Fin3403 Test 4

Front 1

On the most basic level, if a firm's WACC is 12%, what does this mean?

Back 1

It is the minimum rate of return the firm must earn overall on its existing assets. If it earns more than
this, value is created.

Front 2

In calculating the WACC, if you had to use book values for either debt or equity, which would you choose? Why?

Back 2

Book values for debt are likely to be much closer to market values than are equity book values.

Front 3

If you can borrow all the money you need for a project at 6%, doesn't it follow that 6% is your cost of capital for the project?

Back 3

No. The cost of capital depends on the risk of the project, not the source of the money.

Front 4

Why do we use an aftertax figure for cost of debt but not for cost of equity?

Back 4

Interest expense is tax-deductible. There is no difference between pretax and aftertax equity costs.

Front 5

What are the advantages of using the DCF model for determining the cost of equity capital? What are the disadvantages? What specific piece of info do you need to find the cost of equity using this model? What are some of the ways in which you could get this estimate?

Back 5

The primary advantage of the DCF model is its simplicity. The method is disadvantaged in that (1)
the model is applicable only to firms that actually pay dividends; many do not; (2) even if a firm
does pay dividends, the DCF model requires a constant dividend growth rate forever; (3) the
estimated cost of equity from this method is very sensitive to changes in g, which is a very uncertain
parameter; and (4) the model does not explicitly consider risk, although risk is implicitly considered
to the extent that the market has impounded the relevant risk of the stock into its market price. While
the share price and most recent dividend can be observed in the market, the dividend growth rate
must be estimated. Two common methods of estimating g are to use analysts’ earnings and payout
forecasts or to determine some appropriate average historical g from the firm’s available data.

Front 6

What are the advantages of using the SML approach to finding the cost of equity capital? What are the disadvantages? What specific pieces of info do you need to use this method? Are all of these variables observable, or do they need to be estimated? What are some of the ways in which you could get these estimates?

Back 6

Two primary advantages of the SML approach are that the model explicitly incorporates the relevant
risk of the stock and the method is more widely applicable than is the DCF model, since the SML
doesn’t make any assumptions about the firm’s dividends. The primary disadvantages of the SML
method are (1) three parameters (the risk-free rate, the expected return on the market, and beta) must
be estimated, and (2) the method essentially uses historical information to estimate these parameters.
The risk-free rate is usually estimated to be the yield on very short maturity T-bills and is, hence,
observable; the market risk premium is usually estimated from historical risk premiums and, hence,
is not observable. The stock beta, which is unobservable, is usually estimated either by determining
some average historical beta from the firm and the market’s return data, or by using beta estimates
provided by analysts and investment firms.

Front 7

How do you determine the appropriate cost of debt for a company? Does it make a difference if the company's debt is privately placed as opposed to being publicly traded? How would you estimate the cost of debt for a firm whose only debt issures are privately held by institutional investors?

Back 7

The appropriate aftertax cost of debt to the company is the interest rate it would have to pay if it
were to issue new debt today. Hence, if the YTM on outstanding bonds of the company is observed,
the company has an accurate estimate of its cost of debt. If the debt is privately-placed, the firm
could still estimate its cost of debt by (1) looking at the cost of debt for similar firms in similar risk
classes, (2) looking at the average debt cost for firms with the same credit rating (assuming the
firm’s private debt is rated), or (3) consulting analysts and investment bankers. Even if the debt is
publicly traded, an additional complication is when the firm has more than one issue outstanding;
these issues rarely have the same yield because no two issues are ever completely homogeneous.

Front 8

Suppose the president of Bedlam Produces has hired you to determine if the firm's cost of debt and cost of equity capital.

a) the stock currently sells for $50 per share, and the div per share will prob be around $5. Prez argues "It will cost us $5 per share to use the stockholders' money this year, so the cost of equity is equal to 10% ($5/50)." What's wrong with this conclusion?

b) Based on the most recent financial statements, Bedlam Products' total liabilities are $8 million. Total interest expense for the coming year will be about $1 mil. Prezz therefore reasons, "We owe 8 mil, and we will pay 1 mil interest. Therefore, our cost of debt is 1 mil/ 8 mil = 12.5%. What's wrong with this conclusion?

c) based on his own analysis, Prez is recommending increase its use of equity financing because "debt costs 12.5%, but equity costs only 10%; thus equity is cheaper." Ignoring all other issues, what do you think about the conclusion that the cost of equity is less than the cost of debt?

Back 8

a. This only considers the dividend yield component of the required return on equity.
b. This is the current yield only, not the promised yield to maturity. In addition, it is based on the
book value of the liability, and it ignores taxes.
c. Equity is inherently more risky than debt (except, perhaps, in the unusual case where a firm’s
assets have a negative beta). For this reason, the cost of equity exceeds the cost of debt. If taxes
are considered in this case, it can be seen that at reasonable tax rates, the cost of equity does
exceed the cost of debt.

Front 9

Both Dow Chemical and Superior Oil are thinking of investing in natural gas wells near Houston. Both companies are all equity financed. Dow and Superior are looking at identical projects. They've analyzed their respective investments, which would involve a negative cash flow now and positive expected cash flows in the future. These cash flows would be the same for both firms. No debt would be used to finance the projects. Both companies estimate that their projects would have an NPV of 1 mil at 18% discount rate and a -1.1 mil NPV at a 22% discount rate. Dow has a beta of 1.25, whereas Superior has a beta of .75. The expected risk premium on the market is 8%, and risk free bonds are yiedling 12%. Should either company proceed? Or Both? Explain

Back 9

RSup = .12 + .75(.08) = .1800 or 18.00%
Both should proceed. The appropriate discount rate does not depend on which company is investing;
it depends on the risk of the project. Since Superior is in the business, it is closer to a pure play.
Therefore, its cost of capital should be used. With an 18% cost of capital, the project has an NPV of
$1 million regardless of who takes it.

Front 10

Under what circumstances would it be appropriate for a firm to use diff costs of capital for its diff operating divisions? If the overall firm WACC were used as the hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? IF you were to try to estimate the appropriate cost of capital for diff divisions, what problems might you encounter? What are two techniques you could use to develop a rough estimate for each division's cost of capital?

Back 10

If the different operating divisions were in much different risk classes, then separate cost of capital
figures should be used for the different divisions; the use of a single, overall cost of capital would be
inappropriate. If the single hurdle rate were used, riskier divisions would tend to receive more funds
for investment projects, since their return would exceed the hurdle rate despite the fact that they may
actually plot below the SML and, hence, be unprofitable projects on a risk-adjusted basis. The
typical problem encountered in estimating the cost of capital for a division is that it rarely has its
own securities traded on the market, so it is difficult to observe the market’s valuation of the risk of
the division. Two typical ways around this are to use a pure play proxy for the division, or to use
subjective adjustments of the overall firm hurdle rate based on the perceived risk of the division.

Front 11

Explain what is meant by business risk and financial risk. Suppose firm A has greater biz risk than Firm B. IS it true that Firm A also has a higher cost of equity capital? Explain

Back 11

Business risk is the equity risk arising from the nature of the firm’s operating activity, and is directly
related to the systematic risk of the firm’s assets. Financial risk is the equity risk that is due entirely
to the firm’s chosen capital structure. As financial leverage, or the use of debt financing, increases,
so does financial risk and, hence, the overall risk of the equity. Thus, Firm B could have a higher
cost of equity if it uses greater leverage.

Front 12

How would you answer in the following debate?

q: isn't it true that the riskiness of a firm's equity will rise if the firm increases its use of debt financing?

a: yes, that's the essence of the prop

q: and isn't it true that, as a firm increases its use of borrowing, the likelihood of default increases, thereby increasing the risk of the firms debt?

a: yes

q: in other words, increased borrowing increases the risk of the equity and the debt?

a: yes

q: well, given the firm only uses debt and equity financing, and given that the risks of both are increased by increased borrowing, does it not follow that increasing debt increases the overall risk of the firm and therefore decreases the value of the firm?

a: ??

Back 12

No, it doesn’t follow. While it is true that the equity and debt costs are rising, the key thing to
remember is that the cost of debt is still less than the cost of equity. Since we are using more and
more debt, the WACC does not necessarily rise.

Front 13

Is there an easily identifiable debt-equity ratio that will maximize the value of a firm? Why/not?

Back 13

Because many relevant factors such as bankruptcy costs, tax asymmetries, and agency costs cannot
easily be identified or quantified, it’s practically impossible to determine the precise debt/equity ratio
that maximizes the value of the firm. However, if the firm’s cost of new debt suddenly becomes
much more expensive, it’s probably true that the firm is too highly leveraged.

Front 14

Refer to the observed capital structures given in Table 17.7. What do you notice about the types of industries with respect to their average debt-equity ratios? Are certain types of industries more likely to be highly leveraged than others? What are some possible reasons for this observed segmentation? Do the operating results and tax history of the firms play a role? How about their future earnings prospects? Explain

Back 14

The more capital intensive industries, such as airlines, cable television, and electric utilities, tend to
use greater financial leverage. Also, industries with less predictable future earnings, such as
computers or drugs, tend to use less financial leverage. Such industries also have a higher
concentration of growth and startup firms. Overall, the general tendency is for firms with
identifiable, tangible assets and relatively more predictable future earnings to use more debt
financing. These are typically the firms with the greatest need for external financing and the greatest
likelihood of benefiting from the interest tax shelter.

Front 15

Why is the use of debt financing referred to as financial "leverage."?

Back 15

It’s called leverage (or “gearing” in the UK) because it magnifies gains or losses.

Front 16

What is homemade leverage?

Back 16

Homemade leverage refers to the use of borrowing on the personal level as opposed to the corporate
level.

Front 17

As mentioned in the text, some firms have filed for bankruptcy because of actual or likely litigation-related losses. Is the a proper use of the bankruptcy process?

Back 17

One answer is that the right to file for bankruptcy is a valuable asset, and the financial manager acts
in shareholders’ best interest by managing this asset in ways that maximize its value. To the extent
that a bankruptcy filing prevents “a race to the courthouse steps,” it would seem to be a reasonable
use of the process.

Front 18

Firms sometimes use the threat of a bankruptcy filing to force creditors to renegotiate terms. Critics argue that in such cases the firm is using bankruptcy a sword rather than a shield. Is this an ethical tactic?

Back 18

As in the previous question, it could be argued that using bankruptcy laws as a sword may simply be
the best use of the asset. Creditors are aware at the time a loan is made of the possibility of
bankruptcy, and the interest charged incorporates it.

Front 19

As mentioned in the text, Continental Airlines filed for bankruptcy, at least in part, as a means of reducing labor costs. Whether this move was ethical, or proper, was hotly debated. Give both sides of the argument.

Back 19

One side is that Continental was going to go bankrupt because its costs made it uncompetitive. The
bankruptcy filing enabled Continental to restructure and keep flying. The other side is that
Continental abused the bankruptcy code. Rather than renegotiate labor agreements, Continental
simply abrogated them to the detriment of its employees. In this, and the last several, questions, an
important thing to keep in mind is that the bankruptcy code is a creation of law, not economics. A
strong argument can always be made that making the best use of the bankruptcy code is no different
from, for example, minimizing taxes by making best use of the tax code. Indeed, a strong case can be
made that it is the financial manager’s duty to do so. As the case of Continental illustrates, the code
can be changed if socially undesirable outcomes are a problem.

Front 20

What is the basic goal of financial management with regard to capital structure?

Back 20

The basic goal is to minimize the value of non-marketed claims.

Front 21

1. Assets

Back 21

Liabilities + Stockholders’ Equity

Front 22

2. NWC

Back 22

CA – CL

Front 23

8. Perpetuity: PV

Back 23

C/r

Front 24

13. Fisher effect

Back 24

1 + R = (1+r)(1+h)

Front 25

3. Average Accounting Return

Back 25

avg net income / avg book value

Front 26

PI

Back 26

Present value of future cash flows / initial outlay

Front 27

7. Crossover Rate

Back 27

NPV(B-A) = NPV(A-B)

Front 28

8. Total Cash Flow

Back 28

Operation Cash Flow + Change in Net Working Capital + Capital Spending

Front 29

9. Operating Cash Flow

Back 29

= EBIT + Depreciation – Taxes
= NI + Depreciation
= Sales – Costs – Taxes
= (Sales – Costs)*(1 – T) + Depreciation*(T)

Front 30

10. Depreciation

Back 30

(initial cost - salvage) / # of years

Front 31

12. After Tax Salvage

Back 31

Salvage – T*(Salvage – Book)

Front 32

reward to risk ration

Back 32

[E(Ri) - Rf] / Bi

Front 33

market risk premium

Back 33

E(Rm) - Rf

Front 34

CAPM

Back 34

E(Ri) = Rf + Bi [E(Rm) - Rf]

Front 35

div growth model approach to cost of capital

Back 35

Re = (D1/P0) + g

Front 36

SML approach to cost of capital

Back 36

Rf + Be[E(Rm) - Rf]

Front 37

cost of debt, equity, pref stock

Back 37

Rf = (D/Po)

Front 38

parts of WACC

Back 38

a) V = D + E

b) We = E/V

c) Wd = D/V

Front 39

WACC

Back 39

WeRe + WdRd (1 - Tc) + WfRf

Front 40

weighted avg flotation cost

Back 40

Fa = (E/V)Fe + (D/V)Fd

Front 41

Leverage

Back 41

Debt$/Equity$

Front 42

EPS

Back 42

Net Income / (# shares outstanding)

Front 43

ROE

Back 43

Net Income / Equity$

Front 44

WACC m&m prop

Back 44

WACC = Ra = (E/V)Re + (D/V) Rd

Front 45

WACC to solve for the cost of equity capital

Back 45

Re = Ra + (Ra - Rd)(D/E)

Front 46

Annual Tax interest shield

Back 46

Tc x interest payment

Front 47

PV of annual interest tax shield

Back 47

DTe

Front 48

Vu

Back 48

Ebit(1-Tc)/Ru

Front 49

Vl

Back 49

Vu + DTc

Front 50

MM prop II with corporate taxes

Back 50

Re = Ru + (Ru - Rd) x (D/E) x (1 - Tc)