AFM373 Lecture Notes - Lecture 6: Capital Structure, Opportunity Cost, Cash Flow

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lilacmouse857

28 Jun 2018

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM373

Professor

Neil Brisley

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Nike

January 24, 2018 1:53 PM

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Cost of capital (equity + debt) to the firm

Takes in account of the opportunity cost

because investors can get stable returns

from a bank, government treasury

bonds, etc.

•

rD = required return for the bondholders to

match the risk.

rE = required return as well for shareholders

to evaluate their investment in the company

From the firm's POV, it is the cost

The required return for the investors are

forward looking.

Investors in the market sets the WACC

Risks of the cash flow that we are

generating (

business risks

)

•

Risks of the capital structure (

financial

risks

)

•

Investors evaluate the two risks

WACC is used to valuate the individual

projects the firm takes on, and also the

valuating the whole firm with free cash flows

What Joanna did in the case for kd is

estimating past debt which is not good.

In theory, we should use the going

forward tax rate.

Beta = 1 for market

We want the forward looking MRP but its

hard to measure. So we used a historical

MRP with geometric rate.

For beta, use either the average or the

most recent YTD beta. Different

arguments for both.

Book value of debt is often very

close to market value.

•

To find the market rate of debt, use

the book value and x 0.96

•

We want market value of enterprise value

(both debt and equity)

For a private corporation, its hard to find

the value of equity

If we believe that cash is not needed, then we can use it

to paydown debt. Only if it is excess cash.

•

The other POV is that its not excess cash, we need it to

operations and it couldn't be used to pay down debt,

then we ignore it and say it's part of net working capital.

Do not deduct it from debt.

•

Why deduct cash to get net debt? If not, why?

Firm's really care about getting the right WACC because if you

underestimate your WACC, you'll start accepting negative NPV

projects. If you overestimate, you'll skip over positive NPV

projects.

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Document Summary

Cost of capital (equity + debt) to the firm rd = required return for the bondholders to match the risk. Takes in account of the opportunity cost because investors can get stable returns from a bank, government treasury bonds, etc. re = required return as well for shareholders to evaluate their investment in the company. From the firm"s pov, it is the cost. The required return for the investors are forward looking. Risks of the cash flow that we are generating (business risks) Wacc is used to valuate the individual projects the firm takes on, and also the valuating the whole firm with free cash flows. What joanna did in the case for kd is estimating past debt which is not good. In theory, we should use the going forward tax rate. We want the forward looking mrp but its hard to measure. For beta, use either the average or the most recent ytd beta.

Related Questions

Question 2

If you calculated WACC for a firm, in what order (from largest to smallest) would you expect to see WACC, cost of equity (re), and cost of debt (rd)? All rates are after taxes, and assume that the firm operates at its target capital structure.

re > rd > WACC.

re > WACC > rd.

WACC > re > rd.

rd > re > WACC.

WACC > rd > re.

Question 3

Andresson Inc. has no debt, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?

The Division A project with a 9% return.

The Division A project with a 11% return.

The Division B project with an 11% return.

The Division B project with a 13% return.

The company-wide project with an 11% return.

Question 4

Which of the following statements is CORRECT?

A change in a company's target capital structure cannot affect its WACC.

WACC calculations should be based on the before-tax costs of all the individual capital components.

Flotation costs associated with issuing new common stock normally increase the WACC.

If a company's tax rate decreases, then, all else equal, its weighted average cost of capital will decline.

An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

Question 5

A company's perpetual preferred stock currently sells for $98.50 per share, and it pays an $7.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 8.00% of the issue price. What is the firm's cost of preferred stock?

7.72%

8.22%

8.83%

9.10%

9.40%

Question 6

O'Henry Inc. has a beta of 1.15 and a tax rate of 30%. The risk free rate of interest is 5.00%; and the market rate of return expected on equity securities is 13.00%. What is the firm's cost of common equity based on the CAPM?

11.30%

12.35%

14.20%

15.35%

17.06%

Question 7

Muller Co. just paid a dividend of $0.60 on stock that is trading at $27.50 per share. They expect a growth rate of 8.00% (constant). Flotation costs are 5%. What is the cost of common equity based on the DCF approach?

9.42%

9.91%

10.48%

10.71%

11.51%

Question 8

A company issues bonds that yield 8.75% to investors with a after-tax cost of debt of 6.1%. Economists estimate the judgmental risk premium at 8.65%. What is an estimate of the company's cost of common equity?

12.59%

13.10%

14.63%

15.60%

17.40%

greysalmon790

Which of the following statements (if any) is (are) true concerning companies that do not pay dividends? a. The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry. b. The dividend capitalization model can be used to determine an accurate cost of equity capital. c. The cost of equity capital is equal to the growth short-term rate of earnings per share. d. The cost of equity capital can be estimated using the Capital Asset Pricing Model.

The optimal capital budget is determined by comparing the expected project returns to the company's

cost of equity schedule

marginal cost of capital schedule

computed break points

optimal opportunity curv

The managerial implications of capital structure theory include all of the following except:

optimal capital structure is influenced heavily by the business risk facing the firm

changes in capital structure result in changes in the market value of the firm's equity

capital structure changes transmit important information to investors

tax shield benefits from equity lead to increased firm value

Using the following information, write a one page narrative of what is found in the information below:

Please include answers to these two questions in the narrative.

Which firm would have the higher expected return between the unlevered equity holder and the levered equity holder? (show all the team calculations in arriving at the final answer).

2. How does the risk and cost of capital of levered equity compare to that of unlevered equity? Which is the superior capital structure choice for a perfect capital market, and why?

Expected CashFlow	=.50(Weak Cash Flows)+.50(strong Cash Flows)
Expected CashFlow	103,500.00
		NPV	$ 9,224.14	=-B6+(B2/(1+B7+B8))
			The investment has a positive NPV
		PV	$ 89,224.14	=+B2/(1+B9)
Cash Flow-weak economy	90,000.00
Cash Flow-strong economy	117,000.00
Initial Investment	80,000.00
Cost of Capital	16.00%
Risk-free Rate	5.00%

Cash Flows and Returns for Unlevered Equity
		Date 1: Cash Flow		Date 1: Return
		Strong	Weak	Strong	Weak
NPV	$ 9,224.14
PV	$ 89,224.14	117,000.00	90,000.00	31.13%	0.87%


Values & Cash Flows for Debt & Equity of the Levered Firm (Table 14.3)
	Date 0	Date 1: Cash Flow
	Initial Value	Strong Economy	Weak Economy
Debt	45,000	47,250	47,250
Levered equity		69,750	42,750
Firm	89,224	117,000	90,000


Returns to Equity with and without Leverage (Table 14.4)
	Date 0	Date 1: Cash Flow		Date 1: Returns
	Initial Value	Strong Economy	Weak Economy	Strong Economy	Weak Economy	Expected Return
Debt	45,000	47,250	47,250	5.00%	5.00%	5.00%
Levered Equity	44,224	69,750	42,750	57.72%	-3.33%	27.19%
Unlevered equity	89,224	117,000	90,000	31.13%	0.87%	16.00%


Systematic Risk and Risk Premiums for Debt, Unlevered Equity, and Levered Equity (Table 14.5)
	Return Sensitivity (Systematic Risk)	Risk Premium

Debt	0.00%	0.00%
Levered Equity	61.05%	0.00%	11.00%
Unlevered Equity	30.26%	-15.13%	22.19%

AFM373 Lecture Notes - Lecture 6: Capital Structure, Opportunity Cost, Cash Flow

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