FIN 401 Study Guide - Final Guide: Risk Premium, Capital Structure, Tax Shield
17 May 2018
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Chapter 12: Cost of Capital: ; ; ` ` ;
(WACC)Weight Average Cost of Capital – Combination of Cost of Debt (Bonds) and Cost of Equity (Stocks)
1.
Security Market Line (SML):
Advantage: Adjust for systematic Risk
Disadvantage:
Have to estimate expected market
risk premium and beta which vary over time; Relying on past to predict future
which is not always reliable
Cost of Equity:
1. Dividend Discount:
2. Growth Model Approach:
Estiatig g :
1. Compound Growth Rate: Use Compound Function
2. Historical Growth Rate:
→
3. Retention Ratio: :
4.
5. Analysts Forecast:
Advantage: Easy to understand & Use
Disadvantage:
Only applicable to companies paying dividends; not applicable if dividends
are’t groig at a ostat rate; sesitie to estiated groth rate hage;
does not explicitly consider risk
WACC: Accept Project if IRR>WACC
)(D%)
Chapter 16: Capital Structure- The mix of different securities issued by the firm to finance its operations. Altering this can change the cost of capital/market value of the firm, therefore
axiizig shareholder’s wealth
Financial Leverage: Extent in which a firm relies on debt; higher leverage= higher WACC = Higher Debt. Leverage amplifies variation of both EPS+ROE; variability increases when financial leverage increase
Financial Break Even Point: When ROE is 0. If Expected EBIT > Break-even point, leverage is beneficial to stockholders otherwise it is detrimental
➢ Break Even EBIT
➢ Solve EPS for current Capital Structure
➢ Solve EPS for proposed capital structure
➢ Solve EBIT: Make current and proposed capital structure equal to each other → Divide by current stocks outstanding for EPS at break-even
Homemade Leverage (HML): The use of personal borrowing to alter the degree of financial leverage
M&M Proposition 1:
➢ No Tax – The value of a levered firm is equal to the value of an unlevered firm
o
o Capital structure is irrelevant; WACC is the same no matter how it is financed
➢ With Tax – The value of levered firm is equal to the value of an unlevered firm plus the tax shield
o
o Debt Financing is beneficial with an extreme scenario of 100% debt financing; WACC decreases
with debt financing
o
= Tc x D
M&M Proposition 2:
➢ No Tax – The cost of capital of a levered equity is equal to the cost of
capital of unlevered equity plus a premium that is proportional to debt-
equity ratio
Cost of equity rises with debt; the risk depends on 2 things. Business risk &
Financial risk
➢ With Tax –
o
o
Debt and Taxes
:
Chapter 4: NPV & Time Value of Money
C: Constant Cash Flow, r: Discount Rate
Ex. How much must you donate or what is the value of bond after a payment is
made. (What is the value of bond before payment is made?
+ C)
Present Value of an n-period annuity w/ constant cash flows
Present Value of Cash flow that occurs in n periods
Ex. Cost of uni is 100 000/year 18 years from today if your discount rate is 9% compounded annually, what is
the present value today of 4 years of university starting 18 years from today?
1. Find PV of 4 years of Uni 18 years from now (n:4, I:9%, PMT: 100000): PV=323971.98
2. Find PV of uni in todays value
3. Chapter 6: Bond: CPN=Coupon Payment
4.
M&M proposal 3: Trade off Theory:
+Tc*D
Cost of Debt: (Bond Valuation)
1. Compound Interest Function: n=years*2 PMT=
P/Y=2 Solve For I%
2.
3.
4.
IRR < R (Reject) IRR > R (Accept)
IRR > COC = NPV>0 IRR<COC =
NPV<0
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