The document discusses methods for evaluating capital investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR). It provides examples of calculating payback periods for two projects (Projects A and B) and explains that Project A would be accepted while Project B would be rejected if the company's maximum payback period is three years. The document also defines NPV as the present value of all cash flows from a project less the initial investment, similar to how discounted cash flow is used to value securities.
The document discusses capital budgeting methods for evaluating investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR). It provides an example calculation of the payback period for Project A using a table of cash flows for Projects A and B over 4 time periods. The payback period for Project A is calculated to be 2.9 years.
This document defines the cost of capital and how to calculate it. It explains that the cost of capital is affected by economic conditions, market factors, and financial decisions. It then provides formulas and examples for calculating the cost of different sources of capital, including debt, preferred stock, retained earnings, and new common stock. Lastly, it demonstrates how to compute the weighted average cost of capital based on a company's target capital structure.
Here are the answers to your homework problems:
1. A stock dividend distributes additional shares to existing shareholders, increasing the number of shares they own but not changing the total value of their holdings. A stock split increases the total number of shares by distributing them in a set ratio but does not change anyone's ownership percentage.
2. Dividend payout ratio = Dividends declared / Net income = $500,000 / $2,500,000 = 20%
3. It's important because different types of stockholders have different preferences regarding dividends vs capital gains. Understanding these preferences helps the firm determine a dividend policy that satisfies different groups of stockholders.
4. No, it would not be
Cost of Capital and its different types of cost of capitalVadivelM9
The document discusses methods for calculating the cost of capital for a company. It covers calculating the costs of different sources of capital, including debt, preferred stock, and common equity. For common equity, it presents three methods: the dividend growth model, capital asset pricing model (CAPM), and risk premium approach. An example is provided for each method to illustrate how to calculate the cost of internal common equity. The weighted average cost of capital (WACC) formula is also introduced.
1. The document discusses the different types of capital firms use including debt, preferred stock, and common equity from retained earnings and new stock issuances. It also discusses how to calculate the costs of each type of capital.
2. The weighted average cost of capital (WACC) is calculated using the costs of different sources of capital weighted by their proportions in the target capital structure. Factors like tax rates, interest rates, and the firm's riskiness influence the WACC.
3. The composite WACC reflects the average risk of a firm's projects but may not be appropriate as the hurdle rate for individual projects, which may have different risk levels requiring adjustment of their WACC.
The document discusses methods for calculating the weighted average cost of capital (WACC) for a firm. It explains how to calculate the cost of each source of capital, including debt, preferred stock, and common equity. For common equity, it outlines three approaches: the dividend growth model, capital asset pricing model (CAPM), and risk premium model. An example calculation is provided for each capital source. The weighted average cost of capital is the average of the costs of each source weighted by its proportion of the firm's total capital structure.
Cost of capital ppt @ bec doms on financeBabasab Patil
The document discusses the cost of capital and how it is calculated. It can be summarized as:
1) The cost of capital is a weighted average of the costs of a firm's capital components (debt, preferred stock, common equity), weighted by the proportion of each in the firm's target capital structure.
2) The cost of each capital component is calculated based on its market yield after adjusting for taxes (for debt) and flotation costs.
3) The weighted average cost of capital (WACC) provides a benchmark to evaluate whether potential projects should be undertaken based on whether their returns exceed the WACC.
The document discusses the cost of capital and how to calculate the weighted average cost of capital (WACC) for a firm. It explains the different sources of capital including debt, preferred stock, and common equity. It also discusses how to estimate the costs of each type of capital and calculate WACC, as well as how to adjust the WACC for project-specific risks that differ from the average risk of the firm.
The document discusses capital budgeting methods for evaluating investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and modified internal rate of return (MIRR). It provides an example calculation of the payback period for Project A using a table of cash flows for Projects A and B over 4 time periods. The payback period for Project A is calculated to be 2.9 years.
This document defines the cost of capital and how to calculate it. It explains that the cost of capital is affected by economic conditions, market factors, and financial decisions. It then provides formulas and examples for calculating the cost of different sources of capital, including debt, preferred stock, retained earnings, and new common stock. Lastly, it demonstrates how to compute the weighted average cost of capital based on a company's target capital structure.
Here are the answers to your homework problems:
1. A stock dividend distributes additional shares to existing shareholders, increasing the number of shares they own but not changing the total value of their holdings. A stock split increases the total number of shares by distributing them in a set ratio but does not change anyone's ownership percentage.
2. Dividend payout ratio = Dividends declared / Net income = $500,000 / $2,500,000 = 20%
3. It's important because different types of stockholders have different preferences regarding dividends vs capital gains. Understanding these preferences helps the firm determine a dividend policy that satisfies different groups of stockholders.
4. No, it would not be
Cost of Capital and its different types of cost of capitalVadivelM9
The document discusses methods for calculating the cost of capital for a company. It covers calculating the costs of different sources of capital, including debt, preferred stock, and common equity. For common equity, it presents three methods: the dividend growth model, capital asset pricing model (CAPM), and risk premium approach. An example is provided for each method to illustrate how to calculate the cost of internal common equity. The weighted average cost of capital (WACC) formula is also introduced.
1. The document discusses the different types of capital firms use including debt, preferred stock, and common equity from retained earnings and new stock issuances. It also discusses how to calculate the costs of each type of capital.
2. The weighted average cost of capital (WACC) is calculated using the costs of different sources of capital weighted by their proportions in the target capital structure. Factors like tax rates, interest rates, and the firm's riskiness influence the WACC.
3. The composite WACC reflects the average risk of a firm's projects but may not be appropriate as the hurdle rate for individual projects, which may have different risk levels requiring adjustment of their WACC.
The document discusses methods for calculating the weighted average cost of capital (WACC) for a firm. It explains how to calculate the cost of each source of capital, including debt, preferred stock, and common equity. For common equity, it outlines three approaches: the dividend growth model, capital asset pricing model (CAPM), and risk premium model. An example calculation is provided for each capital source. The weighted average cost of capital is the average of the costs of each source weighted by its proportion of the firm's total capital structure.
Cost of capital ppt @ bec doms on financeBabasab Patil
The document discusses the cost of capital and how it is calculated. It can be summarized as:
1) The cost of capital is a weighted average of the costs of a firm's capital components (debt, preferred stock, common equity), weighted by the proportion of each in the firm's target capital structure.
2) The cost of each capital component is calculated based on its market yield after adjusting for taxes (for debt) and flotation costs.
3) The weighted average cost of capital (WACC) provides a benchmark to evaluate whether potential projects should be undertaken based on whether their returns exceed the WACC.
The document discusses the cost of capital and how to calculate the weighted average cost of capital (WACC) for a firm. It explains the different sources of capital including debt, preferred stock, and common equity. It also discusses how to estimate the costs of each type of capital and calculate WACC, as well as how to adjust the WACC for project-specific risks that differ from the average risk of the firm.
BlueBookAcademy.com - Value companies using Discounted Cash Flow Valuationbluebookacademy
The document outlines the steps to build a discounted cash flow (DCF) valuation model. It includes: 1) forecasting historical performance and future cash flows, 2) calculating the terminal value, 3) determining the weighted average cost of capital (WACC) discount rate, and 4) discounting the forecasted cash flows and terminal value to calculate the firm's value. An example DCF model is provided with assumptions and valuation results. Pros, cons, and best practices of DCF modeling are also discussed.
This document discusses various aspects of capital budgeting and project financing, including:
1) Types of equity financing like retained earnings and issuing new stock or bonds.
2) Methods of debt financing such as bonds and term loans.
3) How to calculate the weighted average cost of capital (WACC) using the costs of equity and debt.
4) Examples are provided to demonstrate calculating the costs of different sources of financing like equity, debt, and the overall WACC.
The document discusses the cost of capital and how it is calculated. It can be summarized as:
1) The cost of capital is the weighted average rate that a firm is expected to pay to fund its assets and operations with different sources of capital such as debt, preferred stock, and common equity.
2) It is calculated by determining the market value proportion of each capital component, the market return expected by investors in each component, and adjusting for factors like taxes and flotation costs.
3) The weighted average cost of capital (WACC) represents the firm's hurdle rate and is used to evaluate whether potential projects can earn more than this required return.
The cost of capital is the weighted average of the costs of different sources of financing like debt and equity. It represents the minimum return required by investors to compensate for the risk of the project. The document discusses various methods to estimate the costs of debt, preferred stock, and equity like using yield to maturity, bond ratings, dividend yield, CAPM, and dividend discount model. It also covers topics like taxes, weights, country risk premium, and treating flotation costs.
This document discusses the weighted average cost of capital (WACC) and its components. It addresses how to calculate WACC using the costs of debt, preferred stock, and common equity weighted by the target capital structure. It also discusses adjusting component costs for taxes and risk and determining the weights. Project risk can be standalone, corporate, or market risk and may require adjusting the composite WACC. Risk adjustments are made subjectively based on a project's estimated beta.
Sheet4Assignment 1 LASA # 2—Capital Budgeting Techniques
Sheet1
Solution
:-A) Computation of WACC:-Cost of equity (Ke) will be calculated using dividend discount model which is as under:-Price of share (P0) = D1/(Ke-g)Ke = (D1/(P0*(1-f))) + gWhere,D1 = D0*(1+g)F = Flotation costKe = ((2.50*(1+6%))/(50*(1-10%))) + 6%Ke = 11.89%i) Equity financing and debt financing are two different sources of financing being used by the organizations to procure funds. Equity and debt are two different sources of financing, equity financing represents internal source of finance whereas debt financing represent external source of finance. Mixture of both is always used by the business organizations to procure funds and is most commonly known as target ratio or capital structure ratio. This ration varies from industry to industry and company and company depending upon various circumstances, equity financing can be raised only through issuing shares in market by the help of initial public offer whereas debt financing can be raise from many sources such as bonds, long term loans, money market instruments etc.Equity Financing has following advantages:1. The total cash flows generated can be used solely for investment purpose, rather than paying back the investors.2. Funds can be raised in shorter time as compared to other sources of funds.However, in equity financing, dilution of ownership easily occurs and more investors can lead to loss of Control.Cost of debt (Kd) will be calculated as follows:-Kd = Market rate of deb*(1-tax rate)Kd = 5%*(1-35%)Kd = 3.25%Debt is a more common source of finance used by most of the organizations, the reason for the same is as follows:-a. Debt is cheaper source of finance as compared to equity the reason being the cost associated with issuing the common stock like. Underwriters commission, legal expenses, various registration charges, issuing of prospectus, printing of various documents etc.b. Debt financing provide leverage to the company which will increase the Earning per Share (EPS) which in turn leads to increase in market value of share, this helps organization to maximize its market capitalization.However, if the expansion venture does not work in favour of the company, then these obligations of repayment of principal and interest may turnout to be a burden to the company. WACC = (Ke*We) + (Kd*Wd)WACC = (11.89%*70%) + (3.25%*30%)WACC = 9.30%B) Computation of NPV of project A:-Depreciation = Cost of the asset – salvage value Life of the asset = 1,500,000/ 3 = 500,000Calculation of cash flows:Revenue – 1,200,000Less Cost – 600,000Less Depreciation – 500,000Profit - 100,000Less taxes (35%) 35,000Profit after taxes .
The document discusses the cost of capital and its components. It defines the cost of capital as the minimum return required for an investment. It is made up of the cost of equity, determined using the dividend growth model or CAPM, and the cost of debt, which is the yield to maturity. The weighted average cost of capital (WACC) weights the costs of equity and debt by their proportions of the firm's total market value to determine the overall required return for the firm. The WACC can then be used as the discount rate when evaluating projects through net present value analysis.
The document provides an overview of cost of capital concepts including the components of cost of capital (debt, preferred stock, common equity), weighted average cost of capital (WACC), and factors that affect the WACC. It then discusses various methods for calculating the cost of different capital components, including the cost of debt, cost of preferred stock, and cost of common equity using the capital asset pricing model (CAPM), dividend capitalization model, and own-bond-yield-plus-risk-premium method. Examples are provided to illustrate how to apply these methods to determine the weighted average cost of capital for a company.
FM CH 4.pptx best presentation for financial managementKalkaye
This chapter discusses the cost of capital, which is the minimum rate of return a firm must earn on its invested capital to maintain its market value. The cost of each source of capital (debt, preferred stock, common stock, retained earnings) is calculated separately as the component or specific cost of capital. The overall cost of capital is the weighted average cost of capital (WACC), which is calculated using either book values or market values of each capital source. The chapter provides examples of calculating the specific cost for each component and the WACC using both book value and market value methods. It also discusses calculating the weighted marginal cost of capital when additional capital is raised from multiple sources.
The document discusses the cost of capital, which is the rate of return a firm must earn on its investments to maintain its market value and attract funds. It defines the key components that make up the cost of capital, including the cost of long-term debt, preferred stock, common stock equity, and retained earnings. It also discusses how to calculate the weighted average cost of capital (WACC) by weighting the cost of each capital component by its proportion in the firm's target capital structure. The document provides examples to demonstrate how to calculate the various costs and the WACC.
This document discusses the cost of capital and how to calculate it. It defines cost of capital as the rate of return a firm must earn on its investments to maintain its market value and attract funds. It then discusses how to calculate the costs of different sources of capital including long-term debt, preferred stock, common stock, and retained earnings. It explains how to calculate the weighted average cost of capital (WACC) and discusses weighting schemes. Finally, it discusses how to determine break points and calculate the weighted marginal cost of capital (WMCC), which can be used with the investment opportunities schedule to make financing decisions.
Monte Carl Simulation is a powerful and effective tool when used properly helps to navigate the expected Net Present Value NPV. This presentation helps to improve the pattern to ackowlege onthe Odessa Investment by Decision Dres.
The document discusses several theories of capital structure:
1) Net income approach assumes capitalization rates are constant as debt increases, making 100% debt optimal.
2) Net operating income approach finds no optimal structure as equity rates adjust to keep overall rates constant.
3) Traditional approach finds an optimal structure where costs initially fall then rise with more debt.
4) MM theory initially argues capital structure is irrelevant without taxes but debt provides tax shields with taxes.
5) Trade-off theory balances tax shields against costs of financial distress and agency, finding an optimal balance.
This document discusses valuation principles and the valuation of corporations and stocks. It provides the following key points:
1. The primary goal of corporations is shareholder wealth maximization, which translates to maximizing stock price. Firms should behave ethically and have responsibilities to society.
2. Common stock represents ownership, with owners electing directors who hire management to maximize stock price.
3. Valuing a corporation involves discounting projected free cash flows at the weighted average cost of capital (WACC) to determine the value of operations, plus the value of non-operating assets.
4. Valuing stock involves discounting projected dividends at the cost of equity. The corporate value is divided among deb
The document contains 3 practice problems related to cost of equity, weighted average cost of capital (WACC), and determining the WACC for a proposed expansion. Problem 11-6 calculates the cost of equity for Carpetto Technologies using the dividend capitalization approach, capital asset pricing model (CAPM), and bond-yield-plus-risk-premium approach. Problem 11-9 calculates the WACC for Patrick Company using market value weights. Problem 11-10 determines the optimal capital structure and WACC for the last dollar raised in Klose Outfitters' expansion.
The Cost of Capital/abshor.marantika/Aulia Riskafina-Jeremy Haposan-Rizki Bhi...Aulia Riskafina Kusuma
This document contains sample questions and answers about capital structure and costs of capital. It discusses topics like defining capital structure weights, calculating costs of debt, equity, and preferred stock, accounting for floatation costs and taxes, and computing a weighted average cost of capital. The questions provide examples and formulas to demonstrate how to analyze capital structures and calculate WACC for companies based on their financing sources and costs.
This document discusses the cost of capital and capital structure. It begins by defining cost of capital as the minimum rate of return a company must earn on its investments to maintain the market value of the firm. It then discusses the significance of calculating the cost of capital and the different types of capital including debt, preferred shares, common equity, and retained earnings. Formulas are provided for calculating the cost of each type of capital. The weighted average cost of capital is defined as the blended cost of all sources of capital weighted by their proportions in the total capital structure. Several problems are provided as examples of calculating the costs of different types of capital.
Bba 2204 fin mgt week 9 cost of capitalStephen Ong
This document provides an overview and learning objectives for a lesson on cost of capital. It discusses the different sources of capital available to firms, including long-term debt, preferred stock, and common stock. It provides formulas for calculating the costs of these different sources. Specifically, it covers how to calculate the after-tax cost of debt, the cost of preferred stock, and the cost of common stock using either a constant growth valuation model or the capital asset pricing model (CAPM). It also discusses how to calculate the weighted average cost of capital (WACC), which weights the costs of each source of capital by the firm's target capital structure.
This document discusses the calculation of a company's weighted average cost of capital (WACC). It defines WACC as the product of the costs of various sources of finance (debt, equity, preference shares) and their proportions in the capital structure. The document provides examples of calculating WACC using both book values and market values for a company's capital sources. It also outlines different methods for determining the costs of equity, debt, and preference shares. Finally, it lists factors that can affect a company's WACC, including interest rates, market risk premium, tax rates, and internal policies around investment, capital structure, and dividends.
The document discusses the cost of capital and how to calculate a company's weighted average cost of capital (WACC). It covers developing a market value-based capital structure, calculating the component costs of capital by adjusting for taxes and flotation costs, and determining the WACC. It also introduces the concept of the marginal cost of capital (MCC) schedule, which shows how the WACC changes as a company raises more capital.
𝐔𝐧𝐯𝐞𝐢𝐥 𝐭𝐡𝐞 𝐅𝐮𝐭𝐮𝐫𝐞 𝐨𝐟 𝐄𝐧𝐞𝐫𝐠𝐲 𝐄𝐟𝐟𝐢𝐜𝐢𝐞𝐧𝐜𝐲 𝐰𝐢𝐭𝐡 𝐍𝐄𝐖𝐍𝐓𝐈𝐃𝐄’𝐬 𝐋𝐚𝐭𝐞𝐬𝐭 𝐎𝐟𝐟𝐞𝐫𝐢𝐧𝐠𝐬
Explore the details in our newly released product manual, which showcases NEWNTIDE's advanced heat pump technologies. Delve into our energy-efficient and eco-friendly solutions tailored for diverse global markets.
BlueBookAcademy.com - Value companies using Discounted Cash Flow Valuationbluebookacademy
The document outlines the steps to build a discounted cash flow (DCF) valuation model. It includes: 1) forecasting historical performance and future cash flows, 2) calculating the terminal value, 3) determining the weighted average cost of capital (WACC) discount rate, and 4) discounting the forecasted cash flows and terminal value to calculate the firm's value. An example DCF model is provided with assumptions and valuation results. Pros, cons, and best practices of DCF modeling are also discussed.
This document discusses various aspects of capital budgeting and project financing, including:
1) Types of equity financing like retained earnings and issuing new stock or bonds.
2) Methods of debt financing such as bonds and term loans.
3) How to calculate the weighted average cost of capital (WACC) using the costs of equity and debt.
4) Examples are provided to demonstrate calculating the costs of different sources of financing like equity, debt, and the overall WACC.
The document discusses the cost of capital and how it is calculated. It can be summarized as:
1) The cost of capital is the weighted average rate that a firm is expected to pay to fund its assets and operations with different sources of capital such as debt, preferred stock, and common equity.
2) It is calculated by determining the market value proportion of each capital component, the market return expected by investors in each component, and adjusting for factors like taxes and flotation costs.
3) The weighted average cost of capital (WACC) represents the firm's hurdle rate and is used to evaluate whether potential projects can earn more than this required return.
The cost of capital is the weighted average of the costs of different sources of financing like debt and equity. It represents the minimum return required by investors to compensate for the risk of the project. The document discusses various methods to estimate the costs of debt, preferred stock, and equity like using yield to maturity, bond ratings, dividend yield, CAPM, and dividend discount model. It also covers topics like taxes, weights, country risk premium, and treating flotation costs.
This document discusses the weighted average cost of capital (WACC) and its components. It addresses how to calculate WACC using the costs of debt, preferred stock, and common equity weighted by the target capital structure. It also discusses adjusting component costs for taxes and risk and determining the weights. Project risk can be standalone, corporate, or market risk and may require adjusting the composite WACC. Risk adjustments are made subjectively based on a project's estimated beta.
Sheet4Assignment 1 LASA # 2—Capital Budgeting Techniques
Sheet1
Solution
:-A) Computation of WACC:-Cost of equity (Ke) will be calculated using dividend discount model which is as under:-Price of share (P0) = D1/(Ke-g)Ke = (D1/(P0*(1-f))) + gWhere,D1 = D0*(1+g)F = Flotation costKe = ((2.50*(1+6%))/(50*(1-10%))) + 6%Ke = 11.89%i) Equity financing and debt financing are two different sources of financing being used by the organizations to procure funds. Equity and debt are two different sources of financing, equity financing represents internal source of finance whereas debt financing represent external source of finance. Mixture of both is always used by the business organizations to procure funds and is most commonly known as target ratio or capital structure ratio. This ration varies from industry to industry and company and company depending upon various circumstances, equity financing can be raised only through issuing shares in market by the help of initial public offer whereas debt financing can be raise from many sources such as bonds, long term loans, money market instruments etc.Equity Financing has following advantages:1. The total cash flows generated can be used solely for investment purpose, rather than paying back the investors.2. Funds can be raised in shorter time as compared to other sources of funds.However, in equity financing, dilution of ownership easily occurs and more investors can lead to loss of Control.Cost of debt (Kd) will be calculated as follows:-Kd = Market rate of deb*(1-tax rate)Kd = 5%*(1-35%)Kd = 3.25%Debt is a more common source of finance used by most of the organizations, the reason for the same is as follows:-a. Debt is cheaper source of finance as compared to equity the reason being the cost associated with issuing the common stock like. Underwriters commission, legal expenses, various registration charges, issuing of prospectus, printing of various documents etc.b. Debt financing provide leverage to the company which will increase the Earning per Share (EPS) which in turn leads to increase in market value of share, this helps organization to maximize its market capitalization.However, if the expansion venture does not work in favour of the company, then these obligations of repayment of principal and interest may turnout to be a burden to the company. WACC = (Ke*We) + (Kd*Wd)WACC = (11.89%*70%) + (3.25%*30%)WACC = 9.30%B) Computation of NPV of project A:-Depreciation = Cost of the asset – salvage value Life of the asset = 1,500,000/ 3 = 500,000Calculation of cash flows:Revenue – 1,200,000Less Cost – 600,000Less Depreciation – 500,000Profit - 100,000Less taxes (35%) 35,000Profit after taxes .
The document discusses the cost of capital and its components. It defines the cost of capital as the minimum return required for an investment. It is made up of the cost of equity, determined using the dividend growth model or CAPM, and the cost of debt, which is the yield to maturity. The weighted average cost of capital (WACC) weights the costs of equity and debt by their proportions of the firm's total market value to determine the overall required return for the firm. The WACC can then be used as the discount rate when evaluating projects through net present value analysis.
The document provides an overview of cost of capital concepts including the components of cost of capital (debt, preferred stock, common equity), weighted average cost of capital (WACC), and factors that affect the WACC. It then discusses various methods for calculating the cost of different capital components, including the cost of debt, cost of preferred stock, and cost of common equity using the capital asset pricing model (CAPM), dividend capitalization model, and own-bond-yield-plus-risk-premium method. Examples are provided to illustrate how to apply these methods to determine the weighted average cost of capital for a company.
FM CH 4.pptx best presentation for financial managementKalkaye
This chapter discusses the cost of capital, which is the minimum rate of return a firm must earn on its invested capital to maintain its market value. The cost of each source of capital (debt, preferred stock, common stock, retained earnings) is calculated separately as the component or specific cost of capital. The overall cost of capital is the weighted average cost of capital (WACC), which is calculated using either book values or market values of each capital source. The chapter provides examples of calculating the specific cost for each component and the WACC using both book value and market value methods. It also discusses calculating the weighted marginal cost of capital when additional capital is raised from multiple sources.
The document discusses the cost of capital, which is the rate of return a firm must earn on its investments to maintain its market value and attract funds. It defines the key components that make up the cost of capital, including the cost of long-term debt, preferred stock, common stock equity, and retained earnings. It also discusses how to calculate the weighted average cost of capital (WACC) by weighting the cost of each capital component by its proportion in the firm's target capital structure. The document provides examples to demonstrate how to calculate the various costs and the WACC.
This document discusses the cost of capital and how to calculate it. It defines cost of capital as the rate of return a firm must earn on its investments to maintain its market value and attract funds. It then discusses how to calculate the costs of different sources of capital including long-term debt, preferred stock, common stock, and retained earnings. It explains how to calculate the weighted average cost of capital (WACC) and discusses weighting schemes. Finally, it discusses how to determine break points and calculate the weighted marginal cost of capital (WMCC), which can be used with the investment opportunities schedule to make financing decisions.
Monte Carl Simulation is a powerful and effective tool when used properly helps to navigate the expected Net Present Value NPV. This presentation helps to improve the pattern to ackowlege onthe Odessa Investment by Decision Dres.
The document discusses several theories of capital structure:
1) Net income approach assumes capitalization rates are constant as debt increases, making 100% debt optimal.
2) Net operating income approach finds no optimal structure as equity rates adjust to keep overall rates constant.
3) Traditional approach finds an optimal structure where costs initially fall then rise with more debt.
4) MM theory initially argues capital structure is irrelevant without taxes but debt provides tax shields with taxes.
5) Trade-off theory balances tax shields against costs of financial distress and agency, finding an optimal balance.
This document discusses valuation principles and the valuation of corporations and stocks. It provides the following key points:
1. The primary goal of corporations is shareholder wealth maximization, which translates to maximizing stock price. Firms should behave ethically and have responsibilities to society.
2. Common stock represents ownership, with owners electing directors who hire management to maximize stock price.
3. Valuing a corporation involves discounting projected free cash flows at the weighted average cost of capital (WACC) to determine the value of operations, plus the value of non-operating assets.
4. Valuing stock involves discounting projected dividends at the cost of equity. The corporate value is divided among deb
The document contains 3 practice problems related to cost of equity, weighted average cost of capital (WACC), and determining the WACC for a proposed expansion. Problem 11-6 calculates the cost of equity for Carpetto Technologies using the dividend capitalization approach, capital asset pricing model (CAPM), and bond-yield-plus-risk-premium approach. Problem 11-9 calculates the WACC for Patrick Company using market value weights. Problem 11-10 determines the optimal capital structure and WACC for the last dollar raised in Klose Outfitters' expansion.
The Cost of Capital/abshor.marantika/Aulia Riskafina-Jeremy Haposan-Rizki Bhi...Aulia Riskafina Kusuma
This document contains sample questions and answers about capital structure and costs of capital. It discusses topics like defining capital structure weights, calculating costs of debt, equity, and preferred stock, accounting for floatation costs and taxes, and computing a weighted average cost of capital. The questions provide examples and formulas to demonstrate how to analyze capital structures and calculate WACC for companies based on their financing sources and costs.
This document discusses the cost of capital and capital structure. It begins by defining cost of capital as the minimum rate of return a company must earn on its investments to maintain the market value of the firm. It then discusses the significance of calculating the cost of capital and the different types of capital including debt, preferred shares, common equity, and retained earnings. Formulas are provided for calculating the cost of each type of capital. The weighted average cost of capital is defined as the blended cost of all sources of capital weighted by their proportions in the total capital structure. Several problems are provided as examples of calculating the costs of different types of capital.
Bba 2204 fin mgt week 9 cost of capitalStephen Ong
This document provides an overview and learning objectives for a lesson on cost of capital. It discusses the different sources of capital available to firms, including long-term debt, preferred stock, and common stock. It provides formulas for calculating the costs of these different sources. Specifically, it covers how to calculate the after-tax cost of debt, the cost of preferred stock, and the cost of common stock using either a constant growth valuation model or the capital asset pricing model (CAPM). It also discusses how to calculate the weighted average cost of capital (WACC), which weights the costs of each source of capital by the firm's target capital structure.
This document discusses the calculation of a company's weighted average cost of capital (WACC). It defines WACC as the product of the costs of various sources of finance (debt, equity, preference shares) and their proportions in the capital structure. The document provides examples of calculating WACC using both book values and market values for a company's capital sources. It also outlines different methods for determining the costs of equity, debt, and preference shares. Finally, it lists factors that can affect a company's WACC, including interest rates, market risk premium, tax rates, and internal policies around investment, capital structure, and dividends.
The document discusses the cost of capital and how to calculate a company's weighted average cost of capital (WACC). It covers developing a market value-based capital structure, calculating the component costs of capital by adjusting for taxes and flotation costs, and determining the WACC. It also introduces the concept of the marginal cost of capital (MCC) schedule, which shows how the WACC changes as a company raises more capital.
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2. Learning Goals
• Sources of capital
• Cost of each type of funding
• Calculation of the weighted average cost of capital
(WACC)
• Construction and use of the marginal cost of capital
schedule (MCC)
2
3. Factors Affecting the Cost of Capital
• General Economic Conditions
– Affect interest rates
• Market Conditions
– Affect risk premiums
• Operating Decisions
– Affect business risk
• Financial Decisions
– Affect financial risk
• Amount of Financing
– Affect flotation costs and market price of security
3
4. • Compute the cost of each source of capital
• Determine percentage of each source of
capital in the optimal capital structure
• Calculate Weighted Average Cost of Capital
(WACC)
4
Weighted Cost of Capital Model
5. • Required rate of return for creditors
• Same cost found in Chapter 12 as yield to maturity
on bonds (kd).
• e.g. Suppose that a company issues bonds with a
before tax cost of 10%.
• Since interest payments are tax deductible, the true
cost of the debt is the after tax cost.
• If the company’s tax rate (state and federal
combined) is 40%, the after tax cost of debt
• AT kd = 10%(1-.4) = 6%.
5
1. Compute Cost of Debt
6. • Cost to raise a dollar of preferred stock.
6
11.90%
$5.00
$42.00
kp = =
The cost of preferred stock:
Example: You can issue preferred stock for a net
price of $42 and the preferred stock pays a
$5 dividend.
Dividend (Dp)
Market Price (PP) - F
Required rate kp =
2. Compute Cost Preferred Stock
7. • Two Types of Common Equity Financing
– Retained Earnings (internal common equity)
– Issuing new shares of common stock (external
common equity)
7
3. Compute Cost of Common
Equity
8. • Cost of Internal Common Equity
– Management should retain earnings only
if they earn as much as stockholder’s
next best investment opportunity of the
same risk.
– Cost of Internal Equity = opportunity
cost of common stockholders’ funds.
– Two methods to determine
• Dividend Growth Model
• Capital Asset Pricing Model
8
3. Compute Cost of Common Equity
9. • Cost of Internal Common Stock Equity
– Dividend Growth Model
9
D1
P0
kS = + g
3. Compute Cost of Common Equity
10. • Cost of Internal Common Stock Equity
– Dividend Growth Model
10
Example:
The market price of a share of common stock is
$60. The dividend just paid is $3, and the expected
growth rate is 10%.
3. Compute Cost of Common Equity
D1
P0
kS = + g
11. • Cost of Internal Common Stock Equity
– Dividend Growth Model
11
3(1+0.10)
60
kS = + .10 =.155 = 15.5%
Example:
The market price of a share of common stock is $60.
The dividend just paid is $3, and the expected growth
rate is 10%.
3. Compute Cost of Common Equity
D1
P0
kS = + g
12. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
12
kS = kRF + (kM – kRF)
3. Compute Cost of Common Equity
13. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
13
Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
3. Compute Cost of Common Equity
kS = kRF + (kM – kRF)
14. • Cost of Internal Common Stock Equity
– Capital Asset Pricing Model (Chapter 7)
14
kS = 5% + 1.2(13% – 5%) 14.6%
3. Compute Cost of Common Equity
=
Example:
The estimated Beta of a stock is 1.2. The risk-free rate
is 5% and the expected market return is 13%.
kS = kRF + (kM – kRF)
15. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
15
3. Compute Cost of Common Equity
D1
P0 - F
kn = + g
16. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation
for floatation costs of the new common shares.
16
3. Compute Cost of Common Equity
Example:
If additional shares are issued floatation costs
will be 12%. D0 = $3.00 and estimated growth
is 10%, Price is $60 as before.
D1
P0 - F
kn = + g
17. • Cost of New Common Stock
– Must adjust the Dividend Growth Model equation for
floatation costs of the new common shares.
17
3. Compute Cost of Common Equity
3(1+0.10)
52.80
kn = + .10 = .1625 =
D1
P0 - F
kn = + g
16.25%
Example:
If additional shares are issued floatation costs will
be 12%. D0 = $3.00 and estimated growth is 10%,
Price is $60 as before.
18. 18
Weighted Average Cost of Capital
Gallagher Corporation estimates the following
costs for each component in its capital structure:
Gallagher’s tax rate is 40%
Source of Capital Cost
Bonds kd = 10%
Preferred Stock kp = 11.9%
Common Stock
Retained Earnings ks = 15%
New Shares kn = 16.25%
19. 19
Weighted Average Cost of Capital
If using retained earnings to finance the
common stock portion the capital structure:
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
20. 20
If using retained earnings to finance the
common stock portion the capital structure:
Weighted Average Cost of Capital
Assume that Gallagher’s desired capital
structure is 40% debt, 10% preferred and
50% common equity.
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
21. 21
Weighted Average Cost of Capital
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 15% = 11.09%
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
If using retained earnings to finance the
common stock portion the capital structure:
Assume that Gallagher’s desired capital
structure is 40% debt, 10% preferred and
50% common equity.
22. 22
If using a new equity issue to finance the
common stock portion the capital structure:
Weighted Average Cost of Capital
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
23. 23
Weighted Average Cost of Capital
WACC = .40 x 10% (1-.4) + .10 x 11.9%
+ .50 x 16.25% = 11.72%
If using a new equity issue to finance the
common stock portion the capital structure:
WACC= ka= (WTd x AT kd ) + (WTp x kp ) + (WTs x ks)
24. Marginal Cost of Capital
• Gallagher’s weighted average cost will change if
one component cost of capital changes.
• This may occur when a firm raises a particularly
large amount of capital such that investors think
that the firm is riskier.
• The WACC of the next dollar of capital raised in
called the marginal cost of capital (MCC).
24
25. Graphing the MCC curve
• Assume now that Gallagher Corporation has
$100,000 in retained earnings with which to
finance its capital budget.
• We can calculate the point at which they will
need to issue new equity since we know that
Gallagher’s desired capital structure calls for
50% common equity.
25
26. Graphing the MCC curve
• Assume now that Gallagher Corporation has
$100,000 in retained earnings with which to
finance its capital budget.
• We can calculate the point at which they will
need to issue new equity since we know that
Gallagher’s desired capital structure calls for
50% common equity.
26
Breakpoint = Available Retained Earnings
Percentage of Total
28. Making Decisions Using MCC
28
Weighted
Cost
of
Capital
Total Financing
10%
11%
12%
13%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Using internal
common equity
Using new
common equity
11.72%
11.09%
29. Making Decisions Using MCC
• Graph MIRRs of potential projects
29
Weighted
Cost
of
Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
MIRR =
12.4%
Project 2
MIRR =
12.1%
Project 3
MIRR =
11.5%
30. Making Decisions Using MCC
• Graph IRRs of potential projects
30
Weighted
Cost
of
Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
IRR =
12.4%
Project 2
IRR =
12.1%
Project 3
IRR =
11.5%
Graph MCC Curve
11.09%
11.72%
31. Making Decisions Using MCC
• Graph IRRs of potential projects
• Graph MCC Curve
31
Weighted
Cost
of
Capital
Total Financing
9%
10%
11%
12%
0 100,000 200,000 300,000 400,000
Marginal weighted cost of capital curve:
Project 1
IRR = 12.4% Project 2
IRR = 12.1%
Project 3
IRR = 11.5%
Accept Projects #1 & #2
Choose projects whose IRR is above the weighted
marginal cost of capital
11.72%
11.09%
32. 32
Answer the following questions and do the following
problems and include them in you ECP Notes.
If the cost of new common equity is higher than the cost of internal equity, why would a
firm choose to issue new common stock?
Why is it important to use a firm’s MCC and not a firm’s initial WACC to evaluate
investments?
Calculate the AT kd, ks, kn for the following information:
Loan rates for this firm = 9%
Growth rate of dividends = 4%
Tax rate = 30%
Common Dividends at t1 = $ 4.00
Price of Common Stock = $35.00
Flotation costs = 6%
Your firm’s ks is 10%, the cost of debt is 6% before taxes, and the tax rate is 40%.
Given the following balance sheet, calculate the firm’s after tax WACC:
Total assets = $25,000
Total debt = 15,000
Total equity = 10,000
33. 33
Your firm is in the 30% tax bracket with a before-tax required rate of return on its
equity of 13% and on its debt of 10%. If the firm uses 60% equity and 40% debt
financing, calculate its after-tax WACC.
Would a firm use WACC or MCC to identify which new capital budgeting projects
should be selected? Why?
A firm's before tax cost of debt on any new issue is 9%; the cost to issue new
preferred stock is 8%. This appears to conflict with the risk/return relationship.
How can this pricing exist?
What determines whether to use the dividend growth model approach or the CAPM
approach to calculate the cost of equity?
35. • The capital budgeting process.
• Calculation of payback, NPV, IRR, and MIRR for
proposed projects.
• Capital rationing.
• Measurement of risk in capital budgeting and
how to deal with it.
Learning Objectives
2
36. • Capital Budgeting is the process of
evaluating proposed investment projects for
a firm.
• Managers must determine which projects
are acceptable and must rank mutually
exclusive projects by order of desirability to
the firm.
The Capital Budgeting Process
3
37. Four methods:
• Payback Period
– years to recoup the initial investment
• Net Present Value (NPV)
– change in value of firm if project is under taken
• Internal Rate of Return (IRR)
– projected percent rate of return project will earn
• Modified Internal Rate of Return (MIRR)
The Accept/Reject Decision
4
38. • Consider Projects A and B that have the
following expected cashflows?
Capital Budgeting Methods
5
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
39. • What is the payback for Project A?
Capital Budgeting Methods
6
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
40. • What is the payback for Project A?
Capital Budgeting Methods
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500
+500
3,500
(10,000)
Cumulative CF
7
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
41. • What is the payback for Project A?
Capital Budgeting Methods
Payback in
2.9 years
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
8
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500
+500
3,500
(10,000)
Cumulative CF
0 1 2 3 4
3,500
-6,500
3,500
-3,000
3,500
+500
3,500
(10,000)
Cumulative CF
42. • What is the payback for Project B?
Capital Budgeting Methods
9
0 1 2 3 4
500 500 4,600 10,000
(10,000)
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
43. Payback in
3.4 years
• What is the payback for Project B?
Capital Budgeting Methods
10
0 1 2 3 4
500
-9,500
500
-9,000
4,600
-4,400
10,000
+5,600
(10,000)
Cumulative CF
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
44. • Accept project if payback is less than the
company’s predetermined maximum.
• If company has determined that it requires
payback in three years or less, then you
would:
– accept Project A
– reject Project B
Payback Decision Rule
11
45. • Present Value of all costs and benefits
(measured in terms of incremental cash
flows) of a project.
• Concept is similar to Discounted Cashflow
model for valuing securities but subtracts
the cost of the project.
Capital Budgeting Methods
Net Present Value
12
46. • Present Value of all costs and benefits (measured in
terms of incremental cash flows) of a project.
• Concept is similar to Discounted Cashflow model for
valuing securities but subtracts of cost of project.
Capital Budgeting Methods
Net Present Value
NPV = PV of Inflows - Initial Investment
NPV = + + – Initial
Investment
CF1
(1+ k)1
CF2
(1+ k)2 ….
CFn
(1+ k )n
13
47. What is the
NPV for
Project B?
14
P R O J E C T
Time A B
0 (10,000) (10,000)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
48. 455
$500
(1.10)1
What is the
NPV for
Project B?
15
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
49. 413
$500
(1.10) 2
What is the
NPV for
Project B?
16
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
50. 3,456
$4,600
(1.10) 3
What is the
NPV for
Project B?
17
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
413
$500
(1.10) 2
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
51. 6,830
$10,000
(1.10) 4
What is the
NPV for
Project B?
18
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
3,456
$4,600
(1.10) 3
413
$500
(1.10) 2
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
52. $11,154
What is the
NPV for
Project B?
19
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
6,830
3,456
413
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
Capital Budgeting Methods
53. PV Benefits > PV Costs
$11,154 > $ 10,000
What is the
NPV for
Project B?
20
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
$11,154
6,830
3,456
413
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
54. NPV > $0
$1,154 > $0
- $10,000 = $1,154 = NPV
What is the
NPV for
Project B?
21
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
PV Benefits > PV Costs
$11,154 > $ 10,000
$11,154
6,830
3,456
413
455
k=10%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
55. 22
• Additional Keys used to enter
Cash Flows and compute the
Net Present Value (NPV)
Financial Calculator:
56. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Key used to enter expected cash flows in order of
their receipt.
Note: the initial investment (CF0) must be
entered as a negative number since it is an outflow.
23
• Additional Keys used to
enter Cash Flows and
compute the Net
Present Value (NPV)
Financial Calculator:
57. NPV IRR
P/YR
CF
N I/Y PV PMT FV
• Additional Keys used to
enter Cash Flows and
compute the Net Present
Value (NPV)
Financial Calculator:
Key used to calculate the net present value of
the cashflows that have been entered in the
calculator.
24
58. NPV IRR
P/YR
CF
N I/Y PV PMT FV
• Additional Keys used
to enter Cash Flows
and compute the Net
Present Value (NPV)
Financial Calculator:
Key used to calculate the internal rate of return
for the cashflows that have been entered in
the calculator. 25
59. Calculate the NPV for Project B with calculator.
26
NPV IRR
P/YR
CF
N I/Y PV PMT FV
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
60. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
Keystrokes for TI BAII PLUS:
CF0 = -10,000
27
CF 10000 +/- ENTER
61. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
C01 = 500
500 ENTER
28
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
62. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
F01 = 2
F stands for “frequency”. Enter 2 since there
are two adjacent payments of 500 in periods 1 and 2.
29
2 ENTER
500 ENTER
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
63. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
C02 = 4600
4600 ENTER
30
2 ENTER
500 ENTER
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
64. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
F02 = 1
1 ENTER
31
4600 ENTER
2 ENTER
500 ENTER
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
65. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
C03 = 10000
10000 ENTER
32
1 ENTER
4600 ENTER
2 ENTER
500 ENTER
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
66. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
F03 = 1
1 ENTER
33
10000 ENTER
1 ENTER
4600 ENTER
2 ENTER
500 ENTER
CF 10000 +/- ENTER
Keystrokes for TI BAII PLUS:
67. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
I = 10
k = 10%
34
Keystrokes for TI BAII PLUS:
10 ENTER
NPV
68. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the NPV for Project B with calculator.
NPV = 1,153.95
CPT
The net present value of Project B = $1,154
as we calculated previously.
35
10 ENTER
NPV
Keystrokes for TI BAII PLUS:
69. • Accept the project if the NPV is greater
than or equal to 0.
Example:
NPVA = $1,095
NPVB = $1,154
NPV Decision Rule
> 0
> 0
Accept
Accept
•If projects are independent, accept both projects.
•If projects are mutually exclusive, accept the project
with the higher NPV.
36
70. • IRR (Internal Rate of Return)
– IRR is the discount rate that forces the NPV to equal
zero.
– It is the rate of return on the project given its initial
investment and future cash flows.
• The IRR is the rate earned only if all CFs are reinvested at the
IRR rate.
Capital Budgeting Methods
37
71. Calculate the IRR for Project B with calculator.
39
NPV IRR
P/YR
CF
N I/Y PV PMT FV
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
72. Enter CFs as for NPV
NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the IRR for Project B with calculator.
IRR = 13.5%
40
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
IRR CPT
73. • Accept the project if the IRR is greater than or
equal to the required rate of return (k).
• Reject the project if the IRR is less than the
required rate of return (k).
Example:
k = 10%
IRRA = 14.96%
IRRB = 13.50%
IRR Decision Rule
> 10%
> 10%
Accept
Accept
41
74. • MIRR (Modified Internal Rate of Return)
– This is the discount rate which causes the project’s PV of
the outflows to equal the project’s TV (terminal value) of
the inflows.
– Assumes cash inflows are reinvested at k, the safe re-
investment rate.
– MIRR avoids the problem of multiple IRRs.
– We accept if MIRR > the required rate of return.
Capital Budgeting Methods
PVoutflow = TVinflows
(1 + MIRR)n
42
75. What is the
MIRR for
Project B?
P R O J E C T
Time A B
0 (10,000.) (10,000.)
1 3,500 500
2 3,500 500
3 3,500 4,600
4 3,500 10,000
Safe =2%
0 1 2 3 4
500 500 4,600 10,000
(10,000)
(10,000)
10,000(1.02)0
10,000
4,600(1.02)1
500(1.02)2
500(1.02)3
4,692
520
531
15,743
10,000 =
15,743
(1 + MIRR)4
(10,000)/(1.02)0
MIRR = .12 = 12%
43
76. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the MIRR for Project B with calculator.
10000 ENTER
1 ENTER
1 ENTER
4600 ENTER
2 ENTER
500 ENTER
CF 0 +/- ENTER
Keystrokes for TI BAII PLUS:
Step 1. Calculate NPV using cash inflows
44
77. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the MIRR for Project B with calculator.
NPV = 14,544
CPT
The net present value of Project B cash inflows = $14,544
(use as PV)
45
2 ENTER
NPV
Keystrokes for TI BAII PLUS:
Step 1. Calculate NPV using cash inflows
78. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the MIRR for Project B with calculator.
FV = 15,743
46
Step 2. Calculate FV of cash inflows using previous NPV
This is the Terminal Value
Calculator Enter:
N = 4
I/YR = 2
PV = -14544
PMT= 0
CPT FV = ?
79. NPV IRR
P/YR
CF
N I/Y PV PMT FV
Calculate the MIRR for Project B with calculator.
MIRR 12.01
47
Step 3. Calculate MIRR using PV of outflows and calculated
Terminal Value.
Calculator Enter:
N = 4
PV = -10000
PMT = 0
FV = 15,743
CPT I/YR = ??
80. • Capital rationing is the practice of placing
a dollar limit on the total size of the
capital budget.
• This practice may not be consistent with
maximizing shareholder value but may be
necessary for other reasons.
• Choose between projects by selecting the
combination of projects that yields the
highest total NPV without exceeding the
capital budget limit.
What is capital rationing?
54
81. • Calculate the coefficient of variation of returns
of the firm’s asset portfolio with the project
and without it.
• This can be done by following a five step
process. Observe the following example.
Measurement of Project Risk
55
82. • Step 1: Find the CV of the Existing Portfolio
– Assume Company X has an existing rate of return
of 6% and standard deviation of 2%.
Measurement of Project Risk
56
Standard Deviation
Mean, or expected value
CV=
= .02
.06
= .3333, or 33.33%
83. • Step 2: Find the Expected return of the New
Portfolio (Existing plus Proposed)
– Assume the New Project (Y) has an IRR of 5.71%
and a Standard Deviation of 2.89%
– Assume further that Project Y will account for 10%
of X’s overall investment.
Measurement of Project Risk
57
(wx x E(Rx)) + (wy x E(Ry))
= (.10 x .0571) + (.90 x .06)
= .00571 + .05400
= .05971, or 5.971%
E(Rp) =
84. • Step 3: Find the Standard Deviation of the New
Portfolio (Existing plus Proposed).
– Assume the proposed is uncorrelated with the
existing project. rxy = 0
Measurement of Project Risk
58
[wx
2σx
2 + wy
2σy
2 + 2wxwyrxyσxσy]1/2
= [(.102)(.02892) + (.902)(.022) + (2)(.10)(.90)(0.0)(.0289)(02)]1/2
= [(.01)(.000835) + (.81)(.0004) + 0]1/2
= .0182, or 1.82%
= [.00000835 + .000324]1/2
= [.00033235]1/2
σp =
85. • Step 4: Find the CV of the New Portfolio
(Existing plus Proposed)
Measurement of Project Risk
59
Standard Deviation
Mean, or expected value
CV=
= .0182
.05971
= .3048, or 30.48%
86. • Step 5: Compare the CV of the portfolio
with and without the Proposed Project.
– The difference between the two coefficients
of variation is the measure of risk of the
capital budgeting project.
Measurement of Project Risk
60
CV without Y Change in CV
CV with Y
33.33% -2.85
30.48%
87. • Firms often compensate for risk by
adjusting the discount rate used to
calculate NPV.
– Higher risk, use a higher discount rate.
– Lower risk, use a lower discount rate
• The risk adjusted discount rate (RADR) can
also be used as a risk adjusted hurdle rate
for IRR comparisons.
Comparing risky projects using risk
adjusted discount rates (RADRs)
61
88. • Non-simple projects have one or
more negative future cash flows
after the initial investment.
Non-simple Projects
62
89. • How would a negative cash flow in year 4
affect Project Z’s NPV?
Non-simple projects
Project Z should be rejected in this case.
63
8,336
-4,098
3,757
4,132
4,545
k=10%
0 1 2 3 4
5,000 5,000 5,000 -6,000
(10,000)
- $10,000 = -$1,664 NPV
90. • Mutually exclusive projects with unequal
project lives can be compared by using two
methods:
– Replacement Chain
– Equivalent Annual Annuity
Mutually Exclusive Projects With
Unequal Lives
68
91. • Assumes each project can be replicated until a
common period of time has passed, allowing
the projects to be compared.
• Example
– Project Cheap Talk has a 3-year life, with an NPV
of $4,424.
– Project Rolles Voice has a 12-year life, with an NPV
of $4,510.
Replacement Chain Approach
69
92. • Project Cheap Talk could be repeated four
times during the life of Project Rolles Voice.
• The NPVs of Project Cheap Talk, in years t3, t6,
and t9, are discounted back to year t0.
Replacement Chain Approach
70
93. • The NPVs of Project Cheap Talk, in years t3,
t6, and t9, are discounted back to year t0,
which results in an NPV of $12,121.
Replacement Chain Approach
3,324
12,121
2,497
1,876
0 3 6 9
4,424 4,424 4,424
4,424
k=10%
71
94. • Amount of the annuity payment that
would equal the same NPV as the actual
future cash flows of a project.
• EAA = NPV
PVIFAk,n
Equivalent Annual Annuity
72
96. ECP Homework
1. The following net cash flows are projected for two separate projects. Your required rate
of return is 12%.
Year Project A Project B
0 ($150,000) ($400,000)
1 $30,000 $100,000
2 $30,000 $100,000
3 $30,000 $100,000
4 $30,000 $100,000
5 $30,000 $100,000
6 $30,000 $100,000
a. Calculate the payback period for each project.
b. Calculate the NPV of each project.
c. Calculate the MIRR of each project.
d. Which project(s) would you accept and why?
97. 2. What is meant by risk adjusted discount rates?
3. Explain why the NPV method of capital budgeting is preferable over the payback method.
4. A firm has a net present value of zero. Should the project be rejected? Explain.
5. You have estimated the MIRR for a new project with the following probabilities:
Possible MIRR Value Probability
4% 5%
7% 15%
10% 15%
11% 50%
14% 15%
a. Calculate the expected MIRR of the project.
b. Calculate the standard deviation of the project.
c. Calculate the coefficient of variation.
d. Calculate the expected MIRR of the new portfolio with the new project. The current
portfolio has an expected MIRR of 9% and a standard deviation of 3% and will
represent 60% of the total portfolio.
ECP Homework
99. Learning Objectives
• Understand the importance of business valuation.
• Understand the importance of stock and bond
valuation.
• Learn to compute the value and yield to maturity of
bonds.
• Learn to compute the value and expected yield on
preferred stock and common stock.
• Learn to compute the value of a complete business.
99
100. General Valuation Model
• To develop a general model for valuing a business,
we consider three factors that affect future
earnings:
– Size of cash flows
– Timing of cash flows
– Risk
• We then apply the factors to the Discounted Cash
Flow (DCF) Model (Equation 12-1)
100
101. Bond Valuation Model
• Bond Valuation is an application of time value
model introduced in chapter 8.
• The value of the bond is the present value of
the cash flows the investor expects to receive.
• What are the cashflows from a bond
investment?
101
102. Bond Valuation Model
• 3 Types of Cash Flows
– Amount paid to buy the bond (PV)
– Coupon interest payments made to the
bondholders (PMT)
– Repayment of Par value at end of Bond’s life
(FV).
102
103. Bond Valuation Model
• 3 Types of Cash Flows
– Amount paid to buy the bond (PV)
– Coupon interest payments made to the
bondholders (PMT)
– Repayment of Par value at end of Bond’s life
(FV).
103
Discount rate (I/YR)
• Bond’s time to maturity (N)
104. 104
Cur Net
Bonds Yld Vol Close Chg
AMR 6¼24 cv 6 91¼ -1½
ATT 8.35s25 8.3 110 102¾ +¼
IBM 63/8 05 6.6 228 965/8 -1/8
Kroger 9s99 8.8 74 1017/8 -¼
IBM 63/8 09 6.6 228 965/8 -1/8
IBM Bond Wall Street Journal Information:
105. 105
Suppose IBM makes annual coupon payments. The person
who buys the bond at the beginning of 2005 for $966.25
will receive 5 annual coupon payments of $63.75 each and
a $1,000 principal payment in 5 years (at the end of 2009).
Assume t0 is the beginning of 2005.
IBM Bond Wall Street Journal
Information:
Cur Net
Bonds Yld Vol Close Chg
AMR 6¼24 cv 6 91¼ -1½
ATT 8.35s25 8.3 110 102¾ +¼
IBM 63/8 05 6.6 228 965/8 -1/8
Kroger 9s99 8.8 74 1017/8 -¼
IBM 63/8 09 6.6 228 965/8 -1/8
106. 106
IBM Bond Timeline:
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
Suppose IBM makes annual coupon payments. The person
who buys the bond at the beginning of 2005 for $966.25 will
receive 5 annual coupon payments of $63.75 each and a
$1,000 principal payment in 5 years (at the end of 2009).
Cur Net
Bonds Yld Vol Close Chg
AMR 6¼24 cv 6 91¼ -1½
ATT 8.35s25 8.3 110 102¾ +¼
IBM 63/8 05 6.6 228 965/8 -1/8
Kroger 9s99 8.8 74 1017/8 -¼
IBM 63/8 09 6.6 228 965/8 -1/8
107. 107
Compute the Value for the IBM Bond given that you require an
8% return on your investment.
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
IBM Bond Timeline:
108. 108
$63.75 Annuity for 5 years
VB = (INT x PVIFAk,n) + (M x PVIFk,n )
$1000 Lump Sum in 5 years
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
IBM Bond Timeline:
109. 109
VB = (INT x PVIFAk,n) + (M x PVIFk,n )
= 63.75(3.9927) + 1000(.6806)
= 254.53 + 680.60 = 935.13
$63.75 Annuity for 5 years $1000 Lump Sum in 5 years
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
IBM Bond Timeline:
110. 110
.01 rounding
difference
N I/YR PV PMT FV
–935.12
5 8 ? 63.75 1,000
IBM Bond Timeline:
$63.75 Annuity for 5 years
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
$1000 Lump Sum in 5 years
111. 111
Most Bonds Pay Interest Semi-Annually:
e.g. semiannual coupon bond with 5 years
to maturity, 9% annual coupon rate.
Instead of 5 annual payments of $90, the bondholder
receives 10 semiannual payments of $45.
0 1 2 3 4 5
2005 2006 2007 2008 2009
45 45
1000
45 45 45 45 45 45 45 45
112. 112
Compute the value of the bond given that you
require a 10% return on your investment.
Since interest is received every 6 months, we need to use
semiannual compounding
VB = 45( PVIFA10 periods,5%) + 1000(PVIF10 periods, 5%)
10%
2
Semi-Annual
Compounding
Most Bonds Pay Interest Semi-Annually:
0 1 2 3 4 5
2005 2006 2007 2008 2009
45 45
1000
45 45 45 45 45 45 45 45
113. 113
Most Bonds Pay Interest Semi-Annually:
= 45(7.7217) + 1000(.6139)
= 347.48 + 613.90 = 961.38
Compute the value of the bond given that you
require a 10% return on your investment.
Since interest is received every 6 months, we need to use
semiannual compounding
VB = 45( PVIFA10 periods,5%) + 1000(PVIF10 periods, 5%)
0 1 2 3 4 5
2005 2006 2007 2008 2009
45 45
1000
45 45 45 45 45 45 45 45
115. Yield to Maturity
• If an investor purchases a 6.375% annual coupon
bond today for $966.25 and holds it until maturity
(5 years), what is the expected annual rate of
return ?
115
-966.25
??
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
+ ??
966.25
116. Yield to Maturity
116
VB = 63.75(PVIFA5, x%) + 1000(PVIF5,x%)
Solve by trial and error.
• If an investor purchases a 6.375% annual coupon
bond today for $966.25 and holds it until maturity
(5 years), what is the expected annual rate of
return ?
-966.25
??
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
+ ??
966.25
118. Yield to Maturity
118
If YTM > Coupon Rate bond Sells at a DISCOUNT
If YTM < Coupon Rate bond Sells at a PREMIUM
-966.25
0 1 2 3 4 5
2005 2006 2007 2008 2009
63.75 63.75 63.75 63.75 63.75
1000.00
119. Interest Rate Risk
• Bond Prices fluctuate over Time
– As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.
119
Interest
Rates
VB
120. Interest Rate Risk
120
• Bond Prices fluctuate over Time
– As interest rates in the economy change,
required rates on bonds will also change
resulting in changing market prices.
Interest
Rates
VB
Interest
Rates VB
121. Valuing Preferred Stock
121
P0 = Value of Preferred Stock
= PV of ALL dividends discounted at investor’s
Required Rate of Return
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
s 42½ 29 QuakerOats OAT 1.14 3.3 24 5067 35 34¼ 34¼ -¾
s 36¼ 25 RJR Nabisco RN .08p ... 12 6263 29¾ 285/8 287/8 -¾
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8
23¾ ...
7¼ 5½RJR Nab pfC .60 9.4 ... 2248 6½ 6¼ 63/8 -
1/8
0 1 2 3
P0=23.75 D1=2.31 D2=2.31 D3=2.31 D=2.31
237/8 20 RJR Nab pfB 2.31 9.7 ... 966 24 235/8 23¾ ...
124. Valuing Individual Shares of Common
Stock
124
P0 = PV of ALL expected dividends discounted at investor’s
Required Rate of Return
Not like Preferred Stock since D0 = D1 = D2 = D3 = DN , therefore the cash
flows are no longer an annuity.
P0 = + + +···
D1
(1+ ks )
D2
(1+ ks )2
D3
(1+ ks )3
D1 D2 D3
P0 D
0 1 2 3
125. Valuing Individual Shares of Common
Stock
125
P0 = PV of ALL expected dividends discounted at investor’s
Required Rate of Return
Investors do not know the values of
D1, D2, .... , DN. The future dividends must be
estimated.
D1 D2 D3
P0 D
0 1 2 3
P0 = + + +···
D1
(1+ ks )
D2
(1+ ks )2
D3
(1+ ks )3
126. Constant Growth Dividend Model
126
Assume that dividends grow at a constant rate (g).
D1=D0 (1+g)
D0
D2=D0 (1+g)2D3=D0 (1+g)3 D=D0 (1+g)
0 1 2 3
127. Constant Growth Dividend Model
127
Requires ks
> g
Reduces to:
P0 = + + + ···
+
D0 (1+ g)
(1+ ks )
D0 (1+ g)2
(1+ ks )2
D0 (1+ g)3
(1+ ks )3
P0 = =
D0(1+g)
ks – g
D1
ks – g
Assume that dividends grow at a constant rate (g).
D1=D0 (1+g)
D0
D2=D0 (1+g)2D3=D0 (1+g)3 D=D0 (1+g)
0 1 2 3
128. Constant Growth Dividend Model
128
P0 = = $30.50
1.14(1+.07)
.11 – .07
What is the value of a share of common stock if the
most recently paid dividend (D0) was $1.14 per share and
dividends are expected to grow at a rate of 7%?
Assume that you require a rate of return of 11%
on this investment.
P0 = =
D0(1+g)
ks – g
D1
ks – g
129. Valuing Total Stockholders’ Equity
• The Investor’s Cash Flow DCF Model
– Investor’s Cash Flow is the amount that is
“free” to be distributed to debt holders,
preferred stockholders and common
stockholders.
– Cash remaining after accounting for
expenses, taxes, capital expenditures and
new net working capital.
129
131. 131
ECP Homework
1. Indicate which of the following bonds seems to be reported incorrectly with respect to discount, premium,
or par and explain why.
Bond Price Coupon Rate Yield to Maturity
A 105 9% 8%
B 100 6% 6%
C 101 5% 4.5%
D 102 0% 5%
2. What is the price of a ten-year $1,000 par-value bond with a 9% annual coupon rate and a 10% annual
yield to maturity assuming semi-annual coupon payments?
3. You have an issue of preferred stock that is paying a $3 annual dividend. A fair rate of return on this
investment is calculated to be 13.5%. What is the value of this preferred stock issue?
4. Total assets of a firm are $1,000,000 and the total liabilities are $400,000. 500,000 shares of common
stock have been issued and 250,000 shares are outstanding. The market price of the stock is $15 and net
income for the past year was $150,000.
a.. Calculate the book value of the firm.
b. Calculate the book value per share.
c. Calculate the P/E ratio.
5. A firm’s common stock is currently selling for $12.50 per share. The required rate of return is 9% and the
company will pay an annual dividend of $.50 per share one year from now which will grow at a constant rate
for the next several years. What is the growth rate?