...Cost of Capital Practice Problems 1. Why is it that, for a given firm, that the required rate of return on equity is always greater than the required rate of return on its debt? The required rate of return on equity is higher for two reasons: • The common stock of a company is riskier than the debt of the same company. • The interest paid on debt is deductible for tax purposes, whereas dividends paid on common stock are not deductible. 2. The Mountaineer Airline Company has consulted with its investment bankers and determined that they could issue new debt with a yield of 8%. If Mountaineer ' marginal tax rate is 39%, what is the after-tax cost of debt to Mountaineer? rd* = 0.08 (1 – 0.39) = 0.0488 or 4.88% 3. The Blue Dog Company has common stock outstanding that has a current price of $20 per share and a $0.5 dividend. Blue Dog’s dividends are expected to grow at a rate of 3% per year, forever. The expected risk-free rate of interest is 2.5%, whereas the expected market premium is 5%. The beta on Blue Dog’s stock is 1.2. a. What is the cost of equity for Blue Dog using the dividend valuation model? re = {[$0.50(1 + 0.03)] /$20} + 0.03 = 0.05575 or 5.575% b. What is the cost of equity for Blue Dog using the capital asset pricing model? re = 0.025 + (0.05) 1.2 = 0.025 + 0.06 = 8.5% 4. Gaggle Internet, Inc. is evaluating its cost of capital under alternative financing arrangements. In consultation with investment bankers, Gaggle expects to be...
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...Cost of Capital Introduction This paper examines key elements of a cost of capital policy to facilitate objective management and allocation of corporate funds. In order for a company to make long-term investments to grow, whether that is new equipment, new products or other assets, managers must be aware of the cost of acquiring any of these assets. The obvious objective for these managers is to earn more than the cost of capital and in doing so will increase their company’s market value. If they fail to adequately estimate their cost of capital and their long-term investments fall beneath the cost of capital, their company’s market value will decline as a result. This ongoing battle of managing and calculating the cost of capital and how to budget them accordingly is extremely important in providing the necessary goals of increasing value to their company’s stockholders. The information that managers use will ultimately dictate the outcomes of their company’s cost of capital policy and how the allocate corporate funds. This paper will highlight several processes and elements managers use in determining capital cost. Functions for Decision Making When corporate managers think about the cost of capital and cost allocation, there are several factors that must be analyzed and weighed. First, managers need to look at the general economic condition for their industry as well as overall market. These would include the demand and supply of capital within the economy, and any...
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...[pic] ILLUSTRATION 1 COMPUTE THE COST FOR THE FOLLOWING: a. A bond that has a Rs 1,000 par value (face value) and coupon interest rate of 12 percent. A new issue would have a flotation cost of 5 percent of the Rs 1,100 market value. The bonds mature in 10 years The firm's average tax rate is 25 percent and its marginal tax rate is 30 percent. b. A preferred stock paying a 9 percent dividend on a Rs 100 par value. If a new issue is offered, flotation costs will be 5 percent of the current price of Rs 125. c. Internal common equity where the current market price of the common stock is Rs 60 The expected dividend for coming year should be Rs 6, increasing thereafter at a 8 percent annual growth rate. The corporation's tax rate is 30 percent. d. A new common stock issue that paid a Rs 12 dividend last year. The par value of the stock is Rs 100, and earnings per share have grown at a rate of 6 percent per year. This growth rate is expected to continue into the foreseeable future. The company maintains a constant dividend-earnings ratio of 30 percent. The price of this stock is now Rs 110, but 5 percent flotation costs are anticipated. Solution A. GIVEN, Par value = Rs 1,000 Coupon interest = 12% Flotation cost = 5% of Rs 1100 = Rs 55 Maturity period (n) = 10 years Marginal tax rate = 30% Average tax rate = 25% ...
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...Cost of Capital- Coffee Industry Group No. 4 Submitted to- Group Members- Prof. Sarath Babu Himakshi Mallik Vitash Sharma Rahul Rishav Avinash M Kopparapu Prudhvi Nadh Cost of Capital- Coffee Industry We have taken into consideration two firms- New World Coffee and New York Yankees. ESTIMATING COST OF EQUITY FOR A PRIVATE FIRM • Basic Problem: Most models of risk and return (including the CAPM) use past prices of an asset to estimate its risk parameters (beta(s)). Private firms and divisions of firms are not traded, and thus do not have past prices. • • Solution 1: Estimate the beta, based upon comparable firms, and after adjusting for risk. o Step 1: Collect a group of publicly traded comparable firms, preferably in the same line of business, but more generally, affected by the same economic forces that affect the firm being valued. A Simple Test: To see if the group of comparable firms is truly comparable, estimate a correlation between the revenues or operating income of the comparable...
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...Managerial Finance – Problem Review Set – Cost of Capital – with solutions 1) |If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. | | | | | | | | | | |b. |A Division B project with a 12% return. | |c. |A Division A project with an 11% return. | |d. |A Division A project with a 9% return. | |e. |A Division B project with an 11% return. | 5) |Vang Inc. estimates that its average-risk projects have a WACC of 10%, its below-average...
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...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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...THE COST OF CAPITAL The investor-supplied items- debt, preferred stock, and common equity- are called capital components. Increases in assets must be financed by increases in these capital components. The cost of each component is called its component cost. For example, Allied can borrow money at 10%, so its component cost of debt is 10%. These costs are then combined to form a weighted average cost of capital, which is used in the capital budgeting process. rd interest rate on the firm’s new debt = before-tax component cost of debt. It can be found in several ways, including calculating the yield to maturity on the firm’s currently outstanding bonds. rd(1-T) after tax component of debt, where T is the firm’s marginal tax rate. rD(1-T) is the debt cost used to calculate the weighted average cost of capital. The after-tax cost of debt is lower than the before-tax cost because interest is deductible. rp component cost of preferred stock, found as the yield investors expect to earn on the preferred stock. Preferred dividends are not tax-deductible, hence, the before- and after-tax costs of preferred are equal. rs component cost of common equity raised by retaining earnings, or internal equity. It is also defined as the rate of return that investors require on the firm’s common stock. Most firms, once they have become well established, obtain all of their new equity as retained earnings, hence, rS is their cost of all new equity. re component cost of external...
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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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...Cost of Capital Pfizer is researched drug corporation that increases their own inventive pharmaceutical goods. Pfizer's global income exceeds $65 billion with a marketplace fissure close to 140 billion. The organization was founded in 1849 by two cousins, Charles Pfizer and Charles Ehart with the mission of learning and evolving new and better, ways to prevent and treat disease and improve the well-being of people. (History, 2014) This paper shall present to the reader Team B’s prospective of the week five video assignment. Our breakdown shall include a brief explanation on the cost of capital, capital asset pricing model, capital base, and capital structure. Cost of Capital The cost of capital is the least adequate rate of return on resource development that must be earned to be accepted by management. Owners use cost of capital to finance their business. Cost of capital refers to the cost of debt or cost of equity. Various corporations use a mixture of equity and debt to investment their productions. In general cost of capital to the industry may result from a subjective standard of all capital resource. In finance, this process is referred as the weighted average cost of capital (WACC). The cost of capital can change depending on the company; it also may rely on different aspects such as profitability, borrowing, and operating history. Capital Asset Pricing Model The capital asset pricing model (CAPM) is defined as, the association amongst risk and probable risk...
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...Case 12 “Best practices “in Estimating the Cost of Capital The Cost of Capital The purpose of this case is to present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital costs. This evidence is valuable in several respects. First, it identifies the most important ambiguities in the application of cost-of-capital theory, setting the stage for productive debate and research on their resolution. Second, it helps interested companies benchmark their cost-of-capital estimation practices against best-practice peers. Third, the evidence sheds light on the accuracy with which capital costs can be reasonably estimated, enabling executives to use the estimates more wisely in their decision-making. Fourth, it enables teachers to answer the inevitable question, “How do companies really estimate their cost of capital?” Survey Findings The detailed survey results appear in Exhibit 2. The estimation approaches are broadly similar across the three samples in several dimensions. • Discounted Cash Flow (DCF) is the dominant investment-evaluation technique. • WACC is the dominant discount rate used in DCF analyses. • Weights are based on market not book value mixes of debt and equity.8 • The after-tax cost of debt is predominantly based on marginal pretax costs, and marginal or statutory tax rates. • The CAPM is the dominant model for estimating the cost of equity. Some firms mentioned other multi-factor asset-pricing models...
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...ef Concepts • Cost of capital is the rate of return that a firm must earn on its project/ investments to maintain its market value and attract funds. • Business risk is the risk to the firm of being unable to cover fixed operating costs. • Financial risk is the risk of being unable to cover required financial obligations such as interest and preference dividends. • Explicit cost is the rate that the firm pays to procure financing. • Implicit cost is the rate of return associated with the best investment opportunity foregone. • Cost of debt is the after tax cost of long-term funds through borrowing. • Net cash proceeds are the funds actually received from the sale of security. • Floatation cost is the total cost of issuing and selling securities. • Cost of preference share capital is the annual preference share dividend divided by the net proceeds from the sale of preference shares. • Cost of equity capital is the rate at which investors discount the expected dividends of the firm to determine its share value. • Dividend valuation model assumes that the value of a share equals the present value of all future dividends that it is expected to provide over an indefinite period. • Diversifiable/unsystematic risk is the portion of a security’s risk that is attributable to firm-specific random causes; can be eliminated through diversification • Non-diversifiable risk is the relevant portion of a security’s risk that is attributable to market factors that affect all firms;...
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...Jeremy Masem FIN 685 10/21/12 Cost of Capital paper The relationship between the method and assumptions made with respect to placing a value on a financial instrument and determining the capital cost for each of these instruments is intertwined. Similar factors are involved in both calculations. Issues surrounding estimating the future cost of capital and placing a value on a financial instrument are similar too. A WACC formula makes it clear that the problem of discount rate determination can be separated in the problem of determining the financial weights and the problem of determining the segment cost of capital (e.viaminvest.com). A company’s assets are generally financed by either debt or equity. The weighted average cost of capital is the average costs of these sources of financing, each of which is weighted by its respective use in the given situation. These sources of financing are financial instruments. Similar to how a company’s assets are generally financed, preferred stock has characteristics of both equity and debt. Preferred shares generally have a dividend requirement that makes them appear similar to debt. When placing the financial value on a bond, bond valuation includes calculating the present value of the bond’s future interest payments or cash flow, and the bond’s value upon maturity, also known as its face value (investopedia.com). A simplified stock valuation model is usually based on the general principle that the price of a common stock equals...
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...REVIEW Vol. 79. No. 4 2004 pp. 967-1010 Costs of Equity and Earnings Attributes Jennifer Francis Duke University Ryan LaFond University of Wisconsin Per M. Olsson Duke University Katherine Schipper Financial Accounting Standards Board ABSTRACT: We examine the relation between the cost of equity capital and seven attributes of earnings: accrual quality, persistence, predictability, smoothness, value relevance, timeliness, and conservatism. We characterize the first four attributes as accounting-based because they are typically measured using accounting information only. We characterize the last three attributes as market-based because proxies for these constructs are typically based on relations between market data and accounting data. Based on theoretical models predicting a positive association between information quality and cost of equity, we test for and find that firms with the least favorable values of each attribute, considered individually, generally experience larger costs of equity than firms with the most favorable values. The largest cost of equity effects are observed for the accounting-based attributes, in particular, accrual quality. These findings are robust to controls for innate determinants of the earnings attributes (firm size, cash flow and sales volatility, incidence of loss, operating cycle, intangibles use/intensity, and capital intensity), as vi/ell as to alternative proxies for the cost of equity capital. W I. INTRODUCTION e investigate the...
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...The relationship between the method and assumptions made with respect to placing a value on a financial instrument and determining the capital cost for each of these instruments is intertwined. Similar factors are involved in both calculations. Issues surrounding estimating the future cost of capital and placing a value on a financial instrument are similar too. A WACC formula makes it clear that the problem of discount rate determination can be separated in the problem of determining the financial weights and the problem of determining the segment cost of capital (e.viaminvest.com). A company’s assets are generally financed by either debt or equity. The weighted average cost of capital is the average costs of these sources of financing, each of which is weighted by its respective use in the given situation. These sources of financing are financial instruments. Similar to how a company’s assets are generally financed, preferred stock has characteristics of both equity and debt. Preferred shares generally have a dividend requirement that makes them appear similar to debt. When placing the financial value on a bond, bond valuation includes calculating the present value of the bond’s future interest payments or cash flow, and the bond’s value upon maturity, also known as its face value (investopedia.com). A simplified stock valuation model is usually based on the general principle that the price of a common stock equals the present value of its future dividends (jstor.org). ...
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...Nike projected a rosy future, many analysts had mixed reactions to the projections. Ford was right to come up with her own forecast, seeing as the reactions ranged from too aggressive to growth opportunities. In order to completely analyze Nike and its possible place in the NorthPoint Large-Cap Fund, Ford needs to know Nike’s cost of capital. One of the most useful ways to measure the cost of capital is the weighted average cost of capital (WACC). Theoretically, the optimal capital structure in the mix of types of financing that produces the lowest WACC. WACC is calculated by multiplying the cost of each type of financing a company uses, be it debt or the many types of equity, by their respective weights. It is the rate of return that a company needs to earn in order to satisfy the returns they have to pay out to debtholders and stockholders. The respective weight of each type of financing is determined by their percentage of total capital. The WACC is extremely relevant to a company’s capital budgeting team and other capital finance department members. WACC is extremely useful in determining whether or not to accept a capital project. If a proposed capital project produces a rate of return higher than the company’s WACC, that project should be accepted. If the project’s rate of return is lower than the WACC, it should be...
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