CHAPTER 10 COST OF CAPITAL

Calculate cost of each capital source:

After-tax (AT) cost of debt = rd(1 - T), where rd is the before-tax cost of debt and T = tax rate. Likewise, rd = AT/(1 – T). (rd = YTM on bonds)

Cost of preferred stock= rp =Dp/Pp; where Dp is annual dividend payment per share and Pp is the preferred stock price per share.

Cost of Retained Earnings= rs Constant growth model: rs = D1/Po + g; D1 = Do(1 + g) CAPM model rs = rrf + (rm – rrf)b

Cost of New Common Stock (re): D1 re = --------- + g where Pn = net price = Po(1 – F%) or $Po - $F Pn F% or $F= flotation cost per share

re typically higher than rs because of flotation costs.

Weighted Average Cost of Capital (WACC) = wdrd(1 - T) + wprp + wc(rs or re) calculate WACC with retained earnings calculate WACC with new common stock

Capital structure weights (wd, wp, wc) based on book values. The weight is the dollar amount of the capital type divided by total assets. The sum of the weights must equal 100%.

Calculate the breakpoint: the amount of new capital a firm can raise before it uses up its level of retained earnings and has to issue new common stock to finance its investments.

$retained earnings $net income x (1 – dividend payout ratio) Breakpoint = -------------------------------- = -------------------------------------------------------- Common equity weight wc

Determine relevant source of common equity (retained earnings vs. new common) based upon the capital budget and the breakpoint.

CHAPTER 11 BASICS OF CAPITAL BUDGETING

Know the effect of understated/overstated WACC on project risk and NPV. A firm’s WACC is its required rate of return. A higher required rate of return implies higher risk and lower values. A lower required rate of return implies lower risk and therefore higher values.

Calculate all methods and know the decision rule for each: Regular payback (PB) and discounted payback (DPB) – know advantages/disadvantages of both payback methods

NPV

IRR

MIRR

Know the reinvestment rate assumption for each method: NPV assumes reinvestment of cash inflows at the firm’s WACC. IRR assumes reinvestment of cash inflows at the project’s IRR. MIRR assumes reinvestment of cash inflows at the firm’s WACC.

I. Decision criterion of acceptable projects: A. Independent 1. Payback and discounted payback exist. 2. NPV is positive 3. IRR and MIRR exceed the WACC. Note: if NPV is positive, IRR and MIRR automatically exceed the WACC. Also, just because payback exists, doesn’t automatically mean discounted payback exists. B. Mutually exclusive 1. Shortest payback 2. Shortest discounted payback 3. Highest NPV 4. Highest IRR 5. Highest MIRR Note: In the event there is a conflict in the ranking of 2 mutually exclusive projects, always choose the project with the highest NPV!

Nonnormal projects vs. normal projects- definition

Multiple IRR project – identify correct decision using NPV profile

Mutually exclusive projects and the crossover rate (rate at which NPVs are equal):

If WACC is less than crossover rate, NPV and IRR will lead to conflicting decisions.

If WACC is greater than crossover rate, no conflict.

Chapter 12 Cash Flow Estimation

Relevant cash flows (examples). Sunk costs are not relevant.

Do we include interest expense in the estimation of operating cash flow?

Calculate capital gain/loss and corresponding tax

Identify relevant cash flow in each year for expansion project: