4 6 5 1 4 9 4 5 1 1 30 1 23 1 23 5 7 1 36 1 30 1 30 4 6 1 43 1 36 1 36 5 1 1 50 1 43 1 43 4 9 advantages disadvantages simple easy to understand and use 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 risk 2 Use analyst s forecasts in the dividends The SML Approach CAPM 1 The risk free rate Rf 2 The market risk premium R E m R f the required or expected return on a risky investment depends on 3 things 3 The systematic risk of the asset relative to average aka its beta coefficient risk free rate estimated beta R E R f i Rm R f R E expected return Rf i 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 advantages R E 6 1 58 8 6 11 1 explicitly adjusts for systematic risk applicable to all companies as long as we can estimate beta Page 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 reliable 14 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 R D 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 …

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