BEC - B2 (MC Practice) Flashcards
How do we calculate WACC? What model do we use?
WACC uses the CAPM model (Capital Asset Pricing Model)
Like this:
R = Risk FreeRate + Beta (Return from Market - RiskFreeRate)
Refer to Ratios Deck for more information.
How do we calculate the “cost of preferred stock” for a company?
The same way we calculate Effective Rate of Interest:
-The amount paid (as a dividend) / net proceeds (selling price - float/costs to issue) = cost (as a percentage)
Easier presentation:
Cost of PS = dividend paid / net proceeds
NOTE IMPORTANT: Dividend paid is calculated by multiplying the percentage BY THE PAR VALUE!
What are the three elements needed to estimate the cost of equity capital?
- Current Dividends per share (also known as “D”)
- Expected growth rate in dividends (also known as “g”)
- Current market price per share of common stock (also known as “P”)
How do you estimate the cost of retained earnings for a company, using the DCF method?
K (cost of RE) in percentages = D / P + G
K% = (dividend at the end of the period/beginning of next period) / Current Stock Price… + Growth rate percentage
Use DCF method to estimate the cost of retained earnings for this company:
Current stock price: $30
Estimated dividend at the end of this year: $3/share
Expected Growth Rate: 10%
K = (3 / 30) + 10%
=10% + 10% = 20%
What types of behavior (change the % of debt/equity in financial structure) will the following events encourage?
- Increase in PE ratio?
- Increased economic uncertainty?
- Decrease in times interest earned ratio?
- Increase in corporate income tax rate?
1) will encourage issuance of more equity
2) will decrease incentives to issue debt (decrease interest cost as well)
3) will decrease incentives to issue debt (decrease in times interest earned means earnings have declined compared with interest cost… more debt is unwise)
4) will encourage higher % of debt in capital structure
Overall cost of capital for a firm is (which):
1) Rate of return on assets that covers the costs associated with the funds employed
2) Cost of the firm’s equity capital at which the market value will remain unchanged
3) Maximum rate of return on assets
4) Minimum rate of return a firm must earn on high-risk projects
1) Ding ding ding
Firms must earn at least a return rate on investments >= their cost of capital, or otherwise the investments are losing money… therefore decreasing the value of a firm.
Which of these possible sources of new capital for a firm has the lowest after tax cost?
- Preferred stock
- Common stock
- Bonds
- Retained Earnings
-Bonds. Debt is a cheaper source of financing than equity. Bonds are the cheapest form.
Plus, the company issuing bonds receives a tax deduction on interest paid. This further reduces the cost of bond financing.
When will a bond sell at a premium?
When the market rate of return is less than the stated coupon rate.
What is the relationship between a firm’s beta factor and the return on capital investment, as it relates to creating value for shareholders?
If rate of return exceeds the beta factor, then the overall value of the firm will increase.
How do you calculate net cost of debt?
Effective interest rate * net of tax. NOT coupon rate… we use effective interest rate (cost of debt)
How do we calculate EPS?
Net Income / Shares Outstanding
What type of bond is most likely to maintain a constant market value?
Floating rate bonds. Automatically adjust the return on a financial investment to produce a constant market value for that instrument.
How do you calculate market rate of interest on a one-year t-bill?
Risk free rate of interest + Inflation Premium
The optimal capitalization for an organization can usually be determined by the ?
Lowest total WACC. This will maximize shareholder’s equity
If a company prefers a method that “increases the credit worthiness of the company”… what does this really mean?
It means the company prefers issuing common stock > debt, because issuing common stock increases equity, and does not have an effect on debt. Therefore, debt to equity ratio is decreased. Subsequently, the credit-worthiness of the firm goes up.
Which of the following describes commercial paper?
- Generally does not have an active secondary market
- Has an interest rate lower than T-Bills
- Is generally sold only through investment banking dealers
- Has a maturity date > 1 year
- True. CP has a secondary market available, but generally this is not an active secondary market. CP is usually sold to the money markets by highly creditworthy companies
- False. Interest rate on CP is below the prime rate, but still above the T-Bill rate usually
- False. CP can be sold in many ways
- False. CP matures (generally) in under 9 months
What are some of the primary characteristics of commercial paper issuance?
- Can only be issued by credit-worthy large corporations (use of the open market is restricted to these guys only)
- CP also avoids the expense of maintaining a compensating balance with a commercial bank
- CP provides a broad distribution for borrowing
- CP helps the borrower’s name be more widely known
Marketable securities with the least amount of default risk are
US Treasury Securities
What are the related consequences of issuing debt, as opposed to equity?
- Relatively low after tax cost (due to interest deduction)
- Reduced EPS
- Reduction of control over the company
- Increased financial risk
- True. Interest payments on debt are tax deductible, creating a tax shield. Lower return rates, reducted further by a tax shield, are an advantage
- Financial leverage = higher EPS as a result of issuing debt. EPS goes up because # of shares stays the same, but NI presumed to be higher (otherwise why are we issuing the money?). EPS is not going to be reduced most likely
- Control of the company is reduced when we issue equity
- True. Financial risk goes up, this is a disadvantage
Using the dividend growth model, how do we calculate the cost of retained earnings (AKA the required return)
Cost of RE = D1 / P0 …. + growth rate
AKA
Dividend to be paid out NEXT year (period), divided by the CURRENT stock price. Plus the assumed growth rate.
What does the beta coefficient measure?
A particular stock’s percentage change, compared to (divided by) the percentage change in the market over the same period.
How do we calculate after-tax cost of debt?
Numerator: AFTER TAX interest cost, divided by
Denominator: Issuance price
What does market capitalization equal?
-Number of common shares outstanding, multiplied by
-the fair market value per share.
ie. 1000 shares of common stock issued at $50 per share, with $80 FMV.
Market Cap = 1000 * 80 = 8,000