6.0 Valuation Method and Cost of Capital

Question 1

Valuing Common Stock

Constant Growth Dividend Model

Answer 1

Rs = Required Rate of Return
G = Growth
Expected dividend = Last Dividend x 1.G (t power)

Expected Dividend
_______________ = Price
Rs - G

or
Rs - G = Div
,,,,,,,,,,,,,,_____
………….Price

Question 2

Common Stock Valuation multiple years

Answer 2

1. Expected Div:
   (1. 0G) to t power
2. Original Div x Step 1
   ———————
   Rs - G

Question 3

Common Stock variable Dividend Growth (Steps)

Answer 3

4yr, 20% yrs 1-3, 8% year 4, $5 div

A high Growth and moderate Dividend
2 Stage - 3 Step

Step 1: calc the PV of Dividends in High Growth years and Total
Y1: 5 x Pv
Y2: 5x1.2= 6 x PV
Y3; 6 x1.2=7.20 x PV &raquo_space;>Sum y1 to y3 pv’s

Step 2: Take the last dividend from High Growth and apply standard model

Rs-G

7.20 x 1.08
————==========194.50
12%-.08

Step 2b: Discount the result back using 1 year less than the one year less than total

Y3 PV x 194.50 = 138.48

Step 3: Add Step 1 and Step 2

Question 4

Preferred Stock Valuation

Answer 4

Cost of Capital

Question 5

Component Costs of Capital

Answer 5

Rate of Return demanded by holders of each type:
* In theory, Retained Earnings should be same as Common but actually lower because of issuance costs.

Providers of Equity Capital are more exposed than debt holders because

1. Firm is not legally obligated to pay them a return.
2. In case of liquidation; Debt holders paid first, Equity second

Debt: The after-tax Rate on the debt
Effective Rate x (1-Marginal Rate)

Common and Preferred use Dividend Yield Ratio

Preferred Stock:
Dividend on Preferred
_________________
Market Price

Common Stock

Market

Question 6

Target Capital Structure

Answer 6

The proportion of each component of Capital should be for the company

10% Debt
20% Preferred
70% Common

Question 7

WACC
Weighted Average Cost of Capital

Def

Answer 7

Composite Rate of the components

The Weights are of MARKET VALUES, NOT BOOK

Step 1: Determine Components of Debt and Preferred;
Debt: Rate x (1-Marginal Rate)
Preferred: Div/Price

Question 7

WACC

Weighted Average Cost of Capital

Answer 7

Composite Rate of the components

The Weights are of MARKET VALUES, NOT BOOK

Step 1: Determine Components of Debt and Preferred;
Debt: Rate x (1-Marginal Rate)
Preferred: Div/Price

Question 8

WCC Formula

No Preferred Equity

Answer 8

Equity/Total x Cost of Equity + Debt/Total x Cost of debt x (1-Tax Rate)

Question 9

Optimal Capital Structure

Answer 9

Wealth Maximization > results from MINIMIZING WACC

• Do not Focus on EPS (EPS can be improved by taking on more DEBT, but that is risky)

Question 10

Effect of Income Taxes on Capital Decisions

Answer 10

1. Receiving Corp Capital Gains taxed at REGULAR RATE. Receiving Individual at 16% or less
2. Company to Company Dividends: Receiving company gets 70%-100% Dividends Received Deduction prevents double taxation. Encourages 1st company to invest in 2nd. Conflict maybe as receiving corp wants dividends, Individuals want Capital gains.
3. Paying Corp’s Interest is tax deductible (debt interest payments), Dividends are not.
   INVESTOR prefers Stock, because only partially taxable (the gain part) while interest is fully taxable.
4. Company may only want to issue debt because doesn’t want to share CONTROL of company. But, investor wants favorable tax treatment.
5. Multinationals have to consider taxes from each country in Capital Structure decisions.