Exam 4 Study Guide not exhaustive Chapter 14 Define Required Return The return required on an investment to be profitable o Otherwise known as the discount rate suppose the required return is 10 we usually mean that an investment will have a positive NPV only if its return exceeds 10 Define Cost of Capital Cost of Capital is the minimum required return on an investment o Required return appropriate discount rate and cost of capital are mostly interchangeable terms because they all mean essentially the same thing o Key fact to grasp is that the cost of capital associated with an investment depends on the risk of that investment o The cost of capital depends primarily on the use of funds not the source Define Cost of Equity Cost of equity is the return that investors require on their investment in the firm o Be able to calculate using the Dividend Growth Model Approach What are advantages and disadvantages of this approach o RE D1 P0 g o Advantages o Disadvantages Primary advantage is its simplicity Easy to understand easy to use Only applicable to companies that pay dividends Key underlying assumption is that growth is constant model only applies to cases in which reasonably steady growth is likely to occur Estimated cost of equity is very sensitive to the estimated growth rate a 1 increase in growth will increase RE significantly Does not consider risk no direct adjustment for the riskiness of investment Greater States Public Service a large public utility paid a dividend of 4 per share last year The stock currently sells for 60 per share You estimate that the dividend will grow steadily at a rate of 6 percent per year into the indefinite future What is the cost of equity capital for Greater States o Example Given this the cost of equity RE is D1 D0 X 1 g 4 X 1 06 4 24 RE D1 P0 g 4 24 60 06 13 07 Be able to calculate using the SML Security Market Line CH 13 Approach What are the advantages and disadvantages of this approach o Required or expected return on a risky investment depends on 3 things The risk free rate Rf The market risk premium is E RM Rf E RM is the Expected Return on The systematic risk of the asset relative to average which we called its beta the Market coefficient o SML equation E Rg Rf E RM Rf Avercrombie and Fitch had an estimated beta of 1 68 In chapter 12 we saw that one estimate of the market risk premium based on large common stocks is about 7 U S Treasury bills are paying about 10 so we will use this as our risk free rate 10 1 68 7 11 86 Define Cost of Debt How is it calculated E Rg Rf E RM Rf Cost of debt is the return investors require on a firm s debt Will be noted as RD Can be calculated using the SML approach but that isn t necessary o Unlike cost of equity cost of debt can be observed directly or indirectly No need to estimate a beta because we can observe the rate we want to know o Cost of debt is the interest rate the firm must pay on new borrowing o If the firm already has bonds outstanding then the YTM on those bonds is the market required rate on the firm s debt o If the bonds are for example rated AA then we can look up the interest rate on newly issued AA bonds Be careful of this Example o Coupon rate on firm s debt is irrelevant here Rate just tells us what the firm s cost of debt was back when the bonds were issued not what cost of debt is today o Suppose the General Tool Company issued a 30 year 7 percent bond 8 years ago The bond is currently selling for 96 of face value or 960 What is General Tool s cost of debt o Because the bond is selling at a discount the yield is greater than 7 percent but not much greater because the discount is fairly small Calculate YTM N 44 30 year bond 8 years ago 22 multiply by 2 because semiannual PV 960 PMT 35 7 percent of face value then divide by 2 for semiannual FV 1000 CPT I Y 3 685 x 2 7 37 Define Cost of Preferred Stock How is it calculated Preferred stock has a fixed dividend period forever so a share of preferred stock is essentially a perpetuity Denoted as RP RP D P0 D is fixed dividend and P0 is the current price per share of preferred stock Example o On feb 23 2011 Alabama Power Co had two issues of ordinary preferred stock with 100 par value One issue paid 4 72 annually and sold for 84 a share The other paid 4 6 per share annually and sold for 84 5 per share What is Alabama Power s cost of preferred stock o RP D P0 stock 1 o 4 72 84 o 5 6 o RP D P0 stock 2 o 4 6 84 5 o 5 4 o Cost of preferred stock is about 5 5 average of both What are Capital Structure Weights How are they calculated Capital Structure Weights are the percentage of Debt and the percentage of Equity V E D 100 E V D V Example o If the total market value of a company s stock equity were calculated as 200 million and the market value of the company s debt were calculated as 50 million then the combined Value would be 250 million E V 200 250 80 D V 50 250 20 How do taxes affect the WACC Interest paid by a corporation is deductible for tax purposes Payments to stockholders such as dividends are not Pretax and Aftertax cost of debt o Suppose a firm borrows 1 million at 9 interest The corporate tax rate is 34 What is the aftertax rate of interest on this loan The total interest will be 90 000 per year This amount is tax deductive however so the 90 000 interest reduces the firm s tax bill by 34 X 90 000 30 600 The aftertax interest bill is thus 90 000 30 600 59 400 The aftertax interest rate is 59 500 1 million 5 94 RD X 1 TC or 9 X 1 34 5 94 What is the Weighted Average Cost of Capital How is it calculated What is it used for The weighted average cost of capital WACC is the weighted average cost of equity and the aftertax cost of debt WACC E V X RE D V X RD X 1 TC It is the overall return the firm must earn on its existing assets to maintain the value of its stock It is also the required return on any investments by the firm that have essentially the same risks as existing operations If evaluating the cash flows from a proposed expansion of existing operations this is the discount rate we should …
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