Ch 8 Exam 3 Vocab 1 Preferred Stock 3 Protective Provisions 2 Cumulative dividends 6 Sinking fund provision 4 Convertibility 5 Call Provision Requires the firm to periodically set aside an amount of money for the a hybrid security with characteristics of both common stock and bonds At the discretion of the holder the stock can be converted into a predetermined Entitles a company to repurchase its preferred stock from holders at stated prices Preferred stock is similar to common stock in that it has no fixed maturity date the nonpayment of dividends does not bring on bankruptcy and dividends are not deductible for tax purposes Preferred stock is similar to bonds in that dividends are limited in amount dividends to provide protection for the preferred stockholder and carries a cumulative features that requires all past unpaid preferred stock dividends be paid before any common stock dividends are declared Generally allow for voting rights in the event of nonpayment of dividends or they restrict the payment of common stock dividends if the preferred stock payments are not met or if the firm is in financial difficulty number of shares of common stock over a given time period retirement of its preferred stock corporation s annual meeting amount he or she has invested in the firm board of directors is voted on separately number of directors being elected ownership in the firm of new shares of stock at a specified price during a 2 to 10 week period bought at the current market price security Certificates issued to the shareholders giving them an option to purchase a stated number gives a designated party the temporary power of attorney to vote for the signee at the Each share of stock allows the shareholder one vote and each position on the minimum rate of return necessary to attract an investor to purchase or hold a the rate of return the investor can expect to earn from the investment if it is a protective provision whereby the investor is not liable for more than the Each share of stock allows the stockholder a number of votes equal to the Entitles the common stockholder to maintain a proportionate share of a certificate that indicates ownership in a corporation the right to vote in stock matters 7 Common stock 8 Voting rights 9 Proxy 10 Limited Liability 11 Majority voting 15 Expected return 16 Required return 12 Cumulative voting 13 Preemptive right 14 Right Ch 9 1 Required rate of return or hold a security minimum rate of return necessary to attract an investor to purchase 5 Cost of debt 2 Flotation costs 4 Weighted average cost of capital a composite of the individual costs of financing incurred For the issuing firm the cost of debt is 1 the rate of return required by the firm s policies regarding the sources of financing it plans to use and the the transaction cost incurred when a firm raises funds by issuing a particular type of security 3 Financial policy particular mix proportions in which they will be used by each capital source A firm s weighed cost of capital is a function of 1 the individual costs of capital 2 the capital structure mix and 3 the level of financing necessary to make the investment investors 2 adjusted for flotation costs any costs associated with issuing new bonds and 3 adjusted for taxes return except that we have to consider the flotation costs associated with issuing preferred stock simply the stockholders required rate of return the mix of long term sources of funds used by the firm This is also called the firm s capitalization The relative total percentage of each type of fund is emphasized Since the stockholders own the firm s retained earnings the cost is Finding the cost of preferred stock is similar to finding the rate of 8 Cost of external equity 9 Capital structure 6 Cost of preferred stock 7 Cost of internal equity Knc D1 NP0 g Ch 10 1 Capital budgeting 2 Payback period the process of planning for purchases of long term assets How long will it take for the project to generate cash to pay for itself 3 Net present value the total PV of the annual net cash flows the initial outlay Drawbacks of Payback Period 1 Firm cutoffs are subjective 2 Does not consider time value of money 3 Does not consider any required rate of return 4 Does not consider all of the project s cash flows Decision Rule If NPV is positive accept If NPV is negative reject investment s initial outlay Decision Rule If PI is greater than or equal to 1 accept If PI is less than 1 reject Internal rate of return that the firm earns on its capital budgeting projects Decision Rule If IRR is greater than or equal to the required rate of return accept 5 the return on the firm s invested capital It is simply the rate of return 4 Profitability index the ratio of the present value of an investment s future free cash flows to the placing a limit on the dollar size of the capital budget 6 Capital rationing 7 Mutually exclusive If IRR is less than the required rate of return reject one will necessarily mean rejecting the others 8 Size disparity Mutually exclusive projects of unequal size projects that if undertaken would serve the same purpose Thus accepting The NPV decision may not agree with IRR or PI Solution select the project with the largest NPV 9 Time disparity big cash flows at the end When one project has big cash flows in the beginning and another project has NPV and PI assume cash flows are reinvested at the required rate of return for the project IRR assumes cash flows are reinvested at the IRR The NPV or PI decision may not agree with the IRR Solution select the project with the largest NPV 10 Unequal lives 11 Equivalent annual annuity When projects have different time periods of cash flows Simply annualize the NPV over the project s life Ch 11 4 Initial outlay 1 Incremental cash flow 2 Working capital 3 Sunk costs the difference between the cash flows a company will produce both with Associated with the project s termination and includes the annual free cash a cost that has already been incurred and cannot be recouped and therefore should What incremental cash flows occur over the life of the project a concept traditionally defined as a firm s investment in current assets the immediate cash outflow necessary to purchase the asset and put it in and without the investment it is thinking about making not be considered in an investment decision operating order 5 Annual cash flow 6 Terminal cash flow flow and salvage value of the project plus or minus any taxable gains or losses