FIN3403 Final Exam Review Chapter 14 Cost of Capital Cost of capital represents the estimated cost of the funding that firms use to finance most of their investments in real assets RRR associated with most projects that the firm will consider undertaking talking about the cost of new funding for investment purposes Steps involved in estimating a firm s cost of capital 1 Estimate the after tax cost of the long term financing sources used by the firm equity debt and 2 Determine the weight to be applied to each source of financing used the of the total capital structure possibly preferred stock that each source represents 3 Calculate the Weighted Average Cost of Capital WACC WACC WDRD BT 1 t WPRP WERE Because the markets RRR on a stock is the firm s cost of equity and it s not easy to estimate the Risk Premium and hence the RRR the cost of equity is difficult to estimate accurately Different approaches for estimating a firm s cost of equity 1 Constant Growth Dividend Valuation Model Approach a Only used for stocks that are characterized by the expectation that eps and dps will grow at a relatively constant rate for an indefinite period of time b Recall that P0 D1 r g i R required return ii G growth rate iii r P1 P0 g c RE D1 P0 g i D1 dividend ii P0 current price 2 CAPM Approach security b E Ri RF E RM RF Bi RE 3 Equity Risk Premium Approach a RE Firm s before tax cost of debt Equity risk premium RE YTM on the debt Equity risk premium a The E Ri on a security depends only upon the systematic risk nondiversifiable risk of a b Equity of firm is riskier than debt from the perspective of investors Therefore the firm s before tax cost of debt provides a base from which to start when estimating the cost of equity c The higher the long term debt costs the more riskier they are d Equity risk premium between 4 to 6 is reasonable Estimating the After Tax Cost of Debt RD AT RD BT 1 t YTM on LT Debt 1 t Estimating the Cost of Preferred Stock RP D P0 o P0 D r o D P0 r Determining the weights to apply to each source of financing Management of the firm will often specify a target capital structure the desired mix of long term financing sources that the firm desires to use in its capital structure For outsiders that are unaware of managements target capital structure the weights can be determined by calculating the market value of the firm s long term debt preferred stocks and common stock and then figuring out what each source represents of the total value o Market value of each source of shares or bonds outstanding x market price per security o MVTOTAL MVD MVP MVE WD MVD MVTOTAL WP MVP MVTOTAL WE MVE MVTOTAL Other issues pertaining to the cost of capital 1 Floatation costs and the weighted average cost of capital a Flotation costs arise when a firm issues new securities for the purpose of raising funds i They refer to the fees paid investment bankers who help the firm raise capital ii They lead to a reduction in a proposal s NPV if incorporated into the analysis iii Internally raised equity capital is preferred to externally raised equity capital 2 The WACC is the correct discount rate to use in capital budgeting when the project being evaluated has approximately the same risk as the average risk associated with the firms existing assets Chapter 16 Capital Structure Capital structure refers to the financing mix used by the firm to finance its assets The effects of using financial leverage debt financing on the remaining shareholders claims are 1 2 Increases the risk of the SH s claims because using financial leverage leads to greater variability in eps and the Return on Equity ROE for the SH s Increases the SHs expected rate of return as measured by expected eps or the expected ROE ROE net income total equity 3 Debt financing by the firm increases the risk of the claims of the common shareholders a The greater the percent of debt financing that you use for capital when starting the business the riskier your investment will be Business risk risk inherent in the firm s operations Financial risk additional risk associated with shareholders claims that is attributable to the firm financing some of its assets with debt financing The use of financial leverage increases the risk of the remaining SHs claims and increases the expected eps and ROE EBIT EPS Break even analysis for alternative financing plans EPS A EBIT I 1 t S and EPS EBIT I 1 t S B B B A A A S S EBIT I I BE B B A S S B A S S B A The relationship between eps and EBIT for a given financing plan is linear As EBIT changes the eps of the more highly levered plan will exhibit greater variability than that for the For any EBIT EBITBE the plan with more debt has higher eps less levered plan Graph on page 125 A world with no taxes and no bankruptcy costs We conclude capital structure decisions are irrelevant unimportant The mix of debt and equity employed does not affect the WACC or firm value There is no optimal capital structure Charts on page 126 A world with corporate taxes and costs associated with bankruptcy static theory of capital structure Since interest expense is tax deductible the amount of the EBIT which goes to SHs and BHs is increased as more debt financing is used and the government s portion decreases Results in an increase in the value of the firm as it begins to sue some debt financing When a firm increases its use of debt relative to equity the probability of going bankrupt increases The amount of cash flow projected to go to the shareholders and the debt holder has increased due to the tax deductibility of interest payments Charts on page 128 There is an optimal capital structure for a firm but our analysis does not indicate how to identify what the optimal D E mix is for a given firm The primary benefit associated with the use of debt financing is the tax subsidy thus firms in relatively high brackets with sufficient earnings to shelter for tax purposes are in a position to benefit from the tax break on interest payments A negative associated with using debt financing is that it results in an increase in expected bankruptcy costs Chart on page 129 Firms in high tax brackets with low levels of business risk are in the best position to use greater percentage of debt financing The logic of theory appears sound and we do observe some consistency with tis conclusions in the real world but also many exceptions The pecking order theory alternative to the static theory of capital structure that basically contends that when firms
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