Chapter 10 Flashcards
What is the breakeven point of EBIT between the choices of debt and equity financing?
Capital to be raised: 4 mil
Cost of debt: 10%
Current shares outstanding: 200k
Additional shares to be sold: 100k
EBIT = (300,000 x 400,000)/ 100,000 = $1.2 mil
Formula to determine breakeven EBIT
EBIT = (total shares of outstanding if stock is sold x cost of debt) / additional shares to be sold If EBIT is lower than breakeven point, equity financing would make sense.
What are the limitations of financial leverage ?
Interest rates go up as amount borrowed increases
Less available cash
Increased risk of default (cost of financial distress)
Why is the cost of insurance leverage fixed?
It is the interest expense on bonds issued.
Which ratio is used to measure insurance leverage?
Reserves-to-surplus
This ratio measures an insurer’s relative exposure to underwriting risks.
Premium-to-surplus
Which ratio can be used to estimate the cost of operations?
Underwriting results to reserves
What is the formula for underwriting results to reserves ratio?
[loss * (1 - tax rate)] / reserves
What are the limitations on an insurer’s ability to expand?
- SAP requires immediate recognition of policy acquisition costs and deferral of revenues
- states require minimum surplus
- cost of insurer debt must be less than the expected return
- as new business is written, there is increased chance of underwriting losses.
What does the cost of capital depend on?
The type of capital.
What is used to determine the cost of capital when there are multiple sources of capital?
WACC
What can the discounted cash flow model only be used for?
To determine the cost of equity. Only used on companies that pay dividends.
What is the discounted cash flow formula to determine the cost of equity for a company paying a dividend?
(Dividend * (1 + dividend growth rate) / price + dividend growth rate
What is the formula got the capital asset pricing model of pricing an asset? (CAPM)
Cost = risk-free rate + beta * (expected market return - risk free rate)
Which types of risk does the CAPM take into account?
Systematic and unsystematic risk. I’m
How is the cost of preferred stock determined?
Like a perpetuity unless it is callable. Then it would be valued like a bond.
Formula: dividend / price
How is the cost of new debt determined?
It is the interest expense.
Risk free rate + risk premium) * (1 - tax rate
When is the WACC used?
Used to determine cost of capital when there are different types of capital.
How is WACC calculated?
Cost of capital = (cost of equity * %) + (cost of debt * %)
What is WACC especially important for?
Budgeting purposes. When looking at projects if return is less than WACC them they have to be avoided so they don’t reduce value to shareholders.
Use dividend growth model. Which of the following equals the cost of equity capital. Capital to be raised $1.5MM Current dividend per share $3 Present cost of stock per share $60 Dividend growth 6%
- 9
- 8
- 3
- 2
?
Which types of risk does RBC look at?
Asset, credit, underwriting
Calculate the cost of insurer debt using the underwriting results to reserves ratio.
$4 million loss
30% tax rate
$100M reserves
-4,000,000 * (1-.30) / $100,000,000 = 2.8%
safety has 4 to 1 premium written to ph surplus ratio and a .6 to 1 reserves to premium written ratio. What is the insurance leverage?
Multiply both to get 2.4
DCF Model
Stock has 10% dividend rate and price is $50. What is the cost of issuing equity?
Dividend = 5
(5 * 1.10) (5.50) / 50 + .10 (50.1$
5.5 / 50.1 = 11%
CAPM model
Risk free rate 3%
Expected market return 15%
Beta of asset 1.2
Calculate cost of equity
(.03 + 1.2) * (15 + 3)
1.23 * .18 = .22
This preferred stock pays a dividend of 10%. Shares are $50. What is the cost?
$5/$50
