B3- Part 3 WACC and Optimal Capital structure

Question 1

What kind of mixture of Debt and equity financing that can maximizes the value of the firm?

Answer 1

• the lowest WACC (Weighted average cost of capital)
• WACC can be used as hurdle rate as cost for each doller added to raise the margin, but not a discount rate unless the project carries the same risk as the corp and result in identical leverage characteristics.

Question 2

How to compute WACC?

Answer 2

WACC = (Cost of Equity x % equity) + ( After-tax weighted aver. cost of debt x % debt)

Weighted aver.cost of debt = Effective annual interest pmt / debt cash available

Cost of debt (after tax) = interest rate x (1-T)

Question 3

What is cost of debt (kdx)?

Answer 3

• Interest on debt is tax deductible : it helps to reduce cost of debt. This is cash inflow. The higher tax rate, the more incentive to use tax financing
• Debt carries the lowest cost of capital. Cheap, Assume least risk
• After- tax cost of debt = Pre-tax cost of debt x (1-T)

Question 4

What is cost of preferred stock (kps)? (PS)

Answer 4

Cost of Ps (kps)= Dividends ps/ Net proceeds of Ps

= Outflow/ Inflow

Assume more risk, dividend is not deductible

Question 5

What is cost of retained earnings (kre)? 3 methods of computing it?

Answer 5

kre= rate of return required by Cs stockholders. The firm should earn at least as much on any earings retained and reinvested in the business as stockholders could have earned on alternative investments of equiv risk.

• 3 methods to compute kre:
  a. Capital asset pricing model (CAPM)
  b. Discounted CF (DCF)
  c. Bond yield plus rish premium (BYRP)

Question 6

How to compute cost of retained earnings by CAPM?

Answer 6

kre= Risk-free rate + Risk premium

Risk premium = bi * PMR

bi= beta coefficient (B > 1: more risky, B< 1 less risky)

PMR= market risk premium = (market rate - risk-free rate)

i.e A firm’s beta is 1.25, then this company is 25% more risky than market rate.

Question 7

How to compute cost of retain earning by DCF method?

Answer 7

kre = (D1/Po) + g

D1= Do x (1+g)

D1 = Dividend per share expected at end of one year

Po= Current market value of the outstanding common stock

g = constant growth rate of dividend

Question 8

How to compute cost of R/E by BYRP?

BYRP = Bond yield plus risk premium

Answer 8

kre = Pretax cost of LT debt + Market risk premium (PMR)

Question 9

Can the average of 2 cost methods: CAPM, DCF, BYPM be used?

Answer 9

yes, as estimate of cost R/E (kre) if there is sufficient consistency in results of 3 methods

Question 10

What is return on investment (ROI)? return on asset (ROA)?

Answer 10

ROI = Income/ Investment

ROI = Profit margin x Investment turnover

Profit magin = Income/ sales

Investment turnover = sales/ Investment

ROA = Net income / Average total assets

Question 11

Limitations of ROI?

Answer 11

a. Short-term focus
b. Dis-incentive to Invest - As Asset is Up, ROI down in ST

ROI = provides % measurement

Residual income = provide an Amt in measurement

Question 12

How to compute residual income? its weakness?

Answer 12

REsidual income ($) = Net income (per IS) - required return

required return = Net book value ($) x Hurdle rate (%)

–

Weakness:

a. reduce comparability ( b/w unequal size of biz units)
b. target rate requires judgement (if WACC not used)

Question 13

What is Economic Value Added (EVA)? vs. residual income method?

Answer 13

EVA= measures the excess of after-tax income earned by an investment over return rate defined by the company’s cost of capital (WACC rate)

Resi. income method = computes required return based on a hurdle rate determined by mgnt.

EVA = After-tax income - required return

required return = Investment x Cost of capital (WACC)

+EVA = performance meets standard . Stock goes UP

Question 14

What is Debt to total Capital ratio?

Answer 14

to measure financial leverage, solvency associated with ROI and residual income. The lower the ratio, the lower risk involved or the greater the presumed ability to pay debt.

Debt to total capital ratio = Total Debt/ Total capital (=Debt+equity)

another alternatives:

Debt to asset ratio = Total debt/ total assets

Debt to equity ratio= Total debt/ total equity

Question 15

What is quick ratio? its limitation?

Answer 15

Quick ratio = (Cash + Marketable securities +receivables)/ Current liabilities

or = (CA-inventory - prepaid)/ CL

Limitation:

only for AT, can mislead depend on type of business industry

Question 16

What is payment discounts?

Answer 16

Pmt discount: - it’s cost if given to customers, it’s return if received from customer

Annual cost (APR) of quick pmt discount = 360/ (Pay period - discount period) x Discount / (100 - Discount %)

i.e term 1/10, net 30 assuming 360 day year

cost= 360/ (30-10) + 1%/ (100%-1%) = 360/20 x 1%/99% =18.2%