...CHAPTER 15 Capital Structure: Basic Concepts Multiple Choice Questions: I. DEFINITIONS HOMEMADE LEVERAGE a 1. The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: a. homemade leverage. b. dividend recapture. c. the weighted average cost of capital. d. private debt placement. e. personal offset. Difficulty level: Easy MM PROPOSITION I b 2. The proposition that the value of the firm is independent of its capital structure is called: a. the capital asset pricing model. b. MM Proposition I. c. MM Proposition II. d. the law of one price. e. the efficient markets hypothesis. Difficulty level: Easy MM PROPOSITION II c 3. The proposition that the cost of equity is a positive linear function of capital structure is called: a. the capital asset pricing model. b. MM Proposition I. c. MM Proposition II. d. the law of one price. e. the efficient markets hypothesis. Difficulty level: Medium INTEREST TAX SHIELD a 4. The tax savings of the firm derived from the deductibility of interest expense is called the: a. interest tax shield. b. depreciable basis. c. financing umbrella. d. current yield. e. tax-loss carryforward savings. Difficulty level: Easy 15-1 UNLEVERED COST OF CAPITAL b 5. The unlevered cost of capital is: a. the cost of capital for a firm with no equity in its capital structure. b. the cost of capital for a firm with no debt in its capital structure. ...
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...international components. The importance of cross-border valuation methods have been underscored by trends toward the relaxation of capital controls, European economic integration, and, since the early 1990s, the opening and growth of Eastern European, Russian, Asian and Latin American markets. Cross-border acquisitions have been a particularly prevalent form of investment since 1980. American corporations, for example, increased their acquisitions of foreign targets by 160% between 1980 and 1990. Acquisitions of American targets by foreign companies rose about 50% during the same period. Some transactions, such as Matsushita Electric's $6.9 billion acquisition of MCA, Inc. in 1991, have been quite large. The majority, however, have been well under $100 million in size, suggesting that these transactions are not just the domain of giant multinationals. Evaluating crossborder opportunities is a critical consideration of executives and investors from around the world. The objective of this note is to review basic methods of valuing cross-border investments and the main issues affecting such valuations. It is intended to be a source of guidance, not a comprehensive review of the topic. The basic principles underlying discounted cash flow techniques for domestic valuations are covered in major finance textbooks. This note tries to accomplish two things. First, it raises the implications of a number of issues specific to cross-border valuations. These include: • The choice...
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...See discussions, stats, and author profiles for this publication at: https://www.researchgate.net/publication/228180753 Arcadian Microarray Technologies, Inc. ARTICLE · OCTOBER 2008 READS 516 2 AUTHORS, INCLUDING: Robert F. Bruner University of Virginia 287 PUBLICATIONS 1,490 CITATIONS SEE PROFILE Available from: Robert F. Bruner Retrieved on: 25 January 2016 Username: TO ACCESS THIS DOCUMENT This is a protected document. The first two pages are available for everyone to see, but only faculty members who have verified faculty status with Darden Business Publishing are able to view this entire inspection copy. Submit VERIFIED FACULTY If you have verified faculty status with Darden Business Publishing, simply enter the same username that you use on the Darden Business Publishing Web site, and then click “Submit.” Please note that this is an inspection copy and is not for classroom use. Faculty Register UNVERIFIED FACULTY If you are teaching faculty and do not yet have verified faculty access with Darden Business Publishing, please click on the “Faculty Register” link and submit your information requesting verified faculty access. Buy Case Now OTHER USERS If you would like to read the full document, click on “Buy Case Now” to be redirected to the Darden Business Publishing Web site where you can purchase this and other Darden cases. If you have any questions or need technical help, please contact Darden Business Publishing...
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...•5. Suppose a Midwest Telephone and Telegraph (MTT) Company bond, maturing in 1 year, can be purchased today for $975. Assuming that the bond is held until maturity, the investor will receive $1,000 (principal) plus 6 percent interest (that is, 0.06 × $1000 = $60). Determine the percentage holding period return on this investment. INTERMEDIATE 6.•a. National Telephone and Telegraph (NTT) Company common stock currently sells for $60 per share. NTT is expected to pay a $4 dividend during the coming year, and the price of the stock is expected to increase to $65 a year from now. Determine the expected (ex ante) percentage holding period return on NTT common stock. b. Suppose that 1 year later, NTT’s common stock is selling for $75 per share. During the 1-year period, NTT paid a $4 common stock dividend. Determine the realized (ex post) percentage holding period return on NTT common stock. c. Repeat Part b given that NTT’s common stock is selling for $58 1 year later. d. Repeat Part b given that NTT’s common stock is selling for $50 1 year later. INTERMEDIATE 7. One year ago, you purchased a rare Indian-head penny for $14,000. Because of the recession and the need to generate current income, you plan to sell the coin and invest in Treasury bills. The Treasury bill yield now stands at 8 percent, although it was 7 percent one year ago. A coin dealer has offered to pay you $12,800 for the coin. Compute the holding period return on this...
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...Financial Leverage And Capital Structure Policy 0 Chapter Outline The Capital Structure Question The Effect of Financial Leverage Capital Structure and the Cost of Equity Capital M&M Propositions I and II with Corporate Taxes Bankruptcy Costs Optimal Capital Structure 1 Capital Restructuring We are going to look at how changes in capital structure affect the value of the firm, all else equal Capital restructuring involves changing the amount of leverage a firm has without changing the firm’s assets The firm can increase leverage by issuing debt and repurchasing outstanding shares The firm can decrease leverage by issuing new shares and retiring outstanding debt 2 Choosing a Capital Structure What is the primary goal of financial managers? Maximize stockholder wealth We want to choose the capital structure that will maximize stockholder wealth We can maximize stockholder wealth by maximizing the value of the firm or minimizing the WACC 3 How does leverage affect the EPS and ROE of a firm? When we increase the amount of debt financing, we increase the fixed interest expense If we have a really good year, then we pay our fixed cost and we have more left over for our stockholders If we have a really bad year, we still have to pay our fixed costs and we have less left over for our stockholders Leverage amplifies the variation in both EPS and ROE 4 The Effect of Leverage Example:...
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...annual balance sheets for General Motors (GM), Merk (MRK), and Kellogg (K). For each company calculate the long term debt-equity ratio for the prior two years. Why would these companies use such different capitals structures? 2. Look up a company and download the annual income statements. For the most recent year, calculate the average tax rate and EBIT, and find the total interest expense. From the annual balance sheets calculate the total long-term debts (including the portion due within one year). Using the interest expense and total long term debts, calculate the average cost of debt. Next, find the estimated beta for the company on the S&P Stock Report. Use this reported beta, a current T-bill rate, and the historical average market risk premium found in a previous chapter to calculate the levered cost of equity. Now calculate the unleveraged cost of equity, then the unlevered EBIT. What is the unlevered value of the company? What is the value of the interest tax shield and the value of the levered company. Answer: |Company name/Year |Debt-equity ratio 2010 |Debt-equity ratio 2011 | |General Motors (GM) |0.28 |0.31 | |Merck (MRK) |0.28 |0.28 | |Kellogg (K) ...
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...assumed that Congoleum was varying its Debt to Equity ratio during those years. We discounted these cash flows by the required return on assets that was in turn calculated through use of the Modigliani-Miller unlevering formula (to derive the Asset Beta) and the Capital Asset Pricing Model. The required return on Congoleum debt was calculated by the expected return of the average CCC-company’s debt and the expected return of debt under default. Then, the present value of financial side effects was taken into account by discounting the interest tax shield by the required return on debt. Finally, we calculated the terminal value of cash flows by assuming a constant 4.14% growth rate in perpetuity and a constant D/E ratio for the years after 1984. Thus, these cash flows were initially discounted under WACC-ME. From there, we factored in prior debt and cash that Congoleum had generated to calculate the total equity value of the firm after the LBO had taken place. Background Congoleum is a firm active in three product market segments: home furnishings, shipbuilding, automotive, and industrial distribution. In the summer of 1979, First Boston Corporation with the help of Prudential Insurance Company proposed a purchase of Congoleum by private and institutional investors. The day before the issuance of the tender offer, Congoleum closed at $25.375 per share with 12.2 million shares...
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...includes a 26% premium over the current GEICO stock price of $55.75. This report attempts to determine a range of appropriate stock prices for GEICO. Using the Gordon dividend discount model, along with historical dividend information and projections by Value Line, we estimate the value of GEICO stock in the range of $58 to $80. A review of historical growth rates in GEICO dividends also lends credibility to the investment’s future potential. • Review of Warren Buffett’s investment record. While our analysis lends credence to the bid price of $70 per share for GEICO, we also examine the historical record of Warren Buffett. Buffett’s investment success may add to shareholder’s comfort, as his track record is remarkable when compared to broader market results. • Buffett’s investment philosophy. A letter to shareholders gives us a unique look at Buffett’s considerations for investing. By reviewing his checklist, we attempt to gain insight as to why such a premium is included in the GEICO offer. • Other issues. Buffett’s position on GEICO’s board of directors may shed light on the amount of information Buffett had about the future prospects of GEICO. At first glance, there appears to be some support for a higher price for GEICO. Value Line’s publication shows that the offer price is reasonable and historical growth rates may indicate reason to be optimistic However, only time will tell. GEICO Valuation GEICO Corp. currently sells for $55.75. The bid price of $70 per share represents...
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...Adjusted present value Wadia Haddaji February 20, 2008 • Topics: 1. Adjusted present value. • Readings: 1. Brealey, Myers and Allen, section 20.4. 1 The Adjusted-Present-Value Rule • Recall that we can write the value of a levered firm as the value of an otherwise identical all-equity firm and the value of its financing decisions: V = VU +NPV(financing decisions). • It is then obvious to define the APV of a project as the sum of its NPV to an all-equity firm and the PV of the associated financing decisions: APV = NPV(unlevered project) + NPV(financing decisions) • Separating the APV of a project into its NPV to an all-equity firm and the value of the associated financing decisions should be generally useful for the financial manager. 2 A Comparison of WACC and APV • Features/advantages of WACC. 1. WACC accounts for tax shield benefit of interest in discount rate. 2. WACC is widely adopted by practitioners and is easy to use. 3. WACC is applicable when D/E remains essentially constant through project life. 4. WACC is most appropriate when the project is “typical” of the firms traditional businesses (i.e., same risk), or “scale enhancing”. • Features/advantages of APV. 1. APV accounts for tax shield benefit of interest in cash flows (not discount rate). 2. APV was introduced by academics and is slowly being adopted in practice. 3. 11% of firms always or almost always use it. • APV often requires/accomodates knowledge of a particular debt repayment schedule. • APV (as opposed...
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...The Boeing 777 Darden Case Study UVA-F-1017 Case Study Assignment Subject: Cost of capital − cost of equity and cost of debt; beta risk; estimation; capital structure. The task for students is to evaluate the 777 against a financial standard, the investors’ required rate of return. The general objective of this case is to exercise students’ skills in estimating corporate (divisional/project) costs of capital – cost of equity and WACC. Case Questions, Analysis, and Directions: Read and analyze the case, and prepare an “Executive Summary” of this case. Write it as if you were writing it to the members of Boeing’s Board of Directors, who may not know much about the project or finance. Your Executive Summary will include: (1) A brief description of the firm and the 777 project – in your own words (about two-three paragraphs). (2) Which equity beta(s) did you use? Why? (3) When you used the capital-asset-pricing-model (CAPM), what equity-market risk-premium and risk-free rate did you use? Why? (4) Are the betas of other (industry similar) firms important? Why? Can they be used and how? If yes, what adjustments are needed? (5) List and briefly discuss various sources of capital used by Boeing. Evaluate the costs of these individual capital components for Boeing 777 project : (i) What is the cost-of-equity (R0), assuming all-equity financing? (ii) What is the cost-of-equity, considering the Boeing’s target leverage ratio? (iii) What is the cost-of-debt? (iv) What is the appropriate...
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...NEVADA DEPARTMENT OF TAXATION Capitalization Rate Study Principles of Development Calendar Year 2012 For the 2014-2015 Secured & 2013-2014 Unsecured Tax Year Valuation In the Department’s capitalization rate study, four capitalization criteria are considered: 1.) 2.) 3.) 4.) The estimate of the equity cost of capital must comport with common sense. The company’s equity risk premium should be reasonably stable over short periods of time. The estimate of the cost of equity should apply for the long term. The estimation procedure must be sufficiently straightforward so that it can be easily understood, applied, and even adjusted by educated practitioners. “The duration of the cost of equity should approximately match the duration of the dividend stream.” “Estimating the Cost of Equity Capital” (Bradford Cornell, John I. Hirshleifer, and Elizabeth P. James, Contemporary Finance Digest, Vol. 1, Number 1, Autumn, 1997). “With the respect to the oldest and most established model, the capital asset pricing model (CAPM), the academic consensus, to the extent that there is one, is that it does not work. Furthermore, there is no widely accepted alternative that does. (Cornell, p. 7) The Department’s capitalization rate model uses comparables, and: 1.) It provides development of “pure plays*”. 2.) It uses comparables to reduce measurement error, however, there is a trade-off between the reduced measurement error that averaging makes possible and the potent bias that it introduces. “There...
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...Powerball Lotto Jackpot Lump Sum or Annuity. *Historical Lump Sum Lottery Winner’s post win catastrophes and financial mismanagement aside. A few of the main factors we need to consider are inflation, income tax and interest rate. Firstly, Using the Present Value Function we can calculate the compound interest of the lump sum ($334.1m) in relation to the total value of the annuity payout ($500m). Based on the PV Formula: PV = FV/(1+i)n 334.1 = 500/(1+i)29 500/334.1 = (1+i)29 29√1.49 = 1+i 1.0139 – 1 = i Interest Rate = 1.4% To meet the $500m Future Value of the annuity payout, Lucky Ducky would have to gain 1.4% compound interest on the lump sum settlement. If Lucky Ducky feels that he can beat a 1.4% interest rate with his own investments he will benefit from taking his chances with the lump sum. Eg. If Lucky Ducky feels he can get 3% interest rate on his lump sum that would equal a FV of over $787m. FV = PV x (1+i)n FV = 334.1 x (1+.03)29 FV = 334.1 x (1+.03)29 FV = 334.1 x 1.0329 FV = $787.32m Inflation, Income tax on the lump sum vs. the annuity as well as investing the annuity differently will have to be considered as well. But for the bases of advice based on financial responsibility I would suggest Lucky Ducky to take the lump sum. Of course this does not consider...
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...growth in mind, Harriet Burns (CEO, 2011) and Richard Irvine (Chief Designer, 2011), were excited by Wren’s offer to sell the company to them. Wren proposed a selling price of 14 times the 2010 net income, or $25.2 million. Both Burns and Irvine agreed the price was fair, but they were faced with a situation- how to raise the capital needed to purchase Harmonic Hearing. Wren gave Burns three months to complete the transaction, creating a deadline of January 2011. To further complicate the situation, Harmonic was in the midst of developing a cutting-edge hearing aid that promised strong sales. To get the product to market quickly, Burns and Irvine needed to find additional capital to finance the R&D, manufacturing, and marketing of the new hearing aid. They could fund this additional cost by raising extra capital, or use internal cash instead (which could slow go-to-market time and dangerously deplete cash reserves). Burns and Irvine were fortune to have two alternatives for financing. The first...
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...BONDS AND SINKING FUNDS Amortization of Bond Premiums and Discounts *APPENDIX: The origin and calculation of bond premiums and discounts were discussed in Section 15.2. We will now look at the premiums and discounts from an accountant’s perspective. The point of view and the schedules developed here provide the basis for the accounting treatment of bond premiums, discounts, and interest payments. Amortization of a Bond’s Premium Bonds are priced at a premium when the coupon rate exceeds the yield to maturity required in the bond market. Suppose that a bond paying a 10% coupon rate is purchased three years before maturity to yield 8% compounded semiannually. The purchase price that provides this yield to maturity is $1052.42. The accounting view is that a period’s earned interest is the amount that gives the required rate of return on the bond investment. The interest payment after the first six months that would, by itself, provide the required rate of return (8% compounded semiannually) on the amount invested is 0.08 ϫ $1052.42 ϭ $42.10 2 The earned interest during the first six months from an accounting point of view is $42.10. The actual first coupon payment of $50 pays $50 Ϫ $42.10 ϭ $7.90 more than is necessary to provide the required rate of return for the first six months.7 The $7.90 is regarded as a refund of a portion of the original premium, leaving a net investment (called the bond’s book value) of $1052.42 Ϫ $7.90 ϭ $1044.52 This book...
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...everything right and still get two different answers because ROE, Net Income and Book value are different ways of looking at the same thing. Here are some common mistakes that causes a difference to creep in. Take a look at the second formula in Appendix B for Chapter 7. It is a formula for Market to Book value of equity. That is, in order to get the market value of equity, one needs to multiply the answer from the right-hand side of that formula by the current book value of equity. The ROE in this model is calculated as: o ROE = this year’s net income/last year’s book value of equity. This is different from the normal way of using numbers from the same year in the numerator and denominator of the formula. The growth rate in equity is not the growth from the equity value previous year to this year, it is cumulative growth from year zero to the last year. For every year t: o GBE at t = Book value of equity at year t-1/ Book value of equity at year zero You have to add 1 to the present value of all abnormal ROE*GBE terms before multiplying the resulting answer by the current book value. To recap, in order to get the answer from the abnormal ROE model, you do this: Market value of equity = Book value of equity today * [1+ abnormal ROE1*GBE0/(1+r)1 + abnormal ROE2*GBE1/(1+r)2 + abnormal ROE3*GBE2/(1+r)3+…+ abnormal ROEt*GBEt-1/(1+r)t + terminal value of [abnormal ROEt*GBEt] /(1+r)t ] How do I calculate the terminal value (not its present value what book...
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