Managerial finance chapter 10

What does the calculation of WACC envolves? •The calculation of WACC involves calculating the weighted average of the required rates of return on debt and equity, where the weights equal the percentage of each type of financing in the firms’s overall capital structure
What is “Re”? is the symbol that represents the cost of raising capital by issuing new stock in the weighted average cost of Capital (WACC) equation
What is “Rd”? (3) 1. is the symbol that represents the before-tax cost of debt in the weighted average cost of Capital (WACC) equation.2. Is the marginal cost of debt capital3. Yield t maturity on outstanding L-T debt, if that is not availale talk to your banker
What is “Rp”? is the symbol that represents the cost of preferred debt in the weighted average cost of Capital (WACC) equation
What is the equation for “WS” aka Equity Equity/ (Debt+ preferred stock + Equity)
What is th equation for “Wp” aka preffered stock Preferred Stock/ (Debt Preferred stock+ Equity)
What should management do when evaluating in a project (which risk is greater than the firm’s current risk level based on any method for assessing risk To take the higher risk level into account, they will need to use discount rate that is greater than the cost of capital to evaluate the project
Why does a company need to adjust the cost of debt for taxes? because interest payments are tax deductible. When all other factors are held constant, a higher tax rate will lower a firm’s weighted average cost of capital only if the firm uses debt financing
For which capital component must you take a tax adjustment when calculating a firm’s weighted average cost of capital (WACC)? DEbt
What is the equation for after-tax cost of debt? After-tax cost of debt= Interest rate on debt security (or issue)- Tax Savings(Generic)
What is the equation for annual coupon? • Annual coupon = bond’s face value x Annual coupon rate
What is preferred stock? Is a hybrid security, because it has some characteristics typical of debt and others typical of equity.
Does debt have voting rights? No
Is there tax adjustments for cost of preferred stock? No tax adjustments are made when calculating the cost of preferred cost
True or False: It is free for a company to raise money through retained earnings, because retained earnings represent money that is left over after dividends are paid out to shareholders False
True or False: Flotation cost are additional costs associated with raising new common stockFlotation costs need to be taken into account when calculating the cost of issuing new common stock, but they do not need to be taken into account when raising capital from retained earnings False
Flotation cost formula Flotation cost = initial investment x flotation cost rate
What for is the WACC used as discount rate? The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk
What are the factors that affect the weighted average cost of capital that are outsides a firms control (WACC)?(4) 1. Tax rate2. The inflation rate3. Interest rates in the economy4.The performance of index funds, such as the S&P 500
What are the factors that a firm can control? (1) capital structure (changing it affects the firm’s (wacc), because this will changes the weights
When will a higher tax rate lower a firm’s WACC when all other factors are held constant? Only if the firms uses debt financing
Considered investing in a project whose risk is greater than the firm’s current risk level based on any method for assessing risk. What should management do?
What sources of long-term capital does firms use? (5) 1. Long-term debt 2 Preferred Stock 3.Common Stock; 4. Retained Earnings 5. New Common Stock
At what costs comes capital? (3) 1. Investments in a business need to be financed2. Operating capital financed by liabilities or equity3. looking from the perspective of the company and CFO: Investor’s return are the CFO’s cost
Which one would you invest in? Highest return or where the return exceeds the cost? Compare the cost of capital to the return
What does the WACC consist of? (3) 1. The average cost of investor-supplied capital2. W’s: firms’ capital structure wieghts3. R’s: the cost of each component
What does stockholders focus on? On after-tax cash flows
What does tax effect and why? Tax only effects cost of debt, because interest is tax deductible
What is cost of capital used for? To make decisions about new capital investments
What is marginal cost? The cost of the next dollar
Historical or Marginal costs for WACC? Marginal costs for each component of WACC and then take the weighted average of the three component’s marginal costs
What is the order of preference for the weights of the WACC? (3) 1. Target capital structure ratio (best one, what the management uses to get their costs low)2.Market values (second best method, most used)3.Book values (the least preferred method, the financial statements
What are the components of cost of debt? (3) 1. Interest is tax deductible so2. Use nominal rate3. Flotation costs are small, so ignore them
What are the components of Cost of preferred stock?(2) 1. Rp= Marginal cost of preferred stock = required rate of return2.Rp= Dp/ Pp
What are the components of cost of equity? (2) 1. Rs = Marginal cost of retained earnings2. Re= Marginal cost of new equity issue
Why a cost for retained earnings? (2) 1. Earnings can either be reinvested or paid out as dividends2. Opportunity cost, if paid out, investors could have earned a return by reinvesting elsewhere
What are the three ways to determine the cost of common equity (Rs)? 1. CAPM: rs = rRF + (rM – rRF) b2. DCF: rs = (D1 / P0) + g3. Own-Bond-Yield-Plus-Risk-Premium: rs = rd + RP
How is the Own-bond-yield-plus-risk-premium method set up? (2) 1. Premium for stock based excess risk over its bond risk2. This RP (Risk Premium) is not the same as the CAPM Market Risk Premium. rs = rd + RP rs = %
What are the differences between “Cost of internal financing” and “Cost of external capital/issuing common stock”? (3) 1. Issuing new stock: Flotation costs paid to the underwriter.2. Internal Financing: Retained Earnings3.Issuing new common stock may send a negative signal to the capital markets, it may may depress the stock price.
When must external equity be used? (2) 1. When there is not enough internal equity (=retained earnings) to finance the business2. This is the Retained Earnings Breaking Point.
What are flotation costs? (2) 1. Flotation costs depend on the firm’s risk and the type of capital being raised.2. Flotation costs are highest for common equity.
What factors influence a company’s composite WACC? (3) 1. Market conditions.2. The firm’s capital structure and dividend policy.3. The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
Should the company use the WACC as hurdle rate for each project?(5) – Composite WACC reflects the risk of an average project undertaken by the firm. : 1. WACC only represents the “hurdle rate” for a typical project with average risk.2. Use a risk-adjusted WACC3. Don’t ever use the cost of one capital component to decide on an capital investment-Different projects have different risks. Project’s WACC should be adjusted to reflect project’s risk.
What are the factors influencing the WACC? (Global Markets) (4) 1. Technology has made the world a smaller place.2.Financial Markets are now increasingly connected with other markets across the world.3.Impact on WACC: Differences in WACC across countries are disappearing4.Small firms may still show differences in WACC across country borders,
Due to what small firms would not be able to access global markets? (2) 1. Local market/economic conditions2.Local government policies
What are the three major capital components? DebtPreferred stockCommon equity

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