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FSU FIN 3403 - STUDY GUIDE EXAM 4

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FIN3403STUDY GUIDE EXAM 4CHAPTERS 14, 16, 17, & 3Chapter 14: COST OF CAPITAL -The cost of capital is important to financial mangers because it REPRESENTS the estimated cost of the funding that firms use to finance most of their investments in real assets. -It is the required rate of return associated with most projects that the firm will consider undertaking. It is important to understand that we are talking about the cost of new funding for investment purposes. -RECALL: the internal Rate of Return must EXCEED the Required Rate of Return on the project for it to be acceptable, similarly when the projected cash flows of the project are discounted to the present (using the required rate of return on the project as the discount rate) and summed, they must exceed 0 for the project to be acceptable.Companies get their cost of capital from multiple sources: 1. Equity -Retained earnings -Common stock 2. Preferred stock 3. Debt -Issuing corporate bonds 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 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) as: WACC = WDRD,BT(1-t) + WERE + WPRP = WDRD,AT + WERE + WPRP *W = Weight *R = Required Return *t = Tax rate*D = Debt, E= Equity , P = Preferred Stock * RBT = Before tax  has to be adjusted to its after tax equivalent because interest payments are TAX DEDCUTIBLE Market value of Debt: # of shares/ Face vale * market value OR # bonds * price per bond Market Value of Preferred: Price per share * # of shares Market Value of Equity: Price * # of shares FINDING THE REUIRED RETURNS: Different Approaches for Estimating a Firm’s Cost of Equity : -The cost of equity is DIFFICULT to estimate accurately why?*RECALL: relationship between the markets Required Rate of Return on the stock and the risk of the stock. In essence the RRR on the stock is the firms cost of equity. T is not easy to precisely estimate the Risk Premium on a stock and hence the RRR. Therefore, a precise estimate of a firms cost of equity is difficult to generate 1. Constant Growth Dividend Valuation Model Approach: -This approach should ONLY be used for stock that are characterized by the expectation the eps and dps will grow at a relatively CONSTANT rate for an indefinite period of time. * Po= D1 / (r-g)  Re is the same are r in this equation so: RE = D1/P0 + g D1 = estimated dividend yield Po= estimated LT growth rate • If D1 is not given replace the numerator with  Do (1 +g)• “Just Paid”  Means Do2. CAPM Approach:- RECALL: CAPM holds that the RE on a security depends only upon the systematic risk (non-diversifiable risk) of a security:RE = Rf + [RRRM - Rf] ßi or RE = Rf + [RPMarket] ßi3. Equity Risk Premium Approach (not in text)-Formula: RE = YTM on the debt + Equity risk premium** Logic of approach: -Equity of firm is riskier than debt from the perspective of INVESTORS. Therefore, the firms before tax cost of debt provides a base from which to start when estimating the cost of equity -AT present, some firms have long term debt cost in the 4 -5 % range while others which are much RISKIER might have a long term debt cost in excess of 10% or even 15%-Thus, differences n risk across firms are reflected to some extent in difference in cost of debt for the firms -How large the equity risk premium should be a question that mist be answered when using this approach. Somewhere in the range of 4-6 percent would seem reasonable. Also, the equity risk premium would not necessarily ne the same for all firms Estimating the After-Tax Cost of Debt: -General Procedure: 1. Calculate the YTM on the firms outstanding long-term debt and then adjust for the tax deductibility of interest payments. The YTM represents the firm’s current before tax cost of debt. *Debt pays interest, which is tax deductible; in other word interest creates a TAX SHIELDFormal: RD, AT = RD,BT *(1-t) = YTM on LT Debt (1-t)-Using debt gives a firm a tax shelter. HIGHER interest means LOWER taxable income at the expense of additional risk -Debt is also known as financial leverage using leverage can be very good thing for the stockholder of the company -Increase the proportion of debt will tend to decrease WACCEstimating the Cots of Preferred Stock: Formula: RP = D/P0 D= Divided and P= current price*The payment of preferred stock is constant and has no maturity and it does NOT increase in value when firm value increase Determining the Weights to Apply to Each Source of Financing: 1. The management of a 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). If this is available, the weights can be used as specified 2. 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 stock, and common stock, respectively, and then figuring out what each source represents of the total value. *Market value of each source = # of shares or bonds outstanding X Market price per security Formula: WD = MVD / MVTOTALWP = MVP / MVTOTALWE = MVE / MVTOTAL MV total = MVD + MVP + MVESum W should = 1.00 MV = # shares/ bonds / Market price 3. An Alternative method for estimating the weights would be to use Book Value for Debt and Equity from the balance sheet. This Approach can product estimated that weights differ substantially from those obtained using market values because of the large difference that often exist between book values and market values for equity *Whenever possible, market values (not book values) should be used in estimating weights as market values are used in estimating the cost of each source of financing Other conceptual Issues pertaining to the Cost of Capital: 1. Flotation Costs and the Weighted Average Cost of Capital: -Flotation costs arise when a firm issues new securities for the purpose of raising funds. These refer to the fees paid investment bankers who help the firm raise capital.* For new equity these costs can be substantial, ranging from 3% to 10% of the gross proceeds. The percentage fees are lower for preferred stock and bond issues


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