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WorksheetsFina 3000 exam 2
Total questions: 89
Worksheet time: 1hrs 6mins
Can't be eliminated through
diversification
The risk that something will
occur in the market that
impacts all firms.
Ex. Economic recessions or
booms, interest rate changes,
taxes, political development
Systematic risk of a stock
Unsystematic risk of a stock
Diversifying risk
Required Return
The market portfolio
Can be eliminated through
diversification
The risk that something will
occur that impacts a single
firm or industry.
Ex. Corporate leadership
changes, New-product release,
lawsuits, competition
Systematic risk of a stock
Unsystematic risk of a stock
Diversifying risk
Required Return
The market portfolio
An investor can diversify risk within a portfolio. By holding more
securities, the investor diversifies away firm risk—can’t eliminate
market risk.
Investors receive compensation in the form of
expected return for holding (only) systematic risk.
Investors are not compensated for risk that could be diversified away.
The CAPM models the relationship between (systematic) risk and
return.
Systematic risk of a stock
Unsystematic risk of a stock
Diversifying risk
Required Return
The market portfolio
= risk-free return + premium for risk
Investors only get a premium for
holding systematic risk
Investors can eliminate
diversifiable risk. The market
doesn’t reward investors who
take unnecessary risk
Systematic risk of a stock
Unsystematic risk of a stock
Diversifying risk
Required Return
The market portfolio
a portfolio
that contains all assets in existence.
(the average portfolio)
r𝑚 = return of the market portfolio
𝜎𝑚 = risk of the market portfolio = only systematic risk (perfectly diversified)
Systematic risk of a stock
Unsystematic risk of a stock
Diversifying risk
Required Return
The market portfolio
= 𝜌𝑖,𝑚 × 𝜎𝑖
= the portion of risk that the
market rewards with a premium
(a)
= 𝜌𝑖,𝑚 × 𝜎𝑖 × 𝜎𝑚/𝜎^2𝑚 = 𝑐𝑜𝑣𝑎r𝑖𝑎𝑛𝑐𝑒(𝑖, 𝑚)/v𝑎r𝑖𝑎𝑛𝑐𝑒(𝑚)
predicts the expected relationship between the market return and the return on the individual stock
tells us how much a stock returns if the market return is 1%
(a)
What does β = 1.50 mean?
The stock is riskier than average. If the market portfolio increases 1%, the stock should increase 1.5%.
What does β = 0.75 mean?
The stock is less risky than average. If the market portfolio increases 1%, the stock should increase 0.75%.
What does β = 1.00?
The stock has the same risk as the
market. If the market increases 1%,
the stock should increase (a)
r𝑖= 𝑓 + 𝛽𝑖∗(E( 𝑚) − 𝑓)
r𝑖=return on asset 𝑖
r𝑓= r𝑒𝑡𝑢r𝑛 𝑜𝑛 r𝑖𝑠𝑘 − 𝑓r𝑒𝑒 𝑎𝑠𝑠𝑒𝑡
𝛽𝑖= 𝑐𝑜𝑣𝑎r𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑎𝑠𝑠𝑒𝑡 𝑎𝑛𝑑 𝑚𝑎 𝑘𝑒𝑡 𝑑𝑖𝑣𝑖𝑑𝑒𝑑 𝑏𝑦 𝑣𝑎r𝑖𝑎𝑛𝑐𝑒 𝑜𝑓 𝑚𝑘𝑡
𝑚= r𝑒𝑡𝑢r𝑛 𝑜𝑛 𝑡ℎ𝑒 𝑚𝑎r𝑘𝑒𝑡 𝑝𝑜r𝑡𝑓𝑜𝑙𝑖𝑜
(a)
E( 𝑚) is the expected
return on the _____ _____. Since we can’t
observe the ______ ______, we use market
indexes (like the S&P 500
index) to represent the
market.
(a)
Beta comes from historical data.
It assumes that all investors will have the same level of access to
relevant information and will all agree with the level of risk and rate
of return from all assets.
It assumes the market is perfectly efficient
Weaknesses of CAPM
Graphing CAPM
Security Market Line
CAPM
Capital budgeting
r𝑖= 𝑓 + 𝛽𝑖∗(E( 𝑚) − 𝑓)
Only systematic risk is on
the x-axis, because all other
risk can/should be
diversified away
Weaknesses of CAPM
Graphing CAPM
Security Market Line
CAPM
Capital budgeting
The SML tells use the required return for a stock based on its beta, the risk-free rate, and the market risk-premium.
We can compare the required return from CAPM to
the expected return to determine if a security is
fairly priced.
If the expected return is greater than the required return, the security is
undervalued
If the expected return is less than the required return, the security is
overvalued
Weaknesses of CAPM
Graphing CAPM
Security Market Line
CAPM
Capital budgeting
Investors are risk-averse and must be compensated for holding risky
assets.
There are two types of risk—systematic and unsystematic.
A well-diversified investor can eliminate non-
systematic risk by holding a diversified portfolio.
The CAPM equation shows the required return for an asset, with
compensation for systematic risk only.
If the expected return is less than the required return, the security is overvalued
Weaknesses of CAPM
Graphing CAPM
Security Market Line
CAPM
Capital budgeting
the process of planning for purchases of assets whose returns are expected to continue beyond 1 year
A key component of capital budgeting is estimating the cash flows associated with a project
A firm should only take on projects that expand shareholder value
Once we have cash flows, we can use DCF to estimate the value of taking on projects
Weaknesses of CAPM
Graphing CAPM
Security Market Line
CAPM
Capital budgeting
is the present
value of a project including the
costs of taking on the project
= PV of costs + PV of cash flows
(a)
graph or chart showing NPV as a function of the discount rate
• With conventional cash flows, the
higher (lower) the discount rate,
the lower (higher) NPV will be
• With conventional cash flows, there
is one point when NPV will equal
zero
(a)
is that rate of return that leads to NPV = 0 for a set of
cash flows
(a)
Pros:
NPV: uses all CFs of the project and discounts at the project cost of capital; shows gains to
shareholders
(a) : easy to explain; reflects rate of return for every dollar invested; doesn’t depend on accuracy of cost of capital
CONS:
(a) : difficult to explain; sensitive to expected cost of capital
IRR: doesn’t use the investor
cost of capital; when we are
trying to decide between
multiple projects, it can
disagree with the NPV rule;
there could be multiple IRRs
When cash flows aren’t
conventional
When projects are mutually
exclusive
When this happens, default to the NPV rule
When NPV and IRR disagree
Independent projects
Mutually exclusive projects
Contingent projects
Payback period method
• A firm can accept any project or
any combination of projects
• NPV decision rule: Accept all
projects where NPV >= 0
• IRR decision rule: Accept all
projects where r <= IRR
When NPV and IRR disagree
Independent projects
Mutually exclusive projects
Contingent projects
Payback period method
• Mutually exclusive projects are those that cannot be accepted at the same time.
• NPV decision rule: Accept the project with the highest NPV where NPV >= 0
• IRR decision rule: Accept the project with
the highest IRR where r <= IRR
• When projects are mutually exclusive,
NPV and IRR may lead to different project
choices because different projects usually
have different interest rate
When NPV and IRR disagree
Independent projects
Mutually exclusive projects
Contingent projects
Payback period method
• Contingent projects are projects where the firm must accept all of them or none
• NPV decision rule: Add NPVs
of each project. Accept all if
the total NPV >= 0
• IRR decision rule: Add CFs of
each period, calculate IRR.
Accept all if total IRR>=
When NPV and IRR disagree
Independent projects
Mutually exclusive projects
Contingent projects
Payback period method
asks how long the investment is tied up and how long it takes to recover the investment
A firm chooses a benchmark length of time (usually in years) until it wants its investment recovered
A shorter payback period indicates a more efficient project
Weaknesses:
-Ignores the time value of money
-There is no set criterion for a good payback period
-Ignores cash flows that happen after the payback period
Decision Rule: If the number of years it takes until the project has paid for itself (payback period) is smaller than the benchmark the firm makes, the firm should accept the project
When NPV and IRR disagree
Independent projects
Mutually exclusive projects
Contingent projects
Payback period method
PI = 𝑁𝑃𝑉+ 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡𝑠/𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡𝑠
This is a project selection method firms use when they are constrained
by budget, labor, other resource
Decision Rule: Accept
the project with the
highest PI first
A project with a higher PI is more
efficient than a project with a lower PI.
(a)
Making a decision:
1. Find the NPV for one cycle of the project.
2. Convert NPV into a series of equal payments (EAA/EAC).
3. Compare the EAA of each project.
4. Decision rule: Accept the project with the highest EAA
Use this method when comparing _____ ____ with different cycle lengths.
Remember: If the project’s CFs are positive and benefit the company, maximize benefit. If the project’s CFs are negative—representing annual costs—you want to minimize cost
(a)
One problem with the IRR rule is that you do not use the firm’s cost of
capital in the calculation of IRR.
The ______ (MIRR) addresses this problem.
Conceptually, the _____finds the value of the project’s CFs as if they
were re-invested throughout the life of the project in other
opportunities of the firm. This is more realistic.
To get the _____, we compare the FV to the initial investment
(a)
There are two primary
methodologies used by finance
practitioners for valuing firms:
Valuation based on Free Cash Flows
(FCFs)
Valuation based on Multiples
(EV/EBITDA)
(a)
Value of any asset = PV of CFs it pays to the investor
Value of firm = PV of all future FCFs
Firm value = 𝐹𝐶𝐹0 + 𝐹𝐶𝐹1/(1 + 𝑟𝑊𝐴𝐶𝐶) + 𝐹𝐶𝐹2/(1 + 𝑟𝑊𝐴𝐶𝐶)2 + … + 𝐹𝐶𝐹∞/(1 + 𝑟𝑊𝐴𝐶𝐶)∞
(a)
= weighted average cost of capital
is the return required by
the average investor
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
The estimate of firm value is only
as good as the estimates of free
cash flows.
We have to assume a long-term
growth rate, which may not be
accurate.
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
The estimate of firm value is only
as good as the estimates of free
cash flows.
We have to assume a long-term
growth rate, which may not be
accurate.
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
Given the challenges of estimating future cash flows, valuation is also estimated using multiples. We typically use various valuation methods to triangulate the correct valuation. The most common financial multiple used in valuing a firm is the EBITDA multiple. If you know the EBITDA multiple for Co. A and the EBITDA for Co. B, you can determine a value for B based on that multiple. ValueB = MultipleA * EBITDAB. The multiples or “comps” method compares the firm to others. E.g. house prices. The multiples approach is where we observe characteristics of one firm and use them to estimate the implied value of similar firms using a common measure. Investment bankers like to use enterprise value/EBITDA multiple: EBITDA mult = EV / EBITDA. The P/E multiple, EBIT ratios, dividend payout ratio, etc. are also commonly used.
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
Pros:
• Widely used
• Dynamic – reacts to changes in the market
• Easy to apply
Cons:
• Ignores time value of money
• If one firm’s multiple changes, another firm’s
enterprise value changes
• Assumes you can find firms that are very
similar
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
1. Accounting recognizes revenues as they
occur while finance cares about when cash
is received
2. Finance considers how starting a project
will affect the rest of the firm.
3. Finance considers opportunity cost
WACC
Problems with fcf/dcf analysis
Multiples for firm valuation
Pros/Cons of using multiples for valuation
Accounting vs finance
Having a negative FCF is not necessarily (a)
• When FCF<0, the firm lost money for the investors. However, it is often negative,
because FCF decreases when firms raise financing.
• For a growth firm, a temporary negative FCF is expected, because growth firms
need to raise lots of financing.
• For an established firm, FCF should typically be positive
𝑭𝑪𝑭𝒕 = 𝑬𝑩𝑰𝑻 × 𝟏 − 𝑻 + 𝑫 − ∆𝑵𝑾𝑪 − ∆𝑮𝒓𝒐𝒔𝒔 𝑷𝑷𝑬
𝑭𝑪𝑭𝒕= (𝑺𝒂𝒍𝒆𝒔 − 𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 − 𝑫) × 𝟏 − 𝑻 + 𝑫 − ∆𝑵𝑾𝑪 − ∆𝑮𝒓𝒐𝒔𝒔 𝑷𝑷𝑬
(a)
the dollar amount
that can be used to calculate annual
depreciation expenses
(a)
In financial statements (accounting), firms
subtract salvage value for the depreciable basis,
but for tax liability and cash flow analysis
(finance), we don’t remove the salvage value.
• Depreciation methods used for GAAP are different from
those allowed by the IRS
• Tax law allows firms to depreciate (a) % of the cost of an
asset regardless of the expected salvage value
Firms have two sets of books:
• Financial statement reporting (GAAP)
• Minimizing taxable income (IRS)
When firms calculate (a) , they
are trying to take as much as possible out
of their taxable income as soon as possible,
so they don’t have to pay as much in taxe
Depreciation is a___ __ . It gets added back
in, because depreciation expense is not money
a firm has to pay.
The depreciation ____ ___ is the cash flow
created form depreciation for the firm. For a
given year, the ____ ___ is t*D. The present
value of the ____ ___ is the PV of the tax
shields from each year
Tax shield
Straight line
Modified accelerated cost recovery system
Project
Net salvage value
depreciation expenses are the same every year until
the equipment is fully depreciated
• 𝐷𝑡 = 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝐵𝑎𝑠𝑖𝑠/𝑈𝑠𝑒𝑓𝑢𝑙 𝐿𝑖𝑓𝑒
• There is no depreciation in year 0, because the equipment is new and has
not lost any of its value yet
Tax shield
Straight line
Modified accelerated cost recovery system
Project
Net salvage value
depreciation payments are dictated by a schedule from the IRS,
and most depreciation happens at the beginning of the life of the
equipment.
𝐷𝑡 = 𝐴𝑙𝑙𝑜𝑤𝑒𝑑 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 × 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑏𝑙𝑒 𝑏𝑎𝑠𝑖𝑠
Tax shield
Straight line
Modified accelerated cost recovery system
Project
Net salvage value
Ending the ____:
When we end a ___, we need to consider some other
cash flows that might occur. The terminal CF is the CF created when we end the ___. It consists of any CF that results from closing down operations.
The terminal CF is typically the Net Salvage Value (NSV) of
any assets and any working capital we can recover. It
might include opportunity costs as well
Tax shield
Straight line
Modified accelerated cost recovery system
Project
Net salvage value
The market value of a depreciable asset at the end of its useful life plus any tax impact there may be because of the sale.
𝑵𝑺𝑽 = 𝑴𝑽 − 𝑻𝒂𝒙𝒆𝒔 𝒐𝒏 𝒔𝒂𝒍𝒆. The market value is the amount for which we
can sell the asset
The tax impact is the tax cost or tax credit a
firm gets from selling the asset.
𝑻𝒂𝒙𝒆𝒔 𝒐𝒏 𝒔𝒂𝒍𝒆 = 𝑻 × (𝑴𝑽 − 𝑩𝑽)
A tax credit is an amount that is removed
from a firm’s tax bill.
Tax shield
Straight line
Modified accelerated cost recovery system
Project
Net salvage value
If a firm expects that MV<BV, then it
expects to have claimed too little in
depreciation expenses by the end of the
project, and it expects to receive a tax
credit from the government when the
project is done.
MV<BV – “sell for loss"
(a)
= Net PPE = Depreciable Basis – Accumulated Depreciation
(a)
The sum of all of the yearly
depreciation values from the beginning of the project to the time we
are measuring the book value.
(a)
Adjusting CFs for (a)
The cost of having safety stock comes from the time value of money.
• A firm spends money on extra inventory at the beginning of a project
• But that extra inventory will typically only sit in a warehouse and not earn a yield.
So how do we account for inventory in free cash flows?
• When there is more inventory, accounts receivable is higher
• And when accounts receivable is higher, cash flows decrease
With more inventory, we need to reduce the free cash flow
Adjusting CFs for ___ ___
Accounts receivable are sales made by the firm to customers who paid on credit.
• Accountants would recognize income from these sales when they occurred, but in finance, cash flows are only adjusted when cash is actually received or paid.
• Higher accounts receivable reduces cash flows
(a)
Adjusting CFs for ____ ___
Accounts payable are purchases
made by the firm on credit.
• Typically, accounts payable are for
raw materials of service contracts
that the firm defers payment on.
• Accounts payable are positive to the
firm’s current cash position
accounts payable
inventory
Opportunity costs and side effects
Opportunity costs
Side effects
____, AR, and AP - the changes in cash flow
from ___, accounts
receivable, and accounts
payable are, together,
ΔNWC.
accounts payable
inventory
Opportunity costs and side effects
Opportunity costs
Side effects
_____________ - The typical firm will have many ongoing projects that are: • Generating their own cash flow streams and • Capable of using other project’s fixed assets.
accounts payable
inventory
Opportunity costs and side effects
Opportunity costs
Side effects
a way a new project will affect a firm. If a firm accepts a new project, it may miss out on getting cash flows from somewhere else. If a firm accepts a new project, it may forgo CFs that would have occurred if we had rejected the project. Classic example: The proposed project will use equipment or other fixed assets that are no longer needed for an existing project. If the borrowed assets could have been salvaged for cash, by accepting the project the firm forgoes that cash
accounts payable
inventory
Opportunity costs and side effects
Opportunity costs
Side effects
a way a new project will affect a firm
If a firm accepts a new
project, that could increase or
decrease the sales of an existing
project.
accounts payable
inventory
Opportunity costs and side effects
Opportunity costs
Side effects
How long should a firm run a project before terminating?
Things to remember when doing this kind of problem:
• Pick a project length that maximizes NPV
• Pick the project where NSV of assets > PV of running the project another year
(a)
What Drives Firm Risk
Why is Beta bigger for some firms than others?
• How cyclical is a firm? i.e. How much is the firm tied to the overall economy?
• Financial Leverage: Percentage of debt the firm finances with
• Operating Leverage: Size of fixed costs in business
The (a) the Beta a firm has, the higher the cost of capital
A business that has a higher proportion of fixed costs and a
lower proportion of variable costs is said to have used more
this.
Those businesses with lower fixed costs and higher variable
costs are said to employ less this.
affects the riskiness, or beta, of a firm
(a)
When evaluating projects we might want
to know the level of sales necessary to
break even in cash flows.
EBITDA (CF) Break Even point: the number of units we
need to sell to break even in cash flows
𝐸𝐵𝐼𝑇𝐷𝐴 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 = 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠/𝑃𝑟𝑖𝑐𝑒−𝑈𝑛𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
Accounting Break Even: (adds D&A)
𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝐵𝑟𝑒𝑎𝑘 𝐸𝑣𝑒𝑛 = 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝐷&𝐴/𝑃𝑟𝑖𝑐𝑒−𝑈𝑛𝑖𝑡 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡
(a)
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐿𝑒𝑣𝑒𝑟𝑎𝑔𝑒 = 1 + 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠/𝐸𝐵𝐼𝑇𝐷𝐴
*Note: EBITDA is the same as pre-tax operating CF
Ex. What does a CF operating leverage of 1.64 tell us?
• This is similar to an elasticity
• If a firm’s sales increase by 1%, its cash flow will increase by 1.64
(a)
Adjust the value of one variable to see the impact on NPV (or something else).
Type of project risk analysis
Sensitivity analysis
Scenario analysis
Cost of captial
WACC
Components of WACC
Deals with problem of sensitivity analysis which considers only one input
time
1. Allow for 2 or 3 outcomes or scenarios (Ex. Bad, average, and good cases)
2. Find the NPV for each scenario
3. Assign a probability for each outcome
4. Solve for an expected NPV
5. (Optional) Use in a Monte Carlo analysis
Sensitivity analysis
Scenario analysis
Cost of captial
WACC
Components of WACC
Cost of capital is concerned with what a firm has to pay for the capital it uses to finance its projects.
For a firm, capital consists of:
• Debt
• Preferred Stock
• Common Stock
The firm’s cost of capital is a weighted average of the return investors require for each of these components and should reflect of the project it’s used to evaluate
Sensitivity analysis
Scenario analysis
Cost of captial
WACC
Components of WACC
the minimum rate of return a company
must achieve on its growth investments to
increase shareholder value
Sensitivity analysis
Scenario analysis
Cost of captial
WACC
Components of WACC
Cost of Debt
𝑟𝐷= return required for new debt
(coupon rate on new bonds)
Preferred Stock
𝑟𝑃= dividend rate on new share
Cost of Equity
• 𝑟𝐸= required return for common stock
• How do we get 𝑟𝐸? (CAPM, Gordon Growth
Model)
Debt
• The market value of a firm’s debt (D) is the sum of the trading
prices of all interest-bearing debt issued by the firm
• The trading on the secondary markets tells us the market
value
• If debt doesn’t trade regularly, we might have to use the
book value or market value of similarly rated debt to get an
estimate
Sensitivity analysis
Scenario analysis
Cost of captial
WACC
Components of WACC
Raising ___:
1. Issuing bonds
2. Taking out loans
Firms use ___ financing mainly because it
provides capital without giving up ownership
and interest payments are tax deductible
(a)
Estimating Cost of (a) :
Using Cost of a Bond -> 𝑟𝐷𝑝𝑟𝑒𝑡𝑎𝑥 = 𝑦𝑖𝑒𝑙𝑑 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦∗ 𝑜𝑛 𝑡ℎ𝑒 𝑏𝑜𝑛𝑑
*YTM = discount rate where PV(bond’s cash flows) equals current price
Using Cost of an Outstanding Loan -> 𝑟𝐷𝑝𝑟𝑒𝑡𝑎𝑥 = 𝑟𝑎𝑡𝑒 𝑎𝑡 𝑤ℎ𝑖𝑐ℎ 𝑡ℎ𝑒 𝑏𝑎𝑛𝑘 𝑐𝑜𝑢𝑙𝑑 𝑟𝑒𝑓𝑖𝑛𝑎𝑛𝑐𝑒 𝑎 𝑙𝑜𝑎𝑛 𝑡𝑜𝑑𝑎𝑦
(a) Cost of Debt
In the U.S., firms can deduct interest payments for tax purposes.
𝑟𝐷 = 𝑟𝐷𝑝𝑟𝑒𝑡𝑎𝑥 ∗ (1 − 𝑡)
component of WACC
• The market value of a firm’s equity/common stock (E) is “the number of shares outstanding” x “trading price per share”
• We do NOT use the “book value of equity” or “shareholders equity”—this is the accounting value, not the market value
• Equity could come from retained earnings or from new stock issuances. In general, the cost of equity capital is higher with new issuances, since the firm has to pay issuance or “flotation” costs
(a)
Raising (a)
1. Internally: Take
net income and
reinvest it as
retained earnings
2. Externally: Issue
new shares (this is
expensive)
For Common Stock
Method 1: Using CAPM
𝑟𝐸 = 𝑟𝑟𝑓 + 𝛽 ∗ (𝐸 𝑟𝑚 − 𝑟𝑟𝑓)
Method 2: Using the Constant-Growth Dividend Model
𝑃0 = 𝐷1/𝑟−G -> 𝑟𝐸 = 𝐷1/𝑃0+ 𝑔
Estimating cost of equity
Preferred stock
Estimating cost of preferred stock
Interpreting WACC
WACC Caveat
equity, but
it has characteristics of debt:
• No maturity date
• No voting rights/ownership
• Pays a required, constant
dividend
• Second in line after debt
• No tax benefit
Estimating cost of equity
Preferred stock
Estimating cost of preferred stock
Interpreting WACC
WACC Caveat
How do we value preferred stock?
Preferred stock: Perpetuity
𝑃𝑉 = 𝑃𝑚𝑡/𝑟
𝑃0 = 𝐷𝑃/𝑟𝑃
Estimating the Cost of Preferred
Stock
𝑃0 = 𝐷1/𝑟 ------> 𝑟𝑃 = 𝐷1/𝑃0
Estimating cost of equity
Preferred stock
Estimating cost of preferred stock
Interpreting WACC
WACC Caveat
WACC increases if we raise external funds
WACC is not constant for a firm for any level of financing.
An increase in WACC indicates a decrease in valuation and higher risk.
WACC increases if risk/Beta increases.
WACC increases if the rate of return on equity increases
Estimating cost of equity
Preferred stock
Estimating cost of preferred stock
Interpreting WACC
WACC Caveat
It is only appropriate to use the WACC for the overall firm if the new project has similar systematic risk as the rest of the firm and the project will be financed using the same capital structure as the firm.
If not, treat the project as a mini-firm with its own debt ratio and cost of capital.
There are two types of new project:
A new restaurant for McDonald’s
vs an investment in LinkedIn by Microsoft
We must adjust the cost of capital of a non-similar
project to reflect the systematic risk of the project itself
Estimating cost of equity
Preferred stock
Estimating cost of preferred stock
Interpreting WACC
WACC Caveat
Case I: Project has greater systematic risk than firm
The project should use a higher value for beta
If we use a lower beta, the cost of capital would be too low, we might accept a project that should have been rejected
Case II: Project has lower systematic risk than firm
The project should use a lower value for beta. If we use a higher beta, we might reject a project that should have been accepted
Solution: Compare the project to a “___ ___” firm that matches the risk
level of the project
(a)
The firm must choose how it will finance its
investments.
This choice of debt, equity, preferred stock,
etc. is the choice of the firm’s ____ ___.
(a)
results from financial leverage—the extent to which
the firm relies on debt.
is the additional risk placed on the common stockholders as a result of the decision to finance with debt.
Debt represents fixed claims against the cash flows of the firm
If a firm uses more debt in its
financing, it is said to have
increased its leverage
(a)
Intuition behind M-M Proposition I
Purely financial transactions do not change the total cash flows from
operations, i.e. the size of the “pie” stays constant. Therefore, debt
nor equity can increase or decrease firm value.
But how can this be when debt is cheaper than equity? Answer:
using more debt will increase the riskiness of the equity.
In a perfect world, WACC will stay constant
M-M Theorem – Proposition II: Raising more debt makes
existing equity riskier. If the firm takes on more debt, the
required return on equity increases.
M-M Theorem – Proposition II (corollary): In a world
with no frictions, the WACC stays constant as you change
the debt to equity ratio.
(a)
The Dark Side of Debt: ___ ___
If taxes were the only issue, (most) companies would be 100% debt financed.
But common sense suggests this doesn’t make much sense. If the debt burden is too high, the company will have trouble paying it back. The result: ___ __.
So firms weigh the benefits of debt (tax avoidance) with the costs
(___ ___) to determine their optimal capital structure. This
determination depends on firm characteristics
(a)
The value
in $$ of foreign denominated
future cash flows will vary as
exchange rates change
foreign exchange risk
political risk
market imperfections
expanded opportunity set
The foreign exchange/FX Market
Sovereign
governments have the right to
regulate their markets. Laws may
change in unexpected ways
foreign exchange risk
political risk
market imperfections
expanded opportunity set
The foreign exchange/FX Market
Restrictions on movement of
goods, tariffs, tax arbitrage
foreign exchange risk
political risk
market imperfections
expanded opportunity set
The foreign exchange/FX Market
Many more opportunities as you
consider global activities
foreign exchange risk
political risk
market imperfections
expanded opportunity set
The foreign exchange/FX Market
Why do we need foreign currency?
• Import/export demand and supply
• Foreign direct investment (physical capital)
• Portfolio investments (financial securities)
• “Speculation”
The FX market establishes the price of each (domestic)
currency in terms of (other) foreign currencies.
The FX market has no central marketplace, so everything
happens through computer trades instead. Trillions of $
of currency changes hands every day
foreign exchange risk
political risk
market imperfections
expanded opportunity set
The foreign exchange/FX Market
the exchange rate in the
market for immediate delivery
(a)
the exchange rate in
the market for future delivery. A purchase on
the forward market is often referred to as
purchasing a forward contract.
(a)
The (a) on the spot and forward
markets need not be (and rarely are) identical.
The difference will reflect differences in
expectations about inflation, GDP growth, etc.
for each country
