FIN3403 Final Exam Conceptual Study Guide Chapter 14 Cost of capital is important to financial managers because it represents the hurdle rate for most investment proposals to be deemed acceptable Also the cost of capital is the cost of the long term financing equity LT debt preferred stock Steps in Estimating a Firm s Cost of Capital 1 Estimate the after tax cost of long term financing equity debt and possible preferred stock 2 Determine the weight to be applied to each sector of financing 3 Calculate the WACC The WACC is the correct discount rate to use in capital budgeting when the project has the same risk as the average risk associated with the firms existing assets But if the project has a different risk that is more or less than the average risk then it would be incorrect to use the WACC as the discount rate For projects that are riskier than average the RRR should be set higher than the firm s WACC and vice versa for project s with less risky than average Know concept don t have to compute The cost of equity is difficult to estimate correctly because it is not easy to precisely estimate the risk premium on a stock Different Approaches for Estimating a Firm s Cost of Equity 1 Constant Growth Dividend Valuation Model Approach This approach should only be used for stocks that are characterized by the expectation the eps and dps will grow at a relatively constant rate for an indefinite period of time Only 3 4 of firms 2 CAPM Approach 3 Equity Risk Premium Approach Depends on only upon the systematic risk no diversifiable risk of a security Firm s before tax cost of debt is the YTM on the debt The equity risk premium is typically between 4 6 Logic The equity of the firm is riskier than the 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 Estimating the After tax Cost of Debt 1 Calculate the YTM on firm s outstanding long term debt YTM before tax cost of debt 2 Then adjust for the tax deductibility of interest payments Floatation costs arise when a firm issues new securities This refers to the fees paid to investment bankers who helped the firm raise capital It would decrease the firm s NPV for new equities cost can be 5 to 10 of gross proceeds Chapter 16 Capital Structure refers to the long term financing mix used by the firm the weighted debt equity and preferred stock Focus only on debt equity mix because preferred is used sparingly by most firms if at all Firms should strive to choose the debt equity mix that minimizes its WACC and maximizes the firm value But if the WACC and the market value of the firm do not change as the debt equity changes then capital structure decisions are unimportant The effect of using financial leverage is that it increases the risk of the shareholder s claims because it leads to greater variability in eps and the ROE for the shareholder s It increases the rate of return Business risk relates to the variability in a firm s eps distribution that would exist if the firm were entirely financed with common equity 100 ownership capital Financial risk refers to the added variability in the eps distribution that the shareholders face due to the use of financial leverage debt financing EBIT EPS Breakeven Analysis for Alternative Financing Plans The relationship between eps and EBIT for a given financing plan is linear The easiest way to draw the relationship is to use the EBIT EPS Indifference point and the level EBIT which produces an eps of zero as two points on the line The steeper the slope of the EBIT EPS line the greater the variability in EPS as EBIT varies Does an optimal capital structure exist for a firm It depends Case 1 In a world without taxes and no bankruptcy costs The debt equity mix employed does not affect the firm s value or the WACC Capital structure decisions are irrelevant because altering the debt equity mix just repackages the claims against the firm s expected EBIT stream all of which goes to shareholders and bondholders The amount of expected EBIT does not depend upon the mix employed nor does the business risk which relates to the uncertainty in firm s EBIT stream As a firm uses more debt financing and less equity both the risk of the remaining shareholders claims and the expected return increases but the share price is unchanged because the higher expected earnings is just offset by the higher risk WACC is constant and value can not be created Nothing changes not even the total risk Case 2 In a world with corporate taxes and costs associated with bankruptcy Here the shareholders bondholders and the government have a claim against the firm s EBIT Since interest expense is tax deductible the amount of the EBIT which goes to SH s and BH s is increased as more debt financing is used and the government s portion decreases This results in an increase in the value of the firm as it uses debt financing But as more debt financing is used the chances of bankruptcy increases but these costs eventually offset the tax subsidy on debt financing Finally there is a debt equity mix that results in a minimum WACC when the benefits of the tax subsidy are just offset by the increase in expected bankruptcy costs In other words the amount of cash flow projected to go to the shareholders and the debt holders has increased due to the tax deductibility of interest payments To summarize the primary benefit of using debt financing is the tax subsidy and the negative outcome is the increase in bankruptcy costs Firms in high tax brackets with low levels of business risk are in the best position to use greater amounts of debt financing The pecking order theory is an alternative to the static theory of capital structure that basically contends that when firms raise new financing they resist going to the capital markets to avoid floatation costs through internal generated equity from retention of earnings or new debt financing Chapter 17 Alternative ways that firms may utilize their earnings is by reinvesting in new projects hoard the cash pay dividends or repurchase some of their outstanding common stock Cash dividends are declared by the Board of Directors and are generally paid on a quarterly basis Declaration Date date Boards declares dividends Ex Dividend Date the date the dividend stays with seller two days before record date Record Date declared dividends are distributed to holder of record on a specific date Payment Date the dividend checks are
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