Exam 4 Review Chapter 14 6 computational 3 conceptual Chapter 16 4 computational 4 conceptual Chapter 17 4 computational 4 conceptual Know how to calculate the WAAC and all of its components weights cost of equity cost of preferred cost of debt tax adjustment Weighted Average Cost of Capital WAAC overall return the firm must earn on its assets to maintain the value of its stock It is a market rate that is based on the market s perception of the risk of the firm s assets When a firm has different operating division with different risks its WAAC is an average of the divisional required returns In such cases the cost of capital for projects of average risk in each division needs to be established If you use a firms WAAC across divisions then riskier divisions will receive the bulk of the funding and less risky divisions will have to forgo what would be good projects if the appropriate discount rate were used This will lead to an increase in risk for the overall firm WAAC WERE WDRDBT 1 TC WERE WPRP WDRDAT WERE WPRP RDAT RDBT 1 TC V D E D V D E 1 D E E V 1 1 D E 100 E V D V Capital Structure Weights E market value of equity outstanding shares x price per share D market value of debt outstanding bonds x bond price V market value of firm D E WE E V percent financed with equity WD D V percent financed with debt WP P V percent financed by preferred Cost of Equity the cost of equity is the required return by equity investors given the risk of the cash flows from the firm Business risk Financial risk two major methods for determining cost of equity 1 Dividend Growth Model Approach RE D1 PO g D1 DO 1 g Advantages easy to understand and use Disadvantages only applicable to companies currently paying dividends not applicable if dividends aren t growing at a reasonably constant rate extremely sensitive to the estimated growth rate does not explicitly consider risk 2 CAPM Approach RE RF BE E RM RF Risk Free rate RF Market risk premium E RM RF systematic risk of asset BE Advantages explicitly adjusts for systematic risk applicable to all companies as long as we can estimate beta Disadvantages estimate the expected market risk premium which varies over time estimate beta which varies over time using the past to predict the future which is not always reliable Cost of Preferred preferred stock generally pays a constant dividend each period dividends are expected to be paid every period forever preferred stock is a perpetuity RP D PO Cost of Debt required return on company s debt equal to the yield to maturity because it is the market rate of interest that would be required on new debt issues NOT the coupon rate the coupon rate is the firm s promised interest payments on existing debt and the current yield is the income portion of total return Calculate by finding yield to maturity Taxes and the WAAC we are concerned with after tax cash flows so we also need to consider the effect of taxes on the various costs of capital interest expense reduces our tax liability this reduction in taxes reduces our cost of debt After tax cost of debt RD 1 TC dividends are not tax deductible so there is no tax impact on cost of equity WAAC WERE WDRD 1 TC Know the advantages disadvantages of various sources of capital which is most expensive which is least expensive and why when Cost of capital required return and appropriate discount rate are different phrases that all refer to the opportunity cost of using capital in one way as opposed to alternative financial market investments of the same systematic risk required return is from an investor s point of view cost of capital is the same return from the firm s point of view appropriate discount rate is the same return used in a PV calculation Know the relationship between floatation costs and WAAC flotation costs and NPV Floatation Costs the required return depends on the risk not how the money is raised however the cost of issuing new securities should not just be ignored either Basic Approach adjust the cost of each source of financing to account for the floatation costs associated with that source Thus the firm s would be somewhat higher if floatation costs are accounted for WAAC Know what financial leverage is and how it affects the firm as well as which firms would have high or low leverage ratios Financial Leverage the firm can increase leverage by issuing debt and repurchasing outstanding shares when we increase the amount of debt financing we increase the fixed interest expense the firm can decrease leverage by issuing new shares and retiring outstanding debt leverage amplifies the variation in both EPS and ROE the variability in both ROE and EPS increases when financial leverage increases ROE Net Income Equity EPS Net Income outstanding shares effect of financial leverage depends on EBIT financial leverage increase ROE and EPS when EBIT is great than the cross over point if we have a good year then we pay our fixed cost and we have more left over for our stockholders if we have a bad year then we still pay our fixed costs and we have less leftover for our stockholders Know the primary goal of financial managers Goal maximize stockholder wealth choose the capital structure that will maximize stockholder wealth can maximize stockholder wealth by maximizing the value of the firm or minimizing WAAC Know the M M Proposition II and be able to calculate cost of equity with tax and cost of equity without tax Modigliani and Miller Theory of Capital Structure the value of the firm is determined by the cash flows to the firm and the risk of the assets changing firm value change the risk of cash flows change the cash flows RA is the cost of the firm s business risk ie The risk of the firm s assets RA RD D E is the cost of the firm s financial risk ie the additional return required by stockholders to compensate for the risk of leverage Annual interest tax shield total value of bond coupon rate tax rate Case I Assumptions no corporate taxes no bankruptcy costs M M Proposition II with no taxes RE RA RA RD D E RA WAAC E V RE D V RD as more debt is used the return on equity increases but the change in proportion of debt versus equity just offsets that increase and WAAC does not change the value of the firm is NOT affected by changes in capital structure the cash flows of the firm do not change therefore value doesn t change the WAAC of thee firm is NOT affected by capital structure no optimal capital structure Case II Assumptions corporate taxes bankruptcy costs M M
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