Exam 3 Flashcards
WACC equation
Wdrd(1-T)+WpRp+Wc*Rs
Government gives tax break on interest paid to debt so
Cost of issuing bond(interst to bond holders) is tax desuctable
Should analysis be focused on historical cost or marginal costs
Marginal cost
Rp is
The marginal cost of preferred stock which is the return investors require on a firms preferred stock
Cost of preferred stock formula
Dp/Pp
Is preferred stock more or less risky
More because they are not required to pay dividends
Why is the yeild on preferred lower than debt
Corps own most preferred and 70% are excluded from tax so BT yield will be lower
Rs is
The marginal cost of common equity using retained earnings
Three ways to determine the cost of common equity
CAPM, DCF, and bond yield plus risk premium
CAPM formula
Rs=Rrf+ (Rm-Rrf)b
DCF equation
Rs= (D1/P0) +g
Bond yield plus risk premium equation
Rs=Rd+RP
Direct cost related to retained earnings and stock
When a company issues new CS they also have to pay a flotation cost to the underwriters
Indirect cost related to RE and CS
Issing new stick may send a neg message signal to the markets wish may depress the stock price
Price of equity with flotation cost equation
Re=D0(1+g)/P0(1-F) +g
Flotation cost depend
On the firms risk and the type of capital being raised and amount being raise
Floation cost are highest for
Common equity but per project cost are small
What factors influence a companys composite WACC
Market conditions, captial structure and dividend policy, investment policy, interest rate and stock price
Riskier projects will have a higher
WACC
What is capital budgeting
Analysis of potential additons to fixed assets. Long term decisions with large expenditures
Steps to capital budgeting
Estimate CF, assess riskiness of CF, determine appropriate cost of capital, find NPV or IRR, accept or decline
Accept project if
NPV>0 and or IRR>WACC
Independent projects
If the cash flows of one are unaffected by the acceptance of the other
Mutually exclusice projects
If the cash flows of one can be adversly impacted by the acceptance of the other
Normal cash flow streams
Cost followed by a series of positive cash inflows
Nonnormal cash flows
Two or more changes of signs
Net present value
Sum of the PV of all cash inflows and outflows of a project
IRR is
The discount rate that forces PV of inflows equal to cost and the NPV equal 0
IRR formula
Sum of (CF/(1+IRR)^t
If IRR>WACC
The projects return exceeds its costs and there is some return left over to boost stockholders returns
The lower the cost of capital the NPV should
Become higher
Reasons shy NPV profiles cross
Size differences, timing differences, value of CFs
Size differences
The smaller project frees up funds at time 0 for investment. Higher opp cost the more valuable these funds so a high WACC favors small projects
Timing differneces
The project with faster payback provides more CF in early years for reinvestment. If WACC is high early CF especually good
Value of CF:
CF can be reinvested and earn addtional interest
NPV method assumes CF are reinvested at
The WACC
IRR mthod assumes CF are reinvest at
IRR
NPV is the best for reinvestment because
CF are reinvested at the opp cost of capital
MIRR
The discount rate that causes the PV of a projects terminal value to equal the PV of cost
MIRR assumes cash flows are reinvest at
WACC
Payback period
The number of years required to recover a projexts cost
Strengths of payback period
Provides an indication of a projects risk and liqudity. Easy to calculate and understand
Weaknesses of the payback period
Ignores the time value of money, ignores CFs after payback period
When to use MIRR instead of IRR
When there are nonnormal CFs and more than one IRR
3 types of cash flows
During operation cash flows, investment stage cash flows, disinvestment stage cash flows
Estimate relevant cash flows
Calc annual operating cash flows, identifying changes in net op working cap, calc terminal cash flows
How is NOWC recovered
From inventory
Is there always a tax in SV
As long as it is positive then yes there will be a tax instead of reinvestment
Is the tax on SV ever a positive cash flow
Tc(MV-BV)
Should financing effects be included in cash flows?
No
Should improvement cost from previous year be included
No, ignore sunk costs
If building could be leased out include
Yes
If the nee line decreases the sales of the firms other lines would this affect
Yes because of externalitys
Postive externality
Buying more ipods will increase the sales of itunes
Negative externality
Ipod mini decreases sales of regular ipod
Stand alone risk
Risk of the project itself
Corporate risk
Project risk considering firms other projects
Market risk
Projexts risk to a well diversified investor
Sensitivity analysis
Measures the effect of changes in a variable on the projects NPV
Advantages to sensitivity anaysis
Identifies variables that may have the greatest potential impact on profitability and allows management to focus on these variables
Disadvtages to sensitivity analysis
Does not relfect the effects of diverification, does not incorporate any info about possible magnitude of the forcast error
If the project was highly correlated witht the economy, how would corporate and market risk be affected
The corp risk would not be directlu effected but combinded with high stand alone and corrleation with econ would suggest a high market risk beta
Monte carlo simulation
Large number of scenarios are run by the computer by randomly picking each variables to calc NPVs and SD
When you do risk analysis
Qualitative factors should also be counted
If project could have a lawsuit then
It has more risk
If assets can be sold easilu
The project could be less risky
If involving foreign investment
Higher risk
Business risk
The riskiness inherent in the firms operations if it uses no debt. Commonly measured by ROIC
ROIC equation
EBIT(1-T)/total capital
What determines business risk
Competition, uncertianty about demand, output prices and cost, product obsolescence, foreign risk exposure, regulatory risk and legal exposure, operating leverage
Operating leverage
Is the use of fixed costs rather than variable cost
If most cost are fixed then
The firm has a high op leverage
More operating leverage leads to
More business risk for then small sales declone causes a big profit decline
ROIC
Meaures the after tax return that the company provides for all its investodz
Financial leverage
Is the use of debt and preferred stock
Financial risk is
The addiontal risk concentrated on common stockholdwrs as a result of financail leverage
Business risk depends on
Business factos such as competition, product obsolesence, and operating leverage
Financila risk depends on
The type of securities issued
As a company starts to borrow money
SD and ROE increase
For leverage to raise expected ROE
Must have ROIC>rd(1-T) because AT interest will be higer than the AT operating income
Optimal captial structure
The capital structure at which P0 is maxed
The target capital structure is
The mix of debt, preferred abd common equity with which the firm intends to raise capital
Why do bond rating and cost of debt depend upon the amount of debt borrowed?
Borrowig more increases financial risk that means a lower bond rating meaning investors require higher interest meaning cost of debt increases
As you borrow more money
EPS increases and TIE decreases
What effect does more devt have on a firms cost of equity
Risk increases, cost increases
Hamada equation
Attempts to quanitify the increases cost of equitu due to financial leverage
The hamada equation formula
Bl=Bu(1+(1-t)(D/E))
Rs=Rrf+(RPm) Bl
How to find optimal capital structure
Min WACC or max stock price
With higher business risk and cap structure
Then the prob of financial distress would be greater at any debt level and OCS would be one that had less debt
Lower business risk
Would lead to an OCS with more debt
Sales stability affects target cap structure
Good=lower business risk
High op leverage an TCS
Business risk higher so lower debt
Increase corp tax rate and TCS
Higher debt level
Increase personal tax and TCS
RE higher and lower debt
Increase bankrupcy cost and TCS
Lower debt level
Managers spending more and TCS
Higher debt level
Morigliani miller irrelevance theory
Firms shouldnt change its cap structure under perfect market conditions
To make cap structure relevant need to relax
Frictionless market, equal access to market price, rational investors, equal access to info
Signaling effects
Issue stock=overvalued
Issue devt=undervalued
Investors react negitivlu
Pecking order hypothesis
Manager have a preferred order(RE-Debt-common stock)
Windows of opportunity
Cap structure is determined by attempts to time the market. Issue with overvalued and repurchase with under
What happens to WACC if interest rates rise
Cost of debt increases causing WACC to rise
What happens to WACC if stock prices decline
Cost of equity will rise causing WACC to rise
What happens to WACC if tax rates are lowered
Cost of equity and WACC decline
What happens to WACC if target debt ratio increases
WACC declines
What happens to WACC if dividends increase
Cost of equity and WACC increase
What happens to WACC if a firm invest in risky assets
Debt, equity and WACC will increase
NPV profiles
Find NPV at a number of different discount rates a then plot on a graph
Crossover rate
The cost of capital at which the NPV profiles of two projects cross and thus at which the projects NPVs are equal
Less competition
Lowers business risk
The more stable the demand
The lower the business risk
Sales price is stable
Less business risk
Input cost are uncertain
High business risk
The faster the produce becomes obsolete the
Greater the business risk
High fixed cost
High business risk
