...Cost of Capital Calculating Cost of Capital: * Component Costs * Capital Structure Component Costs: * Cost of debt – R d * Cost of preferred stock – R p * Cost of equity – R e Component Cost of Debt (R d) * Loan: R d = Effective Annual Rate of Loan. EAR=1+APRmm-1 * Bond: R d = YTM. P0=c×1Rd-1Rd(1+Rd)t+FV(1+Rd)t Where: “c” is dollar coupon; “FV” is Face or par value, which is $1,000; “t” is remaining years to maturity. “P 0” is current market price of bond. Note: If the bond pays semi-annual coupon, divide “C” by 2; multiply “t” by 2; and multiply answer (R d) by 2. * Cost of Preferred Stock (R p): Rp=DIVPSP0 Where: DIV is $ preferred stock dividend; or dividend yield x PAR. P 0 is current market price of preferred stock. Note: Par value of preferred stock is $100. * Cost of Equity (Re) 1. Discounted Cash Flow Model (DCF model) Re=D1P0+g Where: D 1 is next period expected dollar dividend of common stock. Or, D1=D0 x (1 + g). “g” is constant dividend growth rate of common stock. P0 is current market price of common stock. 2. Capital Asset Pricing Model (CAPM) Re=Rf+E(Rm)-Rf×β Market Risk Premium Market Risk Premium Where: R f is risk-free rate. E(R m) is expected return on market. is beta of company. Estimating beta: Rstock=c+β×Rmarket+e Capital Structure: * Debt * Long-term debt * Interest-bearing short-term debt used to finance long-term assets. ...
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...Marriott Corporation - The Cost of Capital (Abridged) The Marriott Corporation is comprised of three major lines of businesses, lodging, restaurants and contract services. In order to decide which projects to take on in these divisions, each year a hurdle rate must be set which they use to discount a project’s cash flow to see if it will be profitable enough. We will conduct an analysis to calculate the hurdle rate for Marriott as a whole and for each division. We will use WACC as the hurdle rate. The results of our analysis show that Marriott’s WACC as a whole is 11,61 %. For lodging, 10,04% and for restaurants 13,03%. These should be the hurdle rates to use when valuating projects. The reason that these values differ is the difference in risk premiums and expected projects, and therefore financing and project lifetimes. We estimated a shorter project lifespan for restaurants than for lodging, since we believe lodging is a long term investment while restaurants and contract services are short term investments. The Marriott Corporation uses its estimate of the cost of capital to select investment projects which would increase the shareholders value by using the appropriate hurdle rates for each division. As is stated on page 2 of the case, a key element of their financial strategy is to invest only in projects that increase shareholders value. This practice makes sense as each division has a different level of risk associated with it and hence the cash flows involved should be...
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...Chapter 11 Efficient Capital Markets: Evidence 1. Roll’s critique (1977) is based on the assumption that capital markets are in equilibrium. What happens when the market is not in equilibrium? Suppose new information is revealed such that the market must adjust toward a new equilibrium which incorporates the news. Or suppose that a new security is introduced into the marketplace, as was the case of new issues studied in the Ibbotson (1975) paper. Given such a situation, the abnormal performance of an asset can be measured by the arbitrage profits available as its price is adjusted to a new market equilibrium. Before the disequilibrium situation as well as afterward, Roll’s critique applies and we cannot expect to observe any abnormal performance relative to an efficient index. However, the adjustment process itself can be used to detect abnormal performance relative to the market index prior to equilibrium. In this way, Ibbotson’s results can be interpreted either as 1) selection of an inefficient index, or 2) detection of abnormal performance during disequilibrium. 2. (a) The securities market can be efficient even though the market for information is not. All that is required for efficient securities markets is that prices fully reflect all available information. Should an individual—for example, a corporate insider—have monopoly access to valuable information, then the market cannot reflect the information because it is not publicly available. This is not a deficiency in...
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...Midland Energy Resources, Inc.: Cost of Capital Analysis TABLE OF CONTENTS I. EXECUTIVE SUMMARY ........................................................................................ 2 II. COMPONENT ESTIMATIONS ............................................................................... 2 1. Effective Tax Rate - t ............................................................................................. 2 2. Capital Structure – D/E ......................................................................................... 3 3. Cost of Debt - r" .................................................................................................... 3 Exploration & Production (E&P) ................................................................................ 3 Refining and Marketing (R&M).................................................................................. 4 Petrochemicals ......................................................................................................... 4 4. Cost of Equity -r# ................................................................................................... 4 1) r$ ........................................................................................................................ 4 2) βlevered ............................................................................................................. 4 Exploration & Production (E&P) .................................................................
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...Chapter 11 The Cost of Capital Sources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for Risk 11-1 What sources of long-term capital do firms use? Long-Term Capital Long-Term Debt Preferred Stock Common Stock Retained Earnings New Common Stock 11-2 Calculating the Weighted Average Cost of Capital WACC = wdrd(1 – T) + wprp + wcrs The w’s refer to the firm’s capital structure weights. The r’s refer to the cost of each component. 11-3 Should our analysis focus on before-tax or after-tax capital costs? Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i.e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible. 11-4 Should our analysis focus on historical (embedded) costs or new (marginal) costs? The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on today’s marginal costs (for WACC). 11-5 How are the weights determined? WACC = wdrd(1 – T) + wprp + wcrs Use accounting numbers or market value (book vs. market weights)? Use actual numbers or target capital structure? 11-6 Component Cost of Debt WACC = wdrd(1 – T) + wprp + wcrs rd is the marginal cost of debt capital. The yield to maturity on outstanding L-T debt is often used as a measure of rd. Why tax-adjust; i.e., why rd(1 – T)? 11-7 A 15-year, 12% semiannual coupon bond sells for $1,153.72. What is the cost of debt (rd)? Remember...
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...CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I. M. Pandey Indian Institute of Management Ahmedabad Vastrapur, Ahmedabad 380015 India E-mail: impandey@iimahd.ernet.in W. P. No. 2002-03-01 March 2002 i CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I M Pandey ABSTRACT This paper provides new insights on the way in which the capital structure and market power and capital structure and profitability are related. We predict and show that capital structure and market power, as measured by Tobin’s Q, have a cubic relationship. That is, at lower and higher ranges of Tobin’s Q, firms employ higher debt, and reduce their debt at intermediate range. This is due to the complex interaction of the market conditions, agency problems and bankruptcy costs. We also show saucer-shaped relation between capital structure and profitability because of the interplay of agency costs, costs of external financing and debt tax shield. To our knowledge, we are the first to uncover these results. Key words: capital structure; market structure; market power; Tobin’s Q; riskshifting; moral hazard; agency problems; pecking order; trade-off theory; asset substitution. ii CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER INTRODUCTION In corporate finance, works of Modigliani and Miller (1958; 1963) about capital structure irrelevance and tax shield advantage paved way for the development of alternative theories and a series of...
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...E 12. D 13. B 14. C 15. A SECTION B: Short Answer (8 Questions) (Answer all questions in this section, each question is worth 5 marks) 1. How is it possible that dividends are so important but, at the same time, dividend policy is irrelevant ? Answer : Signalling theory shows that dividends are important since they convey inside information to investors hence affect shares price. Under the MM assumptions, dividend policy is irrelevant because it only defines the form in which shareholders’ returns are received. Funds paid out as dividends can be replaced at zero cost by issuing more shares. From the shareholders’ viewpoint, returns can be received in the form of dividends (explicit cash flows) and capital gains (implicit cash flows). Changing dividend policy changes the form in which returns are received in a particular period, but cannot change the present value of the cash flows. 2. Suppose Growth Unlimited has just paid a $1 dividend. Over the next 3 years, you estimate the dividends will increase 50%, 25% and 20% respectively. After that, dividends should grow at 10% per year. An appropriate discount rate for this firm is 15%. What is the stock price for Growth Unlimited? Answer : P3=1*1.5*1.25*1.2*1.1/(0.15-0.1)=49.5 Current price P0=1*1.5/1.15 + 1*1.5*1.25/1.15^2 + 1*1.5*1.25*1.2/1.15^3 + P3/1.15^3=36.75 3. A share market analyst is able to identify the mispricing of share prices by comparing...
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...US E RE VI PR EW O P ON E R LY T Y ± N OF OT C E NG FO A R GE SA LE LEA OR R N CL ING AS SR O Northern Forest Products OM Case 90 Cost of Capital Directed FO R Northern Forest Products (NFP) was established in the 1800s to log timber in the Great North Woods. In response to changing conditions, the company underwent radical changes in the way it operates and currently it is a large multidivisional corporation. The major focus of the company remains managing over one million acres of timber production and overseeing the manufacture of consumer paper products from pulp derived from its land holdings. Over the years the company has diversified into several other related businesses, such as a moderately sized mill that produces paneling and wood flooring. This operation has developed a consistent outlet for all of its output and therefore is stable. The company is also involved in real estate as a result of developing some of the prime lake front properties from its forestlands for residential and private recreational use. Successful property development during the 1970s resulted in expanded real estate holdings. However, residential development was particularly hard hit during a recent economic downturn, and the company struggles in this area. NFP is aware of the increasing international demand for wood products and is concerned about recent environmental pressures concerning logging. The company believes that diversification strengthens...
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...US E RE VI PR EW O P ON E R LY T Y ± N OF OT C E NG FO A R GE SA LE LEA OR R N CL ING AS SR O Northern Forest Products OM Case 90 Cost of Capital Directed FO R Northern Forest Products (NFP) was established in the 1800s to log timber in the Great North Woods. In response to changing conditions, the company underwent radical changes in the way it operates and currently it is a large multidivisional corporation. The major focus of the company remains managing over one million acres of timber production and overseeing the manufacture of consumer paper products from pulp derived from its land holdings. Over the years the company has diversified into several other related businesses, such as a moderately sized mill that produces paneling and wood flooring. This operation has developed a consistent outlet for all of its output and therefore is stable. The company is also involved in real estate as a result of developing some of the prime lake front properties from its forestlands for residential and private recreational use. Successful property development during the 1970s resulted in expanded real estate holdings. However, residential development was particularly hard hit during a recent economic downturn, and the company struggles in this area. NFP is aware of the increasing international demand for wood products and is concerned about recent environmental pressures concerning logging. The company believes that diversification strengthens...
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...CASE 90: Northern Forest Products | Topic: Cost of Capital | Instructor: Dr. BILICI and Dr. Tran Phi Long | GROUP 11: Nguyễn Diệp An Hoàng Tiến Nhật Anh Phạm Nguyên Hạnh Đỗ Quang Huy Nguyễn Hoàng Long Nguyễn Phương Thủy Phạm Anh Thư Phan Thị Thu Trang Nguyễn Đức Trung Vũ Thị Minh Tú NOTHERN FOREST PRODUCT CASE STUDY Question 1: Explain the importance of risk adjustment in the capital budgeting allocation process by answering the following questions. a. Explain why risk adjustments are important and how they can affect firm value. Risk adjustment is of importance since evaluation of a project would not be appropriate if the hurdle rate is only based on the company risk. In determining the cost of capital for the project, risk must be accounted on the process of allocating capital and resources. The lack of risk adjustment in considering the proportion amount of capital invested in each project would result in the misallocation of resources. By adjusting the firm’s overall hurdle rate, the company can review the divisional risk before taking capital allocation and investment decision. Without risk adjustment, the firm’s stock value would be affected for taking in and allocating large proportion of resource in project with high risk which may result in loss. Besides, when the firm rejects acceptable project with low risk or allocate small amount of capital in the project, it may lose its competitiveness over other firms. To conclude, the improper risk...
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...CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I. M. Pandey Indian Institute of Management Ahmedabad Vastrapur, Ahmedabad 380015 India E-mail: impandey@iimahd.ernet.in W. P. No. 2002-03-01 March 2002 i CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER I M Pandey ABSTRACT This paper provides new insights on the way in which the capital structure and market power and capital structure and profitability are related. We predict and show that capital structure and market power, as measured by Tobin’s Q, have a cubic relationship. That is, at lower and higher ranges of Tobin’s Q, firms employ higher debt, and reduce their debt at intermediate range. This is due to the complex interaction of the market conditions, agency problems and bankruptcy costs. We also show saucer-shaped relation between capital structure and profitability because of the interplay of agency costs, costs of external financing and debt tax shield. To our knowledge, we are the first to uncover these results. Key words: capital structure; market structure; market power; Tobin’s Q; riskshifting; moral hazard; agency problems; pecking order; trade-off theory; asset substitution. ii CapStrMktPower I M Pandey CAPITAL STRUCTURE AND MARKET POWER INTRODUCTION In corporate finance, works of Modigliani and Miller (1958; 1963) about capital structure irrelevance and tax shield advantage paved way for the development of alternative theories and a series of...
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...Chapter 910 The Cost of Capital ANSWERS TO END-OF-CHAPTER QUESTIONS 910-1 a. The weighted average cost of capital, WACC, is the weighted average of the after-tax component costs of capital—-debt, preferred stock, and common equity. Each weighting factor is the proportion of that type of capital in the optimal, or target, capital structure. The after-tax cost of debt, rd(1 - T), is the relevant cost to the firm of new debt financing. Since interest is deductible from taxable income, the after-tax cost of debt to the firm is less than the before-tax cost. Thus, rd(1 - T) is the appropriate component cost of debt (in the weighted average cost of capital). b. The cost of preferred stock, rps, is the cost to the firm of issuing new preferred stock. For perpetual preferred, it is the preferred dividend, Dps, divided by the net issuing price, Pn. Note that no tax adjustments are made when calculating the component cost of preferred stock because, unlike interest payments on debt, dividend payments on preferred stock are not tax deductible. The cost of new common equity, re, is the cost to the firm of equity obtained by selling new common stock. It is, essentially, the cost of retained earnings adjusted for flotation costs. Flotation costs are the costs that the firm incurs when it issues new securities. The amount actually available to the firm for capital investment from the sale of new securities is the sales price of the securities less flotation...
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...PROVIDED BY THE EXAMINATIONS SECTION: Calculators, and Mathematical tables (PV and FV) PRINT YOUR STUDENT NUMBER ON TOP RIGHT HAND CORNER ANSWER ALL QUESTION ON THE PROVIDED ANSWER SHEET ALL ANSWERS MUST BE ANSWERED IN PENCIL. FINS 1613 Final Exam 1 S1 2006 Multiple Choice - 50 Questions: 1 mark each No negative marking 1) Hiphop Limited must choose between one of two mutually exclusive projects. • Project A has an up-front cost (t = 0) of $120,000, and it is expected to produce cash inflows of $80,000 per year at the end of each of the next two years. Two years from now, the project can be repeated at a higher up-front cost of $125,000, but the cash inflows will remain the same. • Project B has an up-front cost of $100,000, and it is expected to produce cash inflows of $41,000 per year at the end of each of the next four years. Project B cannot be repeated. Both projects have a cost of capital of 10 percent. Hiphop wants to select the project that provides the most value over the next four years. What is the net present value (NPV) of the project that creates the most value for the company? a) b) c) d) e) $34,425 $30,283 $29,964 $29,240 $24,537 2) Which of the following statements is most correct? a) b) c) d) e) Corporations generally face fewer regulations than sole proprietorships do. Corporate shareholders have unlimited liability. It is...
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...following statements is True (T) or False(F) (i) Financial statements are an important source of information to shareholders and stakeholders. (ii) Both the BS and the IS shows the financial position of fen at the end of the year. (ii) BS of a company must be prepared in the horizontal format only. (iv) Preparation of Profit & Loss Appropriation A/c is a requirement under the Companies Act, 1956. (v) Ratio Analysis is the only technique of analysis of financial statements. (vi) Methodical presentation of financial statements helps in Nation of various ratios. (vii) In Common Size Statements, each item is expressed as a percentage of some common items (total). (viii) Trend Percentage Analysis helps in Dynamic Analysis. (ix) Liquidity Ratios help in analysing the cash position of the firm. (x) In calculation of Acid Test Ratio, Inventory is included in current assets. (xi) Working Capital Turnover Ratio may be classified as an Activity Ratio. (xii) Debt-Equity Ratio is a measure of long-term solvency of a firm. (xiii) GP Ratio and NP Ratio give the profitability of the firm from the point of view of the shareholders. (xiv) Return on Equity and Earnings per Share are one and the same thing. (xv) DU PONT Analysis looks into the elements of profits. (xvi) Ratio Analysis provides the solution to the financial problems. Answers: (i) T, (ii) F, (iii) F, (iv) F, (v) F, (vi) T, (vii) T, (viii) T, (ix) F, (x) F, (xi) T, (xii) T, (xiii) F, (xiv) F, (xv) T, (xvi) F.] 2. Multiple...
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...product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the projects that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake. Conclusion: After calculating the NPV and the IRR for each project, I have determined that both the dishwasher and the trash compactor projects should be pursued. Both of them have shown positive NPVs at the new discount rate of 11.58% (WACC). Both projects also yielded IRRs greater than the given hurdle rate. The disposal did not meet these requirements and therefore should not be undertaken. Based on the optimal capital structure analysis, they should pursue as 70% debt proportion, which will give them the lowest cost of capital at 11.58%. Currently Star has no debt in their capital structure, so these new projects should begin to add debt to the company. However, no matter what debt and equity proportions are chosen for each project, the discount rate of 11.58% should be used, as the capital budgeting decisions should be independent of the...
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