Exam 4 Study Guide not exhaustive Chapter 14 1 Define Required Return 2 Define Cost of Capital a Return required on an investment to be profitable a Minimum required return on an investment i Cost of capital associated with an investment depends on the risk of that ii Cost of capital depends primarily on the use of funds not the source investment 3 Define Cost of Equity a Cost of equity is the return that investors require on their investment in the firm b Be able to calculate using the Dividend Growth Model Approach What are advantages and disadvantages of this approach i Advantages 1 Primary advantage is its simplicity 2 Easy to understand easy to use ii Disadvantages 1 Only applicable to companies that pay dividends 2 Key underlying assumption is that growth is constant model only applies to cases in which reasonably steady growth is likely to occur 3 Estimated cost of equity is very sensitive to the estimated growth rate a 1 increase in growth will increase Return significantly 4 Does not consider risk no direct adjustment for the riskiness of investment iii Formula for RE D1 P0 g disadvantages of this approach c Be able to calculate using the SML Approach What are the advantages and i Required or expected return on a risky investment depends on 3 things 1 The risk free rate Rf 2 The market risk premium E RM Rf 3 The systematic risk of the asset relative to average which we called its beta coefficient B ii E Rg Rf B E RM Rf iii Advantages 1 2 It explicitly adjusts for risk It is applicable to companies other than just those with steady dividend growth iv Disadvantages 1 Requires an estimation of the market risk premium and the beta coefficient a Can cause inaccurate results 2 We rely on the path to predict the future a Economic conditions can change quickly 4 Define Cost of Debt How is it calculated a Cost of debt is the return investors require on a firm s debt i Can be calculated using SML better just to use the interest rate the firm must pay on new borrowing 5 Define Cost of Preferred Stock How is it calculated a Preferred stock has a fixed dividend period forever perpetuity b RP Dividend Price of stock 6 What are Capital Structure Weights How are they calculated a Capital structure weights are the percentage of debt and the percentage of equity 7 How do taxes affect the WACC Interest paid by a corporation is deductible for tax purposes a b Payments to stockholders dividends are not 8 What is the Weighted Average Cost of Capital How is it calculated What is it used for a The weighted average cost of capital is the weighted average cost of equity plus the after tax cost of debt b WACC E V x RE D V x RD x 1 TC c It is the overall return the firm must earn on its existing assets to maintain the value of its stock If evaluating the cash flows from a proposed expansion of existing operations this is the discount rate to use d 9 What is the Pure Play Approach Why is it used in practice a The pure play approach is using the WACC that is unique to a particular project based on companies in similar lines of business b On Wall Street a company that focuses on a single line of business is called a pure play 10 What is the Subjective Approach Why is it used in practice a The subjective approach is when firms adopt an approach that involves making subjective adjustments to the overall WACC due to establishing discount rates for individual projects b Assuming all projects either fall into low moderate or high risk Mandatory has an irrelevant cost of capital because it must be taken 11 What are Flotation Costs Why must they be taken into account How should they be taken into account in calculations 2 ways a Flotations costs are the costs of issuing new bonds or stocks when they accept a new project i Sometimes it is suggested that a firm s WACC should be adjusted upward to reflect flotation costs this is not the best approach because the required return on an investment depends on the risk of the investment not the source of funds Chapter 16 1 What is the effect of leverage a Financial leverage refers to the extent to which a firm relies on debt b The more debt financing the firm uses in its capital structure the more financial leverage it employs c We describe the impact of leverage in terms of its effects on earnings per share or return on equity d When EBIT is high leverage is beneficial e Because the impact that financial leverage has on both the expected return to stockholders and the riskiness of the stock capital structure is an important consideration 2 What is Homemade Leverage What is its effect on investor preference and ROE a Homemade leverage is the use of personal borrowing to alter the degree of financial leverage i If all market participants have equal access to the capital markets there is nothing special about corporate borrowing b Any stockholder who prefers the capital structure can create it themselves using homemade leverage c Risk increases for stockholders which increases return on equity 3 Explain Capital Structure Theory as developed by Modigliani Miller assumptions thought process and results costs a Case I Business Risk and Financial Risk with no corporate taxes or bankruptcy i Prop I value of the firm is independent of the firm s capital structure ii Prop II As a firm raises its debt equity ratio the increase in leverage raises the risk of the equity which raises the required return 1 WACC stays the same 2 Business risk is the equity risk that comes from the nature of the 3 Financial risk is the equity risk that comes from the financial firm s operating activities policy capital structure b Case II Interest Tax Shield with corporate taxes interest payment x corporate tax rate i Failure to meet debt obligations can result in bankruptcy ii A levered firm will have a lower tax bill 1 Interest tax shield is the tax saving attained by a firm from interest expense iii Prop I because debt is perpetual same tax shield will be generated every 1 Debt and tax shield have the same discount rate 2 Value of a levered firm is higher than the value of an unlevered year firm iv Prop II 1 Use WACC a Without debt the WACC is higher therefore firm is better off with debt Optimal capital structure is the maximization of debt c Case III Bankruptcy Costs i Key disadvantage of using debt is bankruptcy costs ii Direct bankruptcy costs are those that are legal and administrative expenses iii Indirect bankruptcy costs are hard to measure generally take form of forgone revenues and
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