financial analysis 2

Question 1

When calculating WACC, our concern is with capital that must be provided by

Answer 1

investors in the form of interest bearing debt, preferred stock and common equity

Question 2

The investor’s supplied items-debt preferred stock and common equity are called

Answer 2

capital components

Question 3

WACC

Answer 3

the weighted average cost of debt, preferred stock and common equity
(%cost of debt)(after-tax cost of debt) + ( % of preferred stock)(cost of preferred stock) + (%oof common equity )(cost of common equity

Question 4

Increases in assets must be financed with

Answer 4

increases in capital components

Question 5

The debt has an adjustment factor of (1-t), this is because

Answer 5

interest on debt is tax deductible but preferred dividends and the return of common stock is not.

Question 6

before-tax cost of debt

Answer 6

The interest rate the firm must pay on its new debt

Question 7

The after-tax cost of debt should be used to calculate

Answer 7

the wacc.

Question 8

The after-tax cost of debt

Answer 8

is the interest rate on new debt, less the tax savings the result because interest is tax deductible

Question 9

We use the after-tax cost of debt in calculating WACC because

Answer 9

we are interested in maximizing the value of the firm’s stock, and the stock price depends on after-tax cash flows.

Question 10

Because we are concerned with after-tax cash flows and because cash flows and rates of return should be calculated on a comparable basis, we adjust the interest rate

Answer 10

downward due to debt preferential tax treatment

Question 11

The component cost of preferred cost is

Answer 11

dividend / price D/P

Question 12

cost of preferred stock

Answer 12

The rate of return investors require on thr firm’s preferred sto.

Question 13

cost of retained earnings

Answer 13

The rate of return required by stockholders on a firm’s common stock.

Question 14

New common equity is usually raised by

Answer 14

retaining some of the current year’s earnings and by issuing new common stock

Question 15

equity raised by issuing stock has a higher cost than equity raised through retained earnings due to the

Answer 15

flotation costs required to sell new common stock.

Question 16

The firm needs to earn at least as much on any earnings retained as the stockholders

Answer 16

could earn on alternative investments of comparable risk.

Question 17

Therefore, due to the fact that flotation costs are involved when issuing new common stock, once firms get beyond the start-up stage, they normally obtain all of their new equity

Answer 17

by retained earnings.

Question 18

Whereas debt and preferred stock are contractual obligations whose costs are clearly stated on the contracts, stocks have no comparable cost or rate. The makes it difficult to measure rs. There are measures that can be used. To recall, the expected return is the

Answer 18

dividend yield, plus its growth

Question 19

The most widely used method for estimating the cost of common equity is

Answer 19

the CAPM.

Question 20

The techniques to calculate the cost of equity from retained earnings are

Answer 20

• CAPM
• BOND-YIELd-PLUS-RISK-PREMIUM
• Dividend-yield-plus-growth-rate, or also called -discounted cash flow approach(DCF.)
• Averaging the alternative estimates.

Question 21

Both the price and the expected rate of return on a share of common stock depend ultimately on

Answer 21

the stock’s expected cash flows.

Question 22

For companies that are expected to remain in business indefinitely, the cash flows are

Answer 22

the dividends

Question 23

If investors expect the firm to be acquired by some other company or to be liquidated

Answer 23

the cash flows will be dividends for some number of years plus a price at the horizon date when the firm is expected to be acquired or liquidated.

Question 24

Investors expect to receive a dividend yield of D/P plus a capital gain, g, for a total expected return, and in equilibriu, the expected return is also equal to the required return, this method of estimating the cost of equity is called the

Answer 24

discounted cash flow.

Question 25

g, from the DCF, the growth rate may be used

Answer 25

if investors expect a continuation of past trends, it may be based on the firm’s historic growth rate,

Question 26

(Add flotation costs to a project’s cost)In situations where reliable inputs for the CAPM approach are not available, as would be true for a closely held company, analysts often use a somewhat subjective procedure to estimate the cost of equity. empirical studies suggest that the risk premium on a firm stock over its own bonds ranges from 3 to 5 percentage points. Based on this evidence, one might

Answer 26

add a judgmental risk premium of 3 to 5% to the interest rate on the firm’s own long-term debt to estimate its cost of equity. So, firms with risky, low rated, and consequently high-interest rate debt also have risky, high cost of equity; and the procedure of basing the cost of equity on the firm’s own readily observable debt cost utilizes this logii

Question 27

For the cost of new common stock, companies generally use an investment banker when they issue new common stock. The banker’s fee is the flotation costs and the total cost of capital raised is the investor’s required return plus the flotation cost. So, in this case, flotation costs are added to the project’s cost, so one approach to handling the flotation costs, found as the sum of the flotation costs for the debt, preferred stock and common equity is to add

Answer 27

this sum to the initial investment cost. Because the investment cost is increased, the project’s expected rate of return is reduced.

Question 28

For most firms at most times, equity flotation costs are not an issue because

Answer 28

most equity comes from retained earnings.

Question 29

hen firms use investment bankers to raise capital, two approaches can be used to account for flotation costs:

Answer 29

• add flotation costs to a project’s cost

- increase the cost of capital

Question 30

Increase the cost of capital,

Answer 30

If there are flotation costs, the issuing firm receives only a portion of the capital provided by investors, with the remainder going to the underwriter, to provide investors with their required rate of return on the capital they contributed, each dollar the firm actually receives must “work harder”; that is, each dollar must earn a higher rate of return than the investor’s required rate of return.

Question 31

It is important to emphasize that the cost of debt is the interest on

Answer 31

new debt

Question 32

Since the cost of debt is in new debt, this means that one is concerned with

Answer 32

its use in capital budgeting decisions.

Question 33

Since the concern is with the use of new debt in capital budgeting decisions, the rate at which the firm has borrowed in the past is irrelevant when answering this question because we need to know the cost of new capital. for these reasons, the yield to maturity on outstandingdebt (which reflect current market conditions) is a better measure of

Answer 33

the cost of debt than the coupon rate

Question 34

When must external equity be used?

Answer 34

When firms need to finance with retained earnings, preferred stock and debt an investment opportunity.
The total amount of capital that can be raised prior to issuing new stock is called the retained earnings breakpoint.

Question 35

The three most important factors that affect WACC that the firm cannot control are

Answer 35

interest rates in the economy, general level of stock prices and tax rates.

Question 36

Note that if the yield curve is upward or downward sloping, the cost of long-term and short-term debt will differ. in this case the yield to maturity

Answer 36

for long term debt is used is generally used to calculate the cost of debt.

Question 37

Why is the yield to maturity for long term debt more used t

Answer 37

Because, more often than not, the capital is being raised to fund long-term projects.

Question 38

(factors that affect wacc) So what happens if the interest rates in the economy rise?

Answer 38

The cost of debt increases because the firm must pay its bondholders more when it borrows

Question 39

(factors that affect wacc) also, if stock prices in general decline, pulling the firm stock price down,

Answer 39

it cost of equity will rise.

Question 40

(fsctors that affect wacc) What is the effect on taxes on cost of capital

Answer 40

When tax rates on dividends and capital gains were lowered relative to rates on interest income, stocks became relative more attractive than debt; consequently, the cost of equity and wacc declined.

Question 41

Factors the firm can control

Answer 41

Changing capital structure, changing dividend payout ratio, altering capital budgeting decisions