Finance Week 10

Question 1

What interest rate should you use when doing capital budgeting?

Answer 1

Always use interest rate that reflects riskiness of the project

Question 2

How do you calculate what interest rate you should use in capital budgeting?

Answer 2

Use CAPM and beta of the new project to calculate interest rate and discount future cash flows using this rate: Ret (new project) = Ret (risk free) + Beta (Ret market - Ret risk free). After finding this, find NPV using this rate.

Question 3

What do you do if there is no beta value, how do you find the interest rate to use for the capital budgeting of a new project?

Answer 3

Can use the company’s cost of capital as an interest rate to do capital budgeting for new project that expands the scale of an existing asset. (new truck for business). This is because scale expanding projects have the same risk as the company’s existing assets and so have the same rate of return required by investors (bond and shareholders) for bearing risk of company’s existing assets. If scale expanding project has a positive NPV using a company’s cost of capital the project contributes at least what investors require and thus +ve to shareholders wealth.

Question 4

How do you find the cost of capital?

Answer 4

This is the value-weighted return required bu investors (bond and shareholders) and it is the weighted average cost of capital. WACC = ((D/V) * Rd * (1 - Tc)) + ((E/V) * Re). D- firms debt bondholders. E- firms debt to shareholders. V Market value of firm (D+E). Rd- required interest rate return bondholders. Re- required interest rate shareholders. Tc- corporate tax rate.

Question 5

Why do you use market value of debt and equity rather than book value in cost of capital calculations?

Answer 5

Cost of capital is return required by investors in proportion to their willingness to pay for firms debt and equity. Book values do not account for internally created intangible assets, shareholders willing to pay for these and require return for bearing the risk

Question 6

Why do you use corporate tax rate in cost of capital calculations?

Answer 6

Interest payments are tax deductible and so this reduces overall cost to company and therefore cost of capital

Question 7

How do you find the required rates of return that are used in the cost of capital calculations?

Answer 7

Use CAPM model to find rates required by bond and shareholders. Re = R risk free + B equity (R market- R risk free). Rd = R risk free + B debt ( R market - R risk free). Can also use CAPM to find return on assets- R a = R risk free + B assets (R market - R risk free)

Question 8

What do you do if there is no beta and the project is not expanding the scale of existing assets?

Answer 8

In this situation, use discount rate that reflects the riskiness of the project:
Can look for companies with existing assets similar to the new project and with no debt (pure equity financing), then estimate their equity betas (equal to asset betas), calculate average beta across companies and use the CAPM model and average beta to find the discount rate. Can look for companies with existing assets that are similar to new investment projects and with debt and equity then estimate the debt and equity betas, calculate average of un-levered betas, lever beta up to account for financing risk, use CAPM and levered beta to find discount rate
Or can use cost of capital as an initial estimate for the discount rate and adjust it upward for a project that is above the risk of company’s existing assets or down for investment of project with a risk below risk of company’s existing assets

Question 9

What is the market risk premium?

Answer 9

Ret risk free - Ret market

Question 10

What if a question also includes preferred stock?

Answer 10

Add this to the WACC calculation

Question 11

What do you do if a company is buying a different one?

Answer 11

Use the Beta of the acquired company for capital budgeting of its assets to reflect its riskiness. Find the return using Beta of original company of scale expanding project to reflect riskiness of these projects.

Question 12

What is the capital structure?

Answer 12

Mix of corporations debt vs its equity and results of a FM financing decisions

Question 13

What capital structure should financial managers choose?

Answer 13

choose capital structure that maximizes shareholders wealth

Question 14

How is the value of a firm determined?

Answer 14

By cashflows generated from firms operations and assets- left side of balance sheet.

Question 15

Where is the capital structure on the balance sheet? What happens if company changes its capital structure and how does this affect the value of the firm?

Answer 15

On the right, if company changes capital structure it still produces same goods and services and so same cash flows from operations and assets- therefore value of the firm is unaffected.

Question 16

What is M&Ms debt irrelevance proposition.

Answer 16

It is that a firm’s capital structure does not affects its value. In an idealized world without taxes and well functioning markets, the market value of a company does not depend on the company’s capital structure. Means FM can’t increase shareholders wealth by optimizing capital structure. Not reality.

Question 17

In an idealized world, how does borrowing affect firms operating risk, Ba?

Answer 17

Borrowing does not affect the firm’s operating risk, Ba, because firm still produces the same goods and services and generates the same cash flows from operations and assets.

Question 18

In idealized world how does borrowing affect risk for bondholders Bd?

Answer 18

In idealized world, firms issue risk free bonds so assume does not affect risk for bondholders.

Question 19

How does borrowing affect risk for shareholders in idealized world?

Answer 19

It does affect risk for shareholders Be as firms with more debt are more likely to default on their obligations and repay face value at maturity, more likely to run into bankruptcy.

Question 20

How does borrowing affect firms return on assets (Ra), return on debt (Rd) and return on equity (Re)?

Answer 20

Borrowing does not affect firms return on assets Ra or return on debt Rd. It does affect return on equity Re because shareholders require higher rate of return for bearing higher risk that a firm defaults.

Question 21

How do you calculate how borrowing increases risk for shareholders?

Answer 21

Ba = D/V * Bd + E/V* Be. So Be = Ba + (D/E * (Ba - Bd))

Question 22

How do you calculate how borrowing increases return required by shareholder?

Answer 22

Ra = D/v * Rd + E/V* Re. So Re = Ra + (D/E * (Ra - Rd))

Question 23

What is M&Ms 2nd proposition?

Answer 23

In idealized world without taxes and well functioning markets, rate of return to shareholders increases with debt-to-equity ratio

Question 24

What is a firms return on assets?

Answer 24

Ebit/ V

Question 25

What is return on equity for firm owned entirely by shareholders?

Answer 25

It is what shareholders receive as dividends / market value of shareholders equity. As shareholders own entire firm, receive all earnings as dividends. If issue new bonds, ROE increases as require higher return for bearing more risk, now Re = ebit - interest / V.

Question 26

What does it mean if the debt-to-equity ratio is 1?

Answer 26

Means that D/V 0.5 and E/V 0.5

Question 27

What if not given Rd?

Answer 27

Use risk free rate

Question 28

How can you find firms value?

Answer 28

EBIT/WACC

Question 29

If asked for value of equity and only given D:E ratio, what do you do?

Answer 29

use equation V = D + E and then substitute ratio so V= 0.25 E + E = 1.25 E

Question 30

How do you find return on assets if fully equity owned?

Answer 30

ROA: EBIT/V. Return on equity is what shareholders receive as dividends divided by MV of shareholders equity. Since shareholder owned, receive all dividends as earnings. Re = Div/E, Re = EBIT/V

Question 31

What is return on assets and equity is fully shareholder owned?

Answer 31

Re= Div * shares / E 
Ra = Re