1) The CFO provided information on the firm's capital structure, bond yields, stock prices, tax rates, and growth expectations to estimate the WACC.
2) The costs of debt, preferred stock, and retained earnings were calculated using the bond yield, dividend yield, CAPM, and DCF approaches.
3) The WACC was estimated to be 7.58% using a 40% weight on debt at 3.6%, 10% weight on preferred stock at 7.4%, and 50% weight on retained earnings at 10.08%.
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
This presentation is an overview of Capital Structure Theories.
Dr. Soheli Ghose ( Ph.D (University of Calcutta), M.Phil, M.Com, M.B.A., NET (JRF), B. Ed).
Assistant Professor, Department of Commerce,St. Xavier's College, Kolkata.
Guest Faculty, M.B.A. Finance, University of Calcutta, Kolkata
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
Discuss the concept of risk in investment decisions.
Understand some commonly used techniques, i.e., payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting.
Focus on the need and mechanics of sensitivity analysis and scenario analysis.
Highlight the utility and methodology simulation analysis.
Explain the decision tree approach in sequential investment decisions.
Focus on the relationship between utility theory and capital budgeting decisions.
Risk and Return: Portfolio Theory and Assets Pricing ModelsPANKAJ PANDEY
Discuss the concepts of portfolio risk and return.
Determine the relationship between risk and return of portfolios.
Highlight the difference between systematic and unsystematic risks.
Examine the logic of portfolio theory .
Show the use of capital asset pricing model (CAPM) in the valuation of securities.
Explain the features and modus operandi of the arbitrage pricing theory (APT).
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
Discuss the concept of risk in investment decisions.
Understand some commonly used techniques, i.e., payback, certainty equivalent and risk-adjusted discount rate, of risk analysis in capital budgeting.
Focus on the need and mechanics of sensitivity analysis and scenario analysis.
Highlight the utility and methodology simulation analysis.
Explain the decision tree approach in sequential investment decisions.
Focus on the relationship between utility theory and capital budgeting decisions.
Risk and Return: Portfolio Theory and Assets Pricing ModelsPANKAJ PANDEY
Discuss the concepts of portfolio risk and return.
Determine the relationship between risk and return of portfolios.
Highlight the difference between systematic and unsystematic risks.
Examine the logic of portfolio theory .
Show the use of capital asset pricing model (CAPM) in the valuation of securities.
Explain the features and modus operandi of the arbitrage pricing theory (APT).
MECH 3330 Project 2 Due 12116 Design a tube bank that .docxARIV4
MECH 3330 Project 2 Due: 12/1/16
Design a tube bank that will increase the temperature of a 1200 CFM flow of air from 35⁰F to
100⁰F. Assume a constant pressure of 1atm. Each tube will have a diameter of 0.5in and a
length of 24in. The tube configuration must fit in an area of 18in by 18in. Assume reasonable
uniform surface temperature for the outside of the tubes.
Finding will be presented in a report with a memo cover sheet. A narrative including an
Introduction, Analysis Methods, Results, and Conclusions needs to be provided.
Introduction: Describe the problem
Analysis Methods: Describe the methods used to analyze the problem. Include equations used
and any other tools used.
Results: Provide a dimensioned drawing of the design along with any results obtained from
calculations or other analysis methods. The drawing should include the tube configuration,
number of tubes, and tub spacing.
Conclusions: Provide a summary of the problem, analysis, and results. Also discuss what
measurements and controls should be added to insure 100⁰F air at the exit.
Notes:
The report must be created in a word processing program.
All drawings must be created with a computer aided drafting program.
Internally Reference all research sources and also include a reference page
FINAL EXAM MGT 5002
MULTIPLE CHOICE CHAPTER 9
(9-5) Required return
1). If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks
a. the stock is experiencing supernormal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.
(9-1) Preemptive right
2). The preemptive right is important to shareholders because it
a. allows managers to buy additional shares below the current market price.
b. will result in higher dividends per share.
c. is included in every corporate charter.
d. protects the current shareholders against a dilution of their ownership interests.
e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
(9-2) Classified stock
3). Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
a. All common stocks fall into one of three classes: A, B, and C.
b. All common stocks, regardless of class, must have the same voting rights.
c. All firms have several classes of common stock.
d. All common stock, regardless of class, must pay the same dividend.
e. Some class or classes of common stock are entitled to more votes per share than other classes.
(9-5) Constant growth model
4). If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.
a. The expected return on the stock is 5% a year.
b. The stock’s ...
The cost of funds used for financing a business. Cost of capital depends on the mode of financing used – it refers to the cost of equity if the business is financed solely through equity, or to the cost of debt if it is financed solely through debt. Many companies use a combination of debt and equity to finance their businesses, and for such companies, their overall cost of capital is derived from a weighted average of all capital sources, widely known as the weighted average cost of capital (WACC). Since the cost of capital represents a hurdle rate that a company must overcome before it can generate value, it is extensively used in the capital budgeting process to determine whether the company should proceed with a project.
2. WACC calculation
You have been just hired as a financial consultant by Harry Davis
Industries. Your assignment is to estimate the firm's cost of capital.
The CFO assembled the following information for you:
1. The firm's marginal tax rate is 40 percent.
2. The firm has outstanding an issue of 8 percent, semiannual coupon, $1,000 par
value bonds with 10 years remaining to maturity. They sell at a price of
$1,148.77. New bonds will be privately placed with no flotation cost.
3. The current price of the firm's perpetual preferred stock (8 percent, $100 par
value) is $114.29. New perpetual preferred stock could be sold to the public at
this price, but Davis would incur flotation costs of 5%.
4. The firm's common stock is currently selling at $50 per share. Its last dividend
was $3, and investors expect the dividend to grow at a constant 4 percent
annual rate into the foreseeable future. The firm's beta is 1; the current yield on
T-bonds is 5 percent; and the market risk premium is estimated at 6 percent.
When using the firm's own bond-yield-plus-risk-premium approach, the
managers assume a risk premium of 4 percentage points.
5. The firm's target capital structure is 40 percent long-term debt, 10 percent
preferred stock, and 50 percent common equity.
3. PARTS OF THE QUESTION
A. Calculate the firm's component costs of debt.
B. Calculate the firm's cost of preferred stock.
C. Assume that the firm is using only retained earnings as equity capital.
Calculate the firm’s cost of retained earnings with the following three
methods:
Calculate the firm's estimated cost of retained earnings based on the
CAPM approach.
Calculate the estimate of the firm's cost of retained earnings based on the
DCF approach.
Calculate the firm's cost of retained earnings based on the bond-yield-
plus-risk premium approach.
D. Calculate the firm's weighted average cost of capital (WACC).
E. Assume that the firm used up all of its retaining earnings and it has to start
issuing common stock with a flotation cost of 20 percent. What will its
cost of common equity be?
4. LET’S SEE WHAT WE HAVE ALREADY
1. -Marginal tax rate is 40%
-Outstanding is 8%
-Semiannual coupon
-Par value of bonds $1,000
-Maturity is 10 years
-Selling price is $1,148.77
-No flotation cost.
2. -Perpetual preferred stock is $114.29
-Par value of bonds $100
-Outstanding is 8%
-Stock could be sold
5. 3. -Common stock selling price is $50 per share
-Dividend is $3
-Expect the dividend to grow at a constant 4 percent
annual rate into the foreseeable future.
-Beta is 1
-T-bonds is 5%
-RPm is 6%
* own bond-yield-plus-risk-premium approach,
assume a risk premium of 4 percentage points.
4. -capital structure is;
40% long-term debt, - Wd
10% preferred stock, - Wps
50% common equity. - Ws
6. NOW LET’S SEE THE QUESTIONS
AGAIN
A. Calculate the firm's component costs of debt.
B. Calculate the firm's cost of preferred stock.
C. Assume that the firm is using only retained earnings as equity capital.
Calculate the firm’s cost of retained earnings with the following three
methods:
Calculate the firm's estimated cost of retained earnings based on the
CAPM approach.
Calculate the estimate of the firm's cost of retained earnings based on the
DCF approach.
Calculate the firm's cost of retained earnings based on the bond-yield-
plus-risk premium approach.
D. Calculate the firm's weighted average cost of capital (WACC).
E. Assume that the firm used up all of its retaining earnings and it has to start
issuing common stock with a flotation cost of 20 percent. What will its
cost of common equity be?
7. *Capital Components
Capital components are sources of
funding that come from investors.
Accounts payable, accruals, and deferred
taxes are not sources of funding that
come from investors, so they are not
included in the calculation of the cost of
capital.
8. *Before-Tax vs.
After-Tax Capital Costs
Firms should incorporate the tax effects
in the cost of capital. They should focus
on the after-tax costs.
Only the cost of debt is affected because
interest is a tax-deductable expense.
9. A. Calculate the firm's component costs of debt.
Since the bond is selling above par, the cost of
debt is less than the coupon interest rate.
The cost of debt is the discount rate that
makes the bond's future cash flows (i.e.,
coupon interest and par value payments)
equal to the market price of the bond. It is
3% semiannually and 6% annually. Therefore
after tax cost of capital is:
Rd AT = rd BT(1 – T)0.036= 0.06(1-0.40)
10. B. Calculate the firm's cost of preferred stock
Cost of preferred stock: Pps = $114.29, Div=8%, Par =
$100, F = 5%
formula:
Dps 0.08 ($100)
Rps= =
Pps (1 – F) $114.29 (1 – 0.05)
$8
= = 0.074 = 7.4%
$108.57
10
11. *Cost of Preferred Stock
Flotation costs for preferred stock are
significant, so are reflected. Use net
price.
Preferred dividends are not tax
deductible, so no tax adjustment.
12. Three ways to determine
the cost of retained earnings
1. CAPM: rs = rRF + (rM – rRF) b
= rRF + (RPM) b
2. DCF: rs = D1/P0 + g
3. Own-Bond-Yield + Judgmental
Risk Premium: rs = rd + JRP
12
13. *What are the two ways that
companies can raise common
equity?
•By retaining earnings that are not paid
out as dividends.
•By issuing new shares of common
stock.
14. *Cost for Retained Earnings
Opportunity cost: The return
stockholders could earn on alternative
investments of equal risk.
They could buy similar stocks and earn rs,
or company could repurchase its own
stock and earn rs. So, rs, is the cost of
reinvested earnings and it is the cost of
common equity.
15. C. Assume that the firm is using only retained earnings as equity
capital. Calculate the firm's estimated cost of retained earnings
based on the CAPM approach.
Rs = Rrf + (RPm)b
Rs = 4% + 6%.1 = 10%
16. C. Calculate the estimate of the firm's cost of retained
earnings based on the DCF approach.
• Rs = [D0 * (1+g)] / P0 + g
• Rs = 3 * (1.04) / 50 + 0.04 = 0.1024
17. C. Calculate the firm's cost of retained earnings
based on the bond-yield-plus-risk premium
approach.
the own bond yield is 6%. The risk
premium is given as 4%. Therefore, the
cost of retained earnings with the third
method is:
6%+4%=10%
18. *Comparing and Awerage of the
Three Methods
In practice, most firms use the CAPM to
estimate the cost of equity capital.
Many firms use the DCF method.
Some firms estimate the cost of equity
capital by adding a risk premium to their
bond interest rate.
Brigham and Ehrhardt suggest that the
average of the three methods can be used
in estimating the cost of equity capital.
19. What’s a reasonable final estimate
of rs?
Method Estimate
CAPM 10.24%
DCF 10%
rd + JRP 10%
Average 10.08%
20. Awerage of the three methods;
The cost of equity capital with the
retained earnings is the average of the
three methods:
10.24%+10%+10%=10.08%
21. *Determining the Weights for the
WACC
The weights are the percentages of the
firm that will be financed by each
component.
Ifpossible, always use the target weights
for the percentages of the firm that will
be financed with the various types of
capital.
22. *Estimating Weights for the Capital
Structure
Ifyou don’t know the targets, it is better
to estimate the weights using current
market values than current book values.
Ifyou don’t know the market value of
debt, then it is usually reasonable to use
the book values of debt, especially if the
debt is short-term.
23. *What factors influence a
company’s WACC?
Uncontrollable factors:
◦ Market conditions, especially interest rates.
◦ The market risk premium.
◦ Tax rates.
Controllable factors:
◦ Capital structure policy.
◦ Dividend policy.
◦ Investment policy. Firms with riskier projects
generally have a higher cost of equity.
24. D.Calculate the firm's weighted average
cost of capital (WACC).
WACC = wd rd (1 – T) + wps rps + ws rs
= 0.4 (0.036) + 0.1 (0.074)+ 0.5
(0.108)
= 0.0758 ≈ 7.58%
24
25. *Is the firm’s WACC correct for
each of its divisions?
No! The composite WACC reflects the
risk of an average project undertaken by
the firm.
Different divisions may have different
risks. The division’s WACC should be
adjusted to reflect the division’s risk and
capital structure.
26. E.Assume that the firm used up all of its retaining earnings and it
has to start issuing common stock with a flotation cost of 20
percent. What will its cost of common equity be?
Re = [ D0 * (1+ g) ] / [P0 * (1-F) ] + g
Re = [3 * ( 1+0.04) ] / [ 50 * ( 1- 0.2)] + 0.04
= 0.118
Editor's Notes
4% semiannually and 8% annually are the coupon rates. The firm can raise money now at the current market rates. Current market rates are 3% semiannually and 6% annually because the bond is selling above par. In other words, interest rates must have fallen since the firm issued the bond. It is able to borrow now at lower rates (i.e., the cost off debt capital is now lower for the firm than what it was previously when the bond was issued).