FIN 401 Chapter Notes - Chapter 14: Retained Earnings, Financial Analyst, Stock Valuation

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30 Jan 2017

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The key fact to grasp is that the cost of capital associated with an investment depends on the risk of that investment. This is one of the most important lessons in corporate finance, so it bears repeating: The cost of capital depends primarily on the use of the funds, not the source. The use of the funds refers to risk associated with the investment. It is a common error to forget this crucial point and fall into the trap of thinking that the cost of capital for an investment depends primarily on how and where the capital is raised. Instead, we must somehow estimate it: the easiest way to estimate the cost of equity capital is to use the dividend growth model. We can arrange this to solve for re as follows: Of these, for a publicly traded, dividend-paying company, the first two can be observed directly, so they are easily obtainable.

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Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of companyâs bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCoâs tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 â Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 â .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 â 2014 = 7%

Beta = PepsiCoâs Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCoâs has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a companyâs cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a businessâs net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Letâs say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companyâs return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

1. Which of the following is true of the change in the weighted average cost of capital of a firm? a. A decrease in the weighted average cost of the capital increases the value of the firm. b. An increase in the weighted average cost of the capital increases the value of the firm. c. A decrease in the weighted average cost of the capital decreases the value of the firm. d. A decrease in the weighted average cost of the capital increases the cash flow generated by the investments. e. Any change in the weighted average cost of capital results in no change in the value of the firm.

2. The cost of debt to the firm is adjusted for _____. a. marginal revenue generated b. taxes c. interest rate d. internal rate of return e. return to investors

3. The firm's cost of external equity capital is the same as the required rate of return on the firm's outstanding common stock. a. True b. False

4. The target capital structure of a firm is the capital structure that: a. minimizes the operating risk of the firm's assets. b. maximizes the tax shield created by debt. c. minimizes the default risk of long-term debt. d. maximizes the price of the firm's stock. e. minimizes the risk premium paid on long-term debt.

5. The correct discount rate for a firm to use in capital budgeting, assuming that new investments are as risky as the firm's existing assets, is its marginal cost of capital. a. True b. False

6. The component costs of capital are market-determined variables in as much as they are based on investors' required returns. a. True b. False

7. The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by: a. the marginal revenue generated by investment in the new projects. b. the investors who purchase the firm's stocks and bonds. c. the internal rate of return of the firm. d. the cash flow generated by the investment in the additional projects. e. the dividend payout ratio fixed by the firm.

8. The marginal cost of capital _____ as more capital is raised during a given period. a. remains the same b. decreases c. increases d. changes in an unpredictable way e. approaches zero 10. The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases. a. True b. False

12. Omega Inc. has a history of abnormally high growth due to general economic fluctuations. Estimating the cost of common equity using the discounted cash flow approach is difficult because: a. the dividend yield is extremely difficult to estimate. b. the proper growth rate is difficult to establish. c. the market price of the common equity is very volatile. d. the firm grows at a constant rate in perpetuity. e. the firm's historical data of dividend yield is unavailable.

13. The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt. a. True b. False

14. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Which of the following is the cost of issuing new common stock? (Round off the answer to two decimal places.) a. 11.96 percent b. 12.25 percent c. 12.63 percent d. 10.24 percent e. 11.42 percent

15. Which of the following is a capital component for the purpose of calculating the weighted average cost of capital in capital budgeting? a. The after-tax cost of long-term debt b. The after-tax cost of common stock c. The after-tax cost of preferred stock d. The after-tax cost of retained earnings e. The after-tax cost of new equity

16. Which of the following statements is true of the impact of tax on the cost of capital of a firm? a. All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital. b. The before-tax cost of debt is the cheapest component of the cost of capital since the tax paid is a deductible expense. c. The before-tax cost of debt is always less than the after-tax cost of debt of a firm. d. The tax paid on dividends of preferred stock reduces the amount of funds that the firm can use for financing capital budgeting projects. e. All else being equal, an increase in the equity capital that a firm raises by retaining earnings results in in the increase in the tax rate applicable to the firm.

18. A firm's weighted average cost of capital (WACC) is: a. set by the board of directors of the firm because it is the benchmark they use to evaluate upper management. b. regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation. c. determined by the financial markets because investors provide the funds used by firms and these funds have costs, which are the returns demanded by investors. d. the same as the firm's internal rate of return (IRR). e. the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year.

19. Everything else equal, an asset's value is directly related to: a. the cost of raising additional capital. b. the rate of return investors require to invest in that asset. c. the risk associated with the investment in that asset. d. the cash flow the asset is expected to generate. e. the rate of return that the firm must earn to satisfy investors' demands.

24. If a project's _____ exceeds the firm's cost of capital, its NPV will be positive. a. marginal cost of capital b. cash flow c. rate of return expected by investors d. internal rate of return (IRR) e. discount rate

25. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. a. True b. False

26. The before-tax cost of debt, rd, is the same as the: a. average yield to maturity (YTM) associated with the firm's bonds. b. dividend yield associated with the firm's common stock. c. average coupon rate of the firm's bonds. d. return on equity if the firm has no preferred stock. e. the firm's marginal tax rate.

29. As per the Bond-Yield-Plus-Risk-Premium Approach, analysts estimate the cost of common equity by adding a risk premium of 3 to 5 percentage points to: a. the cost of preferred stock of the firm. b. the risk free rate of the common equity of the firm. c. the interest rate on the long term debt of the firm. d. the return on the firm's investment in municipal bonds. e. the growth rate of the firm.

30. The marginal cost of capital (MCC) is the cost of the last dollar of new capital that the firm raises, and the marginal cost declines as more and more of a specific type of capital is raised during a given period. a. True b. False

31. Which of the following statements is true of flotation costs? a. Flotation costs decrease the cost of preferred stock to the issuing firm. b. Flotation costs are added to the issue price of preferred stock to compute the cost of preferred stock. c. Floatation costs are added to the cost of debt to compute the weighted average cost of capital of a firm. d. Floatation costs result in higher funds available from the issue of preferred stock to the firm. e. Floatation costs increase the rate the issuing firm must earn to pay the preferred dividend.

34. Under normal circumstances, the weighted average cost of capital is used as the firm's required rate of return because: a. as long as the firm's investments earn returns greater than the cost of capital, the value of the firm will not decrease. b. returns below the cost of capital will cover all the fixed costs associated with the capital and provide excess returns to the firm's stockholders. c. it is comparable to the average of all the interest rates on debt that currently prevail in the financial markets. d. it is an indication of the return the firm is expecting to earn in future from all of its expansion plans. e. the weighted average cost of capital remains unchanged if the components costs of capital changes.

36. The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. a. True b. False

38. The after-tax cost of debt is used to calculate the weighted average cost of capital since we are concerned with the after-tax cash flows of the firm. a. True b. False

39. Beige Inc. plans to issue preferred stock that pays an $11.50 dividend per share and sells for $120 per share in the market. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, so Beige will net $115.20 per share. Which of the following is Beige's cost of preferred stock? (Round off the answer to two decimal places.) a. 8.89 percent b. 12.25 percent c. 11.50 percent d. 15.20 percent e. 9.98 percent

40. The Jackson Company has just paid a dividend of $3.00 per share on its common stock, and it expects this dividend to grow by 10 percent per year, indefinitely. The firm has a beta of 1.50; the risk-free rate is 10 percent; and the expected return on the market is 14 percent. Which of the following is the required rate of return as per the capital asset pricing model (CAPM) approach? a. 9 percent b. 12 percent c. 7 percent d. 16 percent e. 18 percent

41. J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Which of the following is the firm's cost of retained earnings? (Round off the answer to two decimal places.) a. 16.34 percent b. 10.42 percent c. 15.50 percent d. 12.20 percent e. 13.25 percent

42. Omega Inc.'s net income is expected to be $600,000 and the firm's payout ratio is 60 percent. The firm's common stock ratio is 30 percent and it has no preferred stock outstanding. Which of the following is the retained earnings break point for Omega Inc.? a. $400,000 b. $250,000 c. $375,000 d. $100,000 e. $800,000

43. Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 per share from the sale of new common stock. The firm recently paid a dividend of $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.) a. 12.24 percent b. 13.56 percent c. 14.12 percent d. 16.47 percent e. 17.53 percent

44. Super Solutions Inc. is a constant growth firm, which just paid a dividend of $3.00, sells for $33.00 per share, and has a growth rate of 6 percent. Which of the following is the cost of retained earnings using the discounted cash flow (DCF) approach? (Round off the answer to two decimal places.) a. 12.55 percent b. 15.64 percent c. 16.25 percent d. 13.35 percent e. 12.40 percent

45. The _____ is equal to the average rate of return that investors require to provide funds to the firm in the form of debt. a. Coupon rate b. Yield to maturity (YTM) c. Maturity value d. Discount rate e. Internal rate of return

46. Oval Inc. has just paid a dividend of $1.50 per share on its common stock, and it expects this dividend to grow by 4 percent per year, indefinitely. The firm plans to issue common stock at $16. The firm's investment bankers believe that new issues of common stock would have a flotation cost equal to 4 percent of the current market price. Which of the following is the cost of newly issued common stock? (Round off the answer to two decimal places.) a. 14.16 percent b. 10.15 percent c. 15.36 percent d. 13.80 percent e. 16.92 percent

47. Diggin Tools just issued new preferred stock, which sold for $85 in the stock markets. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 30 percent. Which of the following is the component cost of preferred stock, rps? (Round off the answer to two decimal places.) a. 10.75 percent b. 10.52 percent c. 12.25 percent d. 11.70 percent e. 11.05 percent

48. Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm's marginal tax rate is 40 percent. Which of the following is Rollins' component cost of debt? (Round off the answer to one decimal place.) a. 8.4 percent b. 7.2 percent c. 6.8 percent d. 5.3 percent e. 9.5 percent

50. Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share; however, the firm will net only $80 per share from the sale of new preferred stock. What is the firm's cost of newly issued preferred stock? (Round off the answer to two decimal places.) a. 11.15 percent b. 12.50 percent c. 16.45 percent d. 10.52 percent e. 13.46 percent

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Take a look at and read this article that discusses the cost of capital. What are your thoughts? Elaborate and Explain

Capital for a small business is simply money. It is the financing for the small business or the money used to operate and buy assets. Cost of capital is the cost of obtaining that money or financing for the small business. The cost of capital is also called the hurdle rate.

Should very small businesses even worry about their cost of capital? The answer to that is absolutely yes! Even very small businesses need money to operate and that money is going to cost something. Companies want that cost to be as low as possible.

What is Capital?

Capital is the money businesses use for financing their operations. The cost of capital is simply the rent, or interest rate, it costs the business to obtain financing. In order to understand cost of capital, you must first understand the concept of capital. Capital for very small businesses may just be the supplier credit they rely on. For larger businesses, capital may be the supplier credit and longer term debt or liabilities, which are the firm's liabilities.

If a company is public or takes on investors, then capital will also include equity capital or common stock. Other equity accounts will be retained earnings, paid-in capital, perhaps preferred stock.

Why is Capital Important?

In order to build new plants, buy new equipment, develop new products, and upgrade informationtechnology, businesses have to have money or capital. For every decision like this, a business owner or Chief Financial Officer (CFO) has to decide if the return on the investment is greater than the cost of capital or the cost of the money it takes to invest in the project.

Business owners do not usually invest in new projects unless the return on the capital they invest in these projects is greater than or at least equal to the cost of the capital they have to use to finance these projects. Cost of capital is the key to all business decisions.

What is the Cost of Capital?

A company's cost of capital is simply the cost of money the company uses for financing. If a company only uses current liabilities and long-term debt to finance its operations, then it uses debt and the cost of capital is usually the interest rate on that debt.

If a company is public and has investors, then cost of capital gets more complicated. If the company only uses funds provided by investors, then the cost of capital is the cost of equity. Usually, this type of company has debt but it also finances with equity financing or money that investors supply. In this case, the cost of capital is the cost of debt and the cost of equity.

The combination of debt and equity financing for a company is the company's capital structure.

What is Return on Capital?

Return on capital is the amount of profit you earn out of a business or project as compared to the amount of capital you invested. The key to cost of capital for a company is that a company's return on capital must always equal or exceed the cost of capital for any project in which the firm wants to invest. In other words, the company's investment rate of return (return on capital) must equal or exceed their financing rate of return (cost of capital) in order for the firm to be profitable.

What Composes the Cost of Capital

One component of the cost of capital is the cost of debt financing. For larger businesses, debt usually means large loans or bonds. For very small companies, the debt can mean trade credit. For either, the cost of debt is the interest rate the company pays on debt.

Another component of the cost of capital is the cost of equity financing if your company is a public company; in other words, if you have investors in your company who provide money in exchange for an ownership stake in the company.

There are several components of the cost of equity capital. First, there is the cost of retained earnings or the money that the company invests back into the company, instead of paying outdividends. Next, there is the cost of new common stock or stock that the company issues to raise money. Last, the company may even issue preferred stock to raise money.

For very small firms, the cost of capital may be much simpler. There are advantages and disadvantages to both debt and equity financing, including cost, that any business owner must consider before adding them to the capital structure of the company. Very small firms may just useshort term debt, in which case we have to establish a cost for this capital component.

The Company's Weighted Average Cost of Capital

Once the business owner understands the concepts of capital and cost of capital, the next step is to understand weighted average cost of capital. Each capital component is a certain percentage of the company's capital structure. In order to arrive at the true cost of capital for a business firm, the owner must multiply the percentage of the company's capital structure for each component by the cost of that component and sum them.

Summary of Cost of Capital

Before a company can engage in buying assets or obtaining financing for its operations, it must make some determination of its cost of capital -- what it really costs the firm for the money it has to have to for all its financing. That cost of financing must never exceed its return on capital. Here is a cost of capital video series that you may find helpful. It helps put the return on capital and cost of capital in real world terms for you.

FIN 401 Chapter Notes - Chapter 14: Retained Earnings, Financial Analyst, Stock Valuation

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