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FSU FIN 3403 - Final Exam Review

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FIN3403 Final Exam ReviewChapter 14: Cost of CapitalCost 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 purposesSteps involved in estimating a firm’s cost of capital1. Estimate the after-tax cost of the long-term financing sources used by the firm (equity, debt, and possibly preferred stock)2. Determine the weight to be applied to each source of financing used (the % of the total capital structure that each source represents)3. Calculate the “Weighted Average Cost of Capital” (WACC)WACC = WDRD,BT(1-t) + WPRP + WEREBecause 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 accuratelyDifferent approaches for estimating a firm’s cost of equity1. Constant Growth Dividend Valuation Model Approacha. 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 timeb. Recall that P0 = D1 / (r-g) i. R= required returnii. G= growth rateiii. r = P1/P0 + gc. RE = D1 / P0 + gi. D1 = dividendii. P0 = current price2. CAPM Approacha. The E(Ri) on a security depends only upon the systematic risk (nondiversifiable risk) of a securityb. E(Ri) = RF + [E(RM) – RF] Bi = RE3. Equity Risk Premium Approacha. RE = Firm’s before tax cost of debt + Equity risk premiumRE = YTM on the debt + Equity risk premiumb. 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 equityc. The higher the long term debt costs the more riskier they ared. Equity risk premium between 4% to 6% is reasonableEstimating 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/P0o P0 = D/ro D = (P0)rDetermining 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 valueo Market value of each source = # of shares or bonds outstanding x market price per securityo MVTOTAL = MVD + MVP + MVE WD = MVD / MVTOTAL WP = MVP / MVTOTAL WE = MVE / MVTOTALOther issues pertaining to the cost of capital1. Floatation costs and the weighted average cost of capitala. Flotation costs arise when a firm issues new securities for the purpose of raising fundsi. They refer to the fees paid investment bankers who help the firm raise capitalii. They lead to a reduction in a proposal’s NPV if incorporated into the analysisiii. Internally raised equity capital is preferred to externally raised equity capital2. 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 assetsChapter 16: Capital StructureCapital structure refers to the financing mix used by the firm to finance its assetsThe effects of using financial leverage (debt financing) on the remaining shareholders’ claims are:1. 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’s2. 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 shareholdersa. The greater the percent of debt financing that you use for capital when starting the business, the riskier your investment will beBusiness risk- risk inherent in the firm’s operationsFinancial 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 ROEEBIT-EPS Break-even analysis for alternative financing plans• EPSA = [ (EBIT - IA)(1-t) ] / SA and EPSB = [ (EBIT - IB)(1-t) ] / SB SB SA• EBITBE =  IA -  IB SB - SA SB – SA• 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 less levered plan• For any EBIT > EBITBE the plan with more debt has higher eps• Graph on page 125A 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 126A 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 129Firms in high tax brackets with low levels of business


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