...MANAGEMENT ADVISORY SERVICES COST OF CAPITAL THEORY 1. All of the following statements are correct except: a. The matching of asset and liability maturities is considered desirable because this strategy minimizes interest rate risk. b. Default risk refers to the inability of the firm to pay off its maturing obligations. c. The matching of assets and liability maturities lowers default risk. d. An increase in the payables deferral period will lead to a reduction in the need to non-spontaneous funding. 2. Which of the following would increase risk? a. Increase the level of working capital. b. Change the composition of working capital to include more liquid assets. c. Increase the amount of short-term borrowing. d. Increase the amount of equity financing. 3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of the following sets of ratios characterizes the firm with the greatest amount of financial risk? A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity. B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity. C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity. D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity. 4. Which of the following classes of securities are listed in order from lowest risk/opportunity for return to highest risk/opportunity for...
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...POST-GRADUATE STUDENT RESEARCH PROJECT Estimating the Cost of Capital of CNX Nifty Prepared by Bhaswar Sarkar Student of PGDM Program of 2011-2013 Xavier Institute of Management, Bhubaneswar Supervised by Dr. Shridhar Kumar Dash Professor, Accounting and Finance Xavier Institute of Management, Bhubaneswar March 2013 Estimating the Cost of Capital of CNX Nifty Prepared by Bhaswar Sarkar1 Abstract This paper calculates the cost of capital of the CNX Nifty 50 Stock Index. It explores the possibility of establishing a new benchmark, the cost of capital of stock index, in the context of capital markets. The weighted average cost of capital (WaCC) of the Nifty 50 Stock Index is computed. The WaCC computed can form a new benchmark against which companies can compare their own cost of capital. Usually, companies raise a combination of debt and equity to finance their business. A new company can use this benchmark as a reference to choose the perfect combination of debt and equity to reduce its overall weighted average cost of capital. The methodology computes the cost of capital for the index by including each of the fifty companies of the Nifty index. An aggregate cost of capital is then calculated for all the companies, leading to a new benchmark called the cost of capital of the Nifty 50 stocks. 1 The author is currently a post-graduate student of business management (Batch 2011-2013) at Xavier Institute of Management, Bhubaneswar. The views...
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...With trillions of dollars in cash sitting on their balance sheets, corporations have never had so much money. How executives choose to invest that massive amount of capital will drive corporate strategies and determine their companies’ competitiveness for the next decade and beyond. And in the short term, today’s capital budgeting decisions will influence the developed world’s chronic unemployment situation and tepid economic recovery. Although investment opportunities vary dramatically across companies and industries, one would expect the process of evaluating financial returns on investments to be fairly uniform. After all, business schools teach more or less the same evaluation techniques. It’s no surprise, then, that in a survey conducted by the Association for Financial Professionals (AFP), 80% of more than 300 respondents—and 90% of those with over $1 billion in revenues—use discounted cash-flow analyses. Such analyses rely on free-cash-flow projections to estimate the value of an investment to a firm, discounted by the cost of capital (defined as the weighted average of the costs of debt and equity). To estimate their cost of equity, about 90% of the respondents use the capital asset pricing model (CAPM), which quantifies the return required by an investment on the basis of the associated risk. But that is where the consensus ends. The AFP asked its global membership, comprising about 15,000 top financial officers, what assumptions they use in their financial models...
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...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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...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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...Week 5 Cost of Capital Video Pfizer corporation is a research based pharmaceutical company in fact they are the world’s largest. They develop their own products, in a risky environment where a new product may have hundreds of millions of dollars invested in it and may fail and not be a viable product. Development of these types of products causes some significant cost of capital challenges for Pfizer. Pfizer’s capital structure like many large publicly held corporations is made up primarily of debt, the money the firm has borrowed, and equity both from retained earnings and the equity investors have contributed by purchasing stock. Pfizer has eight billion outstanding shares of common stock in the market. A key challenge the company faces is providing enough financing to fund these risky and sometimes long term R&D projects. They have significant revenue of $65B per year but that alone does not mean they will have the cash in the right place at the right time. First it is important that Pfizer selects the right R&D projects to fund. They prioritize R&D projects based on the rank order of the projects values using financial metrics and select projects that will provide a good return for their shareholders. When selecting projects they determine a productivity index using the NPV of the project in the numerator and the present value of the costs in the denominator. This is a “bang for the buck” approach to determine how much return you believe you will get for each...
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...Quiz 11 Cost of Capital 1(11-2) NPV and IRR F I Answer: b EASY [i]. A basic rule in capital budgeting is that If a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False 2(11-2) Mutually exclusive projects F I Answer: b EASY [ii]. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False 3(11-3) IRR F I Answer: b EASY [iii]. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR. a. True b. False 4(11-4) Multiple IRRs F I Answer: b EASY [iv]. The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False 5(11-5) Reinvestment rate assumption F I Answer: b EASY [v]. The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False 6(11-6) Modified IRR F I Answer: b EASY [vi]. When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being...
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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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...Cost of Capital FINANCING DECISION In financing decision, it is totally concentrated on how to generate finance from long term sources It is also considered the following points: Cost of Finance Time period Purpose of Finance Amount of Finance Risk involvement SOURCES OF FINANCE Finance required for investing purpose may be from one or combination of the following sources: 1) From Debt Source 2) From Equity Source i. Ordinary Shares ii. Preference Shares iii. Retained Earning Why do we use different source of finance? COST OF FINANCE It is the minimum rate of return that a firm must earn on its investment for the market value of the firm to remain unchanged. WEIGHTED AVERAGE COST OF CAPITAL Capital is the combination of different components (sources) and the cost of each component is called specific cost. When these specific costs are combined to arrive at overall cost of capital, it is referred to as the weighted average cost of capital. Assumptions Entity’s financial and business risks are unaffected by the acceptance and financing of projects. Financial structure of the entity remains constant. It means that if the entity needs additional funds then are to be raised in accordance with the existing proportion. Components of Cost of Capital Risk-free cost of particular type of financing (r) Business risk premium (b) Financial risk premium (f) k = r + b +f Explicit and Implicit Cost Explicit Cost From the desk of M. Azam 1 Cost...
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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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...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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...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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...HOW DO CFOS MAKE CAPITAL BUDGETING AND CAPITAL STRUCTURE DECISIONS? by John Graham and Campbell Harvey, Duke University* e recently conducted a comprehensive survey that analyzed the current practice of corporate finance, with particular focus on the areas of capital budgeting and capital structure. The survey results enabled us to identify aspects of corporate practice that are consistent with finance theory, as well as aspects that are hard to reconcile with what we teach in our business schools today. In presenting these results, we hope that some practitioners will find it worthwhile to observe how other companies operate and perhaps modify their own practices. It may also be useful for finance academics to consider differences between theory and practice as a reason to revisit the theory. We solicited responses from approximately 4,440 companies and received 392 completed surveys, representing a wide variety of firms and industries.1 The survey contained nearly 100 questions and explored both capital budgeting and capital structure decisions in depth. The responses to these questions enabled us to explore whether and how these corporate policies are interrelated. For example, we investigated whether companies that made more aggressive use of debt financing also tended to use more sophisticated capital budgeting techniques, perhaps because of their greater need for discipline and precision in the corporate investment process. More generally, the design of our survey...
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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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