FINA 3301 Chapter Notes - Chapter 18: Risk Management, Eurodollar, Call Option

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lilacmule890

28 Mar 2016

School

Northeastern University

Department

Finance & Insurance

Course

FINA 3301

Professor

Mark Bernfeld

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Document Summary

Risk is the possibility that our future earnings and free cash flows will be significantly lower than expected. Debt capacity: risk management can reduce the volatility of cash flows and this decreases the probability of bankruptcy: lower risk companies can use more debt which can lead to higher stock prices due to interest tax savings. Maintaining the optimal capital budget over time: risk management can help smooth out cash flows and limit the need for external capital which is expensive. Financial distress: risk management can reduce the likelihood of low cash flows and hence of financial distress. Borrowing costs: firms can sometimes reduce input costs: such as interest rate on debt: this is done through instruments called swaps. Tax effects: companies with volatile earnings pay more taxes than do more stable companies due to the treatment of tax credits. Compensation systems: more stable earning can be tied to bonus incentives for managers.

Related Questions

Fill in the blank using a number of terms listed below (@1 point per question).

Beta coefficient, Bonds, CAPM, Cash flows, Change, CV, Convertible bonds, Correlation, Correlation coefficient, Debenture, Discount, Diversifiable risk, Expected return, Interest rate risk, Inverted, Junk Bonds, Market risk, More, Normal, Opposite, Probability distribution, Ratings, Reinvestment rate risk, Risk, Risk averse investor, Risk premium, Standard deviation

When interest rates move up or down, bond prices move in the _________________ direction.

_____________ are referred to as non-amortized debt, which means interest is paid regularly during the term, usually semiannually, whereas repayment of principal does not occur until the maturity date.

The longer a bond has to maturity, _______________ sensitive the bondâs price is to changes in market interest rates. This is called ________________________.

Bonds with short maturities expose investors to high ____________________, which is the risk that income from a bond portfolio will decline because cash flows received from bonds will be rolled over at lower interest rates.

A bond with an annual coupon payment of $100 originally sold at par for $1,000. Market interest rates are currently 12%. This bond would be selling at a _____________ in order to compensate the purchaser for the below market coupon rate.

Once a bond has been issued, if the holder of the bond retains it until maturity the market value of the bond may ________________, but the ________________ will not.

An unsecured bond is referred to as a(n) __________________.

____________________ can generally be issued at somewhat lower interest rates than regular bonds.

Double-B and lower bonds are speculative, to be called _______________.

Bonds are assigned _____________ that reflect the probability of their going into default. The higher it is, the lower its risk and therefore its interest rate.

When the yield curve slopes upward, it is said to be _______________, because it is like this most of the time. Conversely, a downward-slopping yield curve is termed ______________.

Which of the following risks cannot be diversified away?

	A.	risk of a local natural disaster affecting company production
	B.	risk created by world political happenings
	C.	risk of losing a major contract
	E.	risk of a failed marketing campaign

Magee Company's stock has a beta of 1.20, the risk-free rate is 4.50%, and the market risk premium is 5.00%. What is Magee's required return?

	A.	10.25%
	B.	10.50%
	D.	11.00%
	E.	11.25%

Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? (Assume the market is in equilibrium.)

	A.	When held in isolation, Stock A has more risk than Stock B.
	C.	Stock A would be a more desirable addition to a portfolio than Stock B.
	D.	The required return on Stock A will be greater than that on Stock B.
	E.	The required return on Stock B will be greater than that on Stock A.

Which of the following statements is CORRECT?

	B.	Portfolio diversification reduces the variability of returns on an individual stock.
	C.	The smaller standard deviation is, the less likely that actual returns will be closer to expected returns, the lower the investment risk.
	D.	A stock with a beta of 1 is more risky than an average stock on the market.
	E.	A well-diversified investor will require to earn higher return on stocks with higher beta.

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? (WACC is the weighted average cost of capital, the financing rate, or discount rate)

	A.	The projectâs IRR increases as the WACC declines.
	B.	The projectâs NPV increases as the WACC declines.
	D.	The projectâs IRR decreases as the WACC declines.
	E.	none of the above is correct.

Burlees Inc.âs CFO has collected the following information to calculate its WACC:

â¢ The companyâs capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.

The companyâs tax rate is 40%.

What is the companyâs cost of common equity?

	A.	9.65%
	B.	13.00%
	D.	17.60%
	E.	18.91%

Burlees Inc.âs CFO has collected the following information to calculate its WACC:

â¢ The companyâs capital structure consists of 60% debt and 40% common stock.

The company has 20-year, 12% annual coupon bonds that have a face value of $1,000 and sell for $1,200.

The company uses the CAPM to calculate the cost of common stock. Currently, the risk-free rate is 3% and the market risk premium is 5%. The companyâs common stock has a beta of 2.

The companyâs tax rate is 40%.

What is the companyâs weighted average cost of capital (WACC)?

	A.	8.69%
	B.	9.21%
	D.	11.04%
	E.	12.51%

Which of the following statement is correct?

	A.	Higher flotation costs tend to reduce the cost of equity capital.
	C.	The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.
	D.	A higher risk projectâs WACC should be adjusted higher.
	E.	Retained earnings bear no capital cost at all.

I need help proof reading my assignment please, thank you in advance.

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.

FINA 3301 Chapter Notes - Chapter 18: Risk Management, Eurodollar, Call Option

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