CMA Part 1
Financial Decision Making
Study Unit 5
Financial Instruments and Cost of Capital
Ronald Schmidt, CMA, CFM
Adrien Dubourg, CMA
Cost of Capital - Defined
• Corporations derive capital essentially from two sources: lenders and shareholders. The
total capital of a firm represents a combination of debt capital and equity capital. These
capital components are described next.
– Debt capital is that portion of total capital derived from the issuance of interest bearing
instruments such as notes, bonds, or loans.
– Equity capital is that portion of total capital derived from permanent investments by
shareholders, as either paid-in capital or retained earnings. A firm may issue new shares of
common or preferred stock, or it may choose to retain earnings instead of distributing them as
dividends.
• Every activity a firm does to generate capital—either explicit or implicit—has a cost
associated with it. The overall cost of capital represents a proportional average of the
various components a firm uses for financing.
2
Cost of Capital – Defined (cont.)
The cost of capital should be considered in capital structure
decisions. Corporations can benefit from using the cost of capital
to benchmark investment decisions and to manage working
capital (e.g., receivables, inventories, and payables) more
efficiently. The cost of capital also can be valuable to use in
measuring and evaluating performance. For example, the actual
and expected return on capital or net assets may be compared
with the cost of capital associated with each.
3
SU – 5.1 Bonds
• Term structure of interest rates – relationship between yield to
maturity and time to maturity
– Types of slopes or “yield curves”
• The shape of the yield curve is closely scrutinized because it helps to give an
idea of future interest rate change and economic activity.
• There are four main types of yield curve shapes:
–
–
–
–
Upward
Flat
Downward sloping
Humped
Continued
4
SU – 5.1 Bonds
• A normal yield curve (upward sloping) is one in which longer
maturity bonds have a higher yield compared to shorter-term
bonds due to the risks associated with time.
• An inverted yield curve is one in which the shorter-term yields
are higher than the longer-term yields, which can be a sign of
upcoming recession.
Continued
5
SU – 5.1 Bonds
• A flat (or humped) yield curve is one in which the shorter- and
longer-term yields are very close to each other, which is also a
predictor of an economic transition.
• The slope of the yield curve is also seen as important: the
greater the slope, the greater the gap between short- and
long-term rates.
Continued
6
SU – 5.1 Bonds
– When plotting yield curves we hold the following constant:
•
•
•
•
Default risk
Taxability
Callability
Sinking fund
Why?
7
SU – 5.1 Bonds
• Bonds are the principal form of long-term debt financing for
corporations and government.
• Features of Bonds
• Par Value = Maturity amount = Face Amount
• State rate = Coupon rate
• Indenture = Terms of the bond
• Issuing bonds takes time and money
• > Risk = > Return (yield)
• How can you mitigate some of the market required return?
8
SU – 5.1 Bonds
• Following are means to reduce the required rate of return for
bonds:
– Sinking Fund – payments to a segregated and accumulate funds
which will equal the maturity value
– Insured
– Secured
9
SU – 5.1 Bonds
• Advantages of Bonds
– Interest is tax deductible
– Retain corporate control
• Disadvantages of Bonds
–
–
–
–
–
Interest is considered legal obligation
Raises risk level and ultimately cost of capital
Raises risk profiles
Contractual requirements (e.g. required debt to equity)
Debt financing limits
10
SU – 5.1 Bonds
• Types of Bonds
– Maturity
• Term bond – single maturity
• Serial bond
– Valuation
• Variable rate
• Zero-coupon or deep-discount bonds
• Commodity-backed bonds
Continued
11
SU – 5.1 Bonds
• Types of Bonds
– Redemption Provisions
• Callable bonds – by the issuer
• Convertible bonds – into equities
– Securitization
• Mortgage bonds – specific
• Debentures – borrower’s general credit but not specific collateral
Continued
12
SU – 5.1 Bonds
• Types of Bonds
– Ownership
• Registered bonds
• Bearer bonds
– Priority
• Subordinated debentures
• Second mortgage bonds
– Repayment Provisions
• Income bonds
• Revenue bonds
13
SU – 5.1 Bonds
• Bond Ratings – Moody’s, Standard and Poor’s, and Fitch
– Investment grade – AAA; Insurance companies and banks
– Non-investment grade – Junk bonds, sometimes used for leveraged
buy-outs
Higher rating = lower interest rate
14
SU – 5.1 Bonds
• Bond valuation and sales price
– Several components to determining the fair price of a bond:
•
•
•
•
•
Risk
Duration
Face amount
Interest payment
Other features such as callable, convertibility
15
SU – 5.1 Bonds
Stated versus Market rate
– Mkt rate is = state rate
– Mkt rate is < state rate
– Mkt rate is > state rate
16
SU – 5.1 Bonds
• Different tables nec. to calculate the value of a bond.
– Present Value of a $1
– Future Value of a $1
– Present value of an ordinary annuity
– Present value of an annuity due
– Future value of an ordinary annuity
17
18
SU – 5.1 Bonds
• See examples on page 128 and 129 of the Gleim study book
19
SU – 5.1 Bonds Question 1
All of the following may reduce the
coupon rate on a bond issued at par
except a
A.
Sinking fund.
B.
Call provision.
C.
Change in rating from Aa to Aaa.
D.
Conversion option.
20
Question 1 Explanation
• Correct Answer: B
A bond issued at par may carry a lower coupon rate than other similar bonds in the market
if it has some feature that makes it more attractive to investors. For example, a sinking fund
reduces default risk. Hence, investors may require a lower risk premium and be willing to
accept a lower coupon rate. Other features attractive to investors include covenants in the
bond indenture that restrict risky undertakings by the issuer and an option to convert the
debt instruments to equity securities. The opportunity to profit from appreciation of the
firm’s stock justifies a lower coupon rate. An improvement in a bond’s rating from Aa to Aaa
(the highest possible) also justifies reduction in the risk premium and a lower coupon rate.
However, a call provision is usually undesirable to investors. The issuer may take advantage
of a decline in interest rates to recall the bond and stop paying interest before maturity.
21
SU – 5.1 Bonds Question 2
A company issued a 15-year, $1,000 par value bond. The coupon
rate on this bond is 9% annually, with interest being paid each 6
months. The investor who purchased the bond expects to earn a
12% nominal rate of return. The cash proceeds received by the
company from the investor totaled
A.
$619.43
B.
$793.43
C.
$875.38
D.
$950.75
22
23
24
Question 2 Explanation
Correct Answer: B
The cash flows consist
of interest of $45
every 6 months for 15
years (30 periods), and
$1,000 at the end of
the 30th interest
period. The 12%
discount rate
translates to 6% every
6 months. Thus, the
calculation is as
follows:
Periodic interest
Maturity amount
Total proceeds
13.765(30 periods @ 6%) × $45 =
$619.43
.174(6%) × $1,000 =
174.00
$793.43
25
SU – 5.1 Bonds Question 3
Which one of the following
statements concerning debt
instruments is correct?
A.
The coupon rate and yield of an outstanding long-term bond will
change over time as economic factors change.
B.
A 25-year bond with a coupon rate of 9% and 1 year to maturity has
more interest rate risk than a 10-year bond with a 9% coupon issued
by the same firm with 1 year to maturity.
C.
For long-term bonds, price sensitivity to a given change in interest
rates is greater the longer the maturity of the bond.
D.
A bond with 1 year to maturity would have more interest rate risk
than a bond with 15 years to maturity.
26
Question 3 Explanation
• Correct Answer: C
The longer a bond’s term, the more time there is for interest
rate volatility to affect a bond’s price, and thus the more
sensitive is its price to interest rate changes.
27
SU – 5.2 Equity
• Common Stock
– Advantages to the issuer
•
•
•
•
No fixed dividend (Common Stock only)
No maturity date
Increases creditworthiness
More attractive to investors
Continued
28
SU – 5.2 Equity
• Common Stock
– Disadvantages to the issuer
•
•
•
•
•
No tax deductible distribution
Diluted controlling rights
Diluted earnings
Higher underwriting costs
Increase average cost of capital
What is a preemptive rights?
29
SU – 5.2 Equity
• Preferred Stock = hybrid of debt and equity
– Advantages to the issuer
• Form of equity
• Does not dilute control
• Superior earning still go to CS
– Disadvantages to the issuer
• No tax deductible distribution and therefore greater cost to bonds
• Dividends in arrears can cause issues
30
SU – 5.2 Equity
• Characteristics of Preferred Stock
–
–
–
–
–
–
–
–
–
Priority in assets and earnings
Potential accumulation of dividends
Convertibility
Participation
Par value
Redeemability
Voting rights
Callability
Maturity – Sinking fund
31
SU – 5.2 Equity
• Stock Valuations
– Preferred is similar to Bonds in valuation
– Discount rate will probably be higher then bonds due to riskiness
– Common stock valued also the same way except based on earnings
(per share)
32
SU – 5.2 Equity Question 1
Preferred stock may be retired
through the use of any one of the
following except a
A.
B.
C.
D.
Conversion.
Call provision.
Refunding.
Sinking fund.
33
Question 1 Explanation
• Correct Answer: C
Preferred stock is equity. Only debt can be refunded
34
SU – 5.2 Equity Question 2
Which one of the following
describes a disadvantage to a
firm that issues preferred stock?
A.
Preferred stock dividends are legal obligations of the
corporation.
B.
Preferred stock typically has no maturity date.
C.
Preferred stock is usually sold on a higher yield basis
than bonds.
D.
Most preferred stock is owned by corporate
investors.
35
Question 2 Explanation
• Correct Answer: C
Preferred stock must usually be sold on a higher yield basis
than bonds because preferred stock stands behind bonds in
priority at liquidation. An incentive must therefore be added to
induce investors to purchase preferred stock. Since preferred
stock is a riskier investment than bonds, investors demand a
risk premium.
36
SU – 5.2 Equity Question 3
Which one of the following situations
would prompt a firm to issue debt, as
opposed to equity, the next time it raises
external capital?
A.
High breakeven point.
B.
Significant percentage of assets under
capital lease.
C.
Low fixed-charge coverage.
D.
High effective tax rate.
37
Question 3 Explanation
• Correct Answer: D
The interest paid on indebtedness is deductible for tax
purposes; dividends paid to equity holders is not. Thus, a firm
with a high effective tax rate would prefer to issue debt, which
would create an additional tax benefit.
38
Other Questions
(on what we covered so far)
1. Debentures are ….
2. From the investor’s viewpoint, the least risky type of bond in which to invest is
a ….
3. All the following may reduce the coupon rate of a bond issued at par except a
1.
2.
3.
4.
Sinking fund
Call provision
Change in rating from Aa to Aaa
Conversion option
4. Why do financial managers prefer to issue Preferred Stock rather than debt?
5. See question 10 on page 150
39
SU – 5.3 Corporate/Stock Valuation Methods
• Dividend Discount Model
– Based on PV of “expected” dividends per share
– Can only be used when dividends are expected to grow at constant
rate
Dividend per share
Cost of Capital – dividend growth rate
See example on p 132 and 133
40
SU – 5.3 Corporate/Stock Valuation Methods
• Preferred Stock Valuation
Dividend per share
Cost of Capital
41
SU – 5.3 Corporate/Stock Valuation Methods
• Common Stock with Variable Dividend Growth
See example page 133
– 3 Step process
• Step 1 – Calculate and sum the PV of Dividends in the period of high growth
• Step 2 – Calculate the PV of the stock based on the period of steady growth
discounted back to year 1 using the dividend discount method.
• Step 3 – Sum the totals from Step 1 and 2
42
Per-share Ratios
• EPS – NI available to CS/Average shares outstanding
• Book value per share – Shareholders’ equity/shares
outstanding
• Dividend yield – Dividend per share/Mrkt value per share
43
Per-share Ratios
• Price-earnings (P/E) ratio – Mrkt price/EPS
• Price-book ratio – Mrket price per share/Book value per share
• Price-sales ratio – Mrkt price per share/sales per share
– Value to analyst
44
SU – 5.3 Corporate/Stock Valuation Methods
Question 1
A company had 150,000 shares outstanding on January 1.
On March 1, 75,000 additional shares were issued through a
stock dividend. Then on November 1, the company issued
60,000 shares for cash. The number of shares to be used in
the denominator of the EPS calculation for the year is
A.
222,500 shares.
B.
225,000 shares.
C.
235,000 shares.
D.
285,000 shares.
45
Question 1 Explanation
• Correct Answer: C
The weighted-average of shares outstanding during the year is used in the EPS
denominator. Shares issued in a stock dividend are assumed to have been
outstanding as of the beginning of the earliest accounting period presented. Thus,
the 75,000 shares issued on March 1 are deemed to have been outstanding on
January 1. The EPS denominator equals 235,000 shares {[150,000 × (12 months ÷ 12
months)] + [75,000 × (12 months ÷ 12 months)] + [60,000 × (2 months ÷ 12
months)]}.
46
SU – 5.3 Corporate/Stock Valuation
Methods Question 2
Frasier Products has been growing at a rate of 10% per year and
expects this growth to continue and produce earnings per share
of $4.00 next year. The firm has a dividend payout ratio of 35%
and a beta value of 1.25. If the risk-free rate is 7% and the return
on the market is 15%, what is the expected current market value
of Frasier’s common stock?
A.
B.
C.
D.
$14.00
$16.00
$20.00
$28.00
47
Question 2 Explanation
Correct Answer: C
The first step is to determine the required
rate of return on Frasier’s stock. The capital
asset pricing model (CAPM) can be used:
Required rate of return = Risk-free rate + β(Market rate – Risk-free rate)
= .07 + 1.25(.15 – .07)
= .07 + .10
= .17
The second step is to calculate the next dividend.
Next dividend = Projected EPS ÷ Dividend payout ratio
= $4 × .35
= $1.40
Now the dividend growth model can be used to calculate the
expected current market value of Frasier’s common stock:
Current market value = Next dividend ÷ (Required rate of return – Dividend growth rate)
= $1.40 ÷ (.17 – .10)
= $1.40 ÷ .07
= $20
48
SU – 5.3 Corporate/Stock Valuation Methods
Question 3
The Hatch Sausage Company is projecting an annual growth rate for
the foreseeable future of 9%. The most recent dividend paid was
$3.00 per share. New common stock can be issued at $36 per share.
Using the constant growth model, what is the approximate cost of
capital for retained earnings?
A.
9.08%
B.
17.33%
C.
18.08%
D.
19.88%
49
Question 3 Explanation
Correct Answer: B
The cost of capital can be found using
the dividend discount model:
Price of stock = Current dividend ÷ (Cost of capital – Dividend growth rate)
$36 = $3.00 ÷ (CC – 9%)
$36CC – $3.24 = $3.00
$36CC = $6.24
CC = 17.33%
Incorrect Answers: A: This percentage is calculated by
improperly multiplying the current dividend by the
projected growth rate then dividing it by the current issue
price per share of common stock. C: This percentage
results from improperly subtracting the dividend from the
price of the stock, or by adding in an additional year’s
dividend change. D: This percentage overstates the cost
of capital.
50
SU – 5.5 Other Sources of Long-term Financing
• Leases – long-term, contractual agreement
– Can be a purchase-and-financing (capital lease)
– Long-term rental contract (operating lease)
• Convertible Securities – debt or pref. stock
– Contain provisions allowing the holder to convert to “specified” number of
common stocks
• Stock Purchase Warrants – call options on the corp. common stock
• Retained Earnings – cumulative accrual-basis income (net of prior
dividents)
51
SU 5.5 Question 1
A major use of warrants in
financing is to
A.
Lower the cost of debt.
B.
Avoid dilution of earnings per
share.
C.
Maintain managerial control.
D.
Permit the buy-back of bonds
before maturity
52
SU 5.5 Question 1 Answer
Correct Answer: A
Warrants are long-term options that give holders the right to buy common stock in the
future at a specific price. If the market price goes up, the holders of warrants will
exercise their rights to buy stock at the special price. If the market price does not
exceed the exercise price, the warrants will lapse. Issuers of debt sometimes attach
stock purchase warrants to debt instruments as an inducement to investors. The
investor then has the security of fixed-return debt plus the possibility for large gains if
stock prices increase significantly. If warrants are attached, debt can sell at an interest
rate slightly lower than the market rate.
Incorrect Answers:
B: Outstanding warrants dilute earnings per share. They are included in the
denominator of the EPS calculation even if they have not been exercised.
C: Warrants can, if exercised, result in a dilution of management’s holdings.
D: A call provision in a bond indenture, not the use of warrants, permits the
buyback of bonds.
53
SU 5.5 Question 1
A major use of warrants in financing is to
A
Lower the cost of debt.
B
Avoid dilution of earnings per share.
C
Maintain managerial control.
D
Permit the buy-back of bonds before maturity.
54
SU 5.5 Question 2 Answer
Correct Answer: A
Warrants are long-term options that give holders the right to buy common stock in the
future at a specific price. If the market price goes up, the holders of warrants will
exercise their rights to buy stock at the special price. If the market price does not exceed
the exercise price, the warrants will lapse. Issuers of debt sometimes attach stock
purchase warrants to debt instruments as an inducement to investors. The investor then
has the security of fixed-return debt plus the possibility for large gains if stock prices
increase significantly. If warrants are attached, debt can sell at an interest rate slightly
lower than the market rate.
Incorrect Answers:
B
Outstanding warrants dilute earnings per share. They are included in the
denominator of the EPS calculation even if they have not been exercised.
C
Warrants can, if exercised, result in a dilution of management’s holdings.
D
A call provision in a bond indenture, not the use of warrants, permits the buyback
of bonds.
55
Essay Question
56
57
SU 5 & 6 - Cost of Capital
The cost of capital is a composite of the costs of various sources
of funds comprising a firm’s capital structure. It represents the
minimum rate of return that must be earned on new investments
so that shareholders’ interests won’t be diluted. This topic
focuses on the details of the cost of capital, including the
weighted average cost of capital, the cost of individual capital
components, calculating the cost of capital, and the marginal
cost of capital.
58
SU – 5.6 Cost of Capital - Current
• Investor Required Rate of Return
– If it is less than required, investors will expect dividend to redirect to
higher return investments.
– Also called the opportunity cost
• Firms cost of capital is typically used to discount the future
cash flows of long-term projects.
– Investments with:
•
•
> return increase the value of company
< should be passed on
59
SU – 5.6 Cost of Capital - Current
• Components of Capital
– Debt – after-tax interest rate on the debt
• Effective rate x (1.0 – Marginal tax rate)
– Preferred Stock – dividend yield ratio
• Cash dividend on PS / Market price of PS
– Common Stock – dividend yield ratio
• Cash dividend of CS / Market price of CS
60
SU – 5.6 Cost of Capital - Current
Retained Earnings cost = Common Stock
Why?
61
SU 5.6 Practice Question 1
A major use of warrants in financing is to
A
Lower the cost of debt.
B
Avoid dilution of earnings per share.
C
Maintain managerial control.
D
Permit the buy-back of bonds before maturity.
62
SU 5.6 Practice Question 1 Solution
Correct Answer: A
Warrants are long-term options that give holders the right to buy common stock in the future at a
specific price. If the market price goes up, the holders of warrants will exercise their rights to buy
stock at the special price. If the market price does not exceed the exercise price, the warrants will
lapse. Issuers of debt sometimes attach stock purchase warrants to debt instruments as an
inducement to investors. The investor then has the security of fixed-return debt plus the
possibility for large gains if stock prices increase significantly. If warrants are attached, debt can
sell at an interest rate slightly lower than the market rate.
Incorrect Answers:
B
Outstanding warrants dilute earnings per share. They are included in the denominator of
the EPS calculation even if they have not been exercised.
C
Warrants can, if exercised, result in a dilution of management’s holdings.
D
A call provision in a bond indenture, not the use of warrants, permits the buyback of bonds.
63
SU 5.6 Practice Question 2
Maloney, Inc.’s $1,000 par value preferred stock paid its $100 per share annual dividend on April
4 of the current year. The preferred stock’s current market price is $960 a share on the date of
the dividend distribution. Maloney’s marginal tax rate (combined federal and state) is 40%, and
the firm plans to maintain its current capital structure relationship. The component cost of
preferred stock to Maloney would be closest to
A
6%
B
6.25%
C
10%
D
10.4%
64
SU 5.6 Practice Question 2 Solution
Correct Answer: D
The component cost of preferred stock is equal to the dividend yield, i.e., the cash dividend
divided by the market price of the stock. (Dividends on preferred stock are not deductible for tax
purposes; therefore, there is no adjustment for tax savings.) The annual dividend on preferred
stock is $100 when the price of the stock is $960. This results in a cost of capital of about 10.4%
($100 ÷ $960).
Incorrect Answers:
A
There is no tax deductibility of preferred dividends and the denominator is the current
market price, not the par value.
B
There is no tax deductibility of preferred dividends.
C
The denominator is the current market price, not the par value.
65
SU 5.6 Practice Question 3
The theory underlying the cost of capital is primarily concerned with the cost of
A
Long-term funds and old funds.
B
Short-term funds and new funds.
C
Long-term funds and new funds.
D
Short-term funds and old funds.
66
SU 5.6 Practice Question 3 Solution
Correct Answer: C
The theory underlying the cost of capital is based primarily on the cost of long-term funds and the acquisition of
new funds. The reason is that long-term funds are used to finance long-term investments. For an investment
alternative to be viable, the return on the investment must be greater than the cost of the funds used. The
objective in short-term borrowing is different. Short-term loans are used to meet working capital needs and not
to finance long-term investments.
Incorrect Answers:
A
The concern is with the cost of new funds; the cost of old funds is a sunk cost and of no relevance for
decision-making purposes.
B
The cost of short-term funds is not usually a concern for investment purposes.
D
The cost of old funds is a sunk cost and of no relevance for decision-making purposes. Similarly, shortterm funds are used for working capital or other temporary purposes, and there is less concern with the
cost of capital and the way it compares with the return earned on the assets borrowed.
67
SU 5.6 Practice Question 4
Osgood Products has announced that it plans to finance future investments so that the
firm will achieve an optimum capital structure. Which one of the following corporate
objectives is consistent with this announcement?
A
Maximize earnings per share.
B
Minimize the cost of debt.
C
Maximize the net worth of the firm.
D
Minimize the cost of equity.
68
SU 5.6 Practice Question 4 Solution
Correct Answer: C
Financial structure is the composition of the financing sources of the assets of a firm.
Traditionally, the financial structure consists of current liabilities, long-term debt, retained
earnings, and stock. For most firms, the optimum structure includes a combination of debt and
equity. Debt is cheaper than equity, but excessive use of debt increases the firm’s risk and drives
up the weighted-average cost of capital.
Incorrect Answers:
A
The maximization of EPS may not always suggest the best capital structure.
B
The minimization of debt cost may not be optimal; as long as the firm can earn more on
debt capital than it pays in interest, debt financing may be indicated.
D
Minimizing the cost of equity may signify overly conservative management.
69
SU – 5.6 Cost of Capital - Current
• Weighted Average Cost of Capital – WACC
– See Gleim success tips
• Management designates a target capital structure for the firm
• Target Capital Structure
• See example on page 143
70
SU – 5.6 Cost of Capital - Current
“Firms WACC is a single, composite rate of return on its
combined components of capital”.
Market value not book value
See example on page 144
71
SU – 5.6 Cost of Capital - Current
See formula to calculate the after-tax WACC w/o PS
Min. WACC = Shareholder Wealth Maximizing
See graph on page 146
72
SU – 5.6 Cost of Capital - Current
• Impact of taxes on Capital Structure and Capital Decisions
– Taxes
– Capital Gains
– Interest
– Multinational corporations
73
SU 5.6 – Question 1
Global Company Press has $150 par value preferred stock with a market
price of $120 a share. The organization pays a $15 per share annual
dividend. Global’s current marginal tax rate is 40%. Looking to the
future, the company anticipates maintaining its current capital
structure. What is the component cost of preferred stock to Global?
A.
6%
B.
7.5%
C.
10%
D.
12.5%
74
SU 5.6 – Question 1 Solution
• Correct Answer: D
The component cost of preferred stock is the dividend divided
by the market price (also called the dividend yield). No tax
adjustment is necessary because dividends are not deductible.
Since the market price is $120 when the dividend is $15, the
component cost of preferred capital is 12.5% ($15 ÷ $120).
75
SU 5.6 – Question 2
What is the weighted average cost of capital for a firm using 65%
common equity with a return of 15%, 25% debt with a return of 6%,
10% preferred stock with a return of 10%, and a tax rate of 35%?
A.
10.333%
B.
11.275%
C.
11.725%
D.
12.250%
76
SU 5.6 – Question 2 Solution
Correct Answer: C
The cost for equity capital is given as
15%, and preferred stock is 10%. The
before-tax rate for debt is given as 6%,
which translates to an after-tax cost of
3.9% [6% × (1.0 – .35)]. The rates are
weighted as follows:
Component
Component
Long-term debt
Weight
25%
Preferred stock
Common stock
Weighted
×
Cost
3.9%
=
Cost
.975%
10%
×
10.0%
=
1.000%
65%
×
15.0%
=
9.750%
11.725%
77
SU 5.6 – Question 3
Joint Products, Inc., a corporation with
a 40% marginal tax rate, plans to issue
$1,000,000 of 8% preferred stock in
exchange for $1,000,000 of its 8%
bonds currently outstanding. The firm’s
total liabilities and equity are equal to
$10,000,000. The effect of this
exchange on the firm’s weighted
average cost of capital is likely to be
A.
B.
C.
D.
No change, since it involves equal amounts of capital in the
exchange and both instruments have the same rate.
A decrease, since a portion of the debt payments are tax
deductible.
A decrease, since preferred stock payments do not need to
be made each year, whereas debt payments must be
made.
An increase, since a portion of the debt payments are tax
deductible.
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SU 5.6 – Question 3 Solution
• Correct Answer: D
The payment of interest on bonds is tax-deductible, whereas
dividends on preferred stock must be paid out of after-tax earnings.
Thus, when bonds are replaced in the capital structure with
preferred stock, an increase in the cost of capital is likely because
there is no longer a tax shield.
79
SU – 5.7 Cost of Capital – New
• Marginal Cost of Capital
– Companies can not solely rely on internally generated capital (which
is the cheapest)
– Marginal cost of capital is the cost to the firm of the next dollar of
new capital raised after existing internal sources are exhaused
80
SU – 5.7 Cost of Capital – New
• Each additional dollar raised becomes increasingly expensive
as investors demand higher returns.
Why?
81
SU – 5.7 Cost of Capital – New
• New debtholders will demand a higher interest rate to
compensate for the increased risk.
Annual interest / Net issue proceeds
The higher the tax rates the more attractive debt becomes as
capital
82
SU – 5.7 Cost of Capital – New
• Cost of new preferred stock
Next dividend / Net issue proceeds
Remember that the floatation costs raises the cost of capital
83
SU – 5.7 Cost of Capital – New
• Cost of new Common Stock
(Next dividend / net issue proceeds) + Dividend growth rate
See example on page 147
84
SU 5.7 – Practice Question 1
A firm seeking to optimize its capital budget has calculated its marginal cost of capital and
projected rates of return on several potential projects. The optimal capital budget is determined
by
A
Calculating the point at which marginal cost of capital meets the projected rate of return,
assuming that the most profitable projects are accepted first.
B
Calculating the point at which average marginal cost meets average projected rate of return,
assuming the largest projects are accepted first.
C
Accepting all potential projects with projected rates of return exceeding the lowest marginal
cost of capital.
D
Accepting all potential projects with projected rates of return lower than the highest
marginal cost of capital.
85
SU 5.7 – Practice Question 1
Correct Answer: A
In economics, a basic principle is that a firm should increase output until
marginal cost equals marginal revenue. Similarly, the optimal capital budget is
determined by calculating the point at which marginal cost of capital (which
increases as capital requirements increase) and marginal efficiency of investment
(which decreases if the most profitable projects are accepted first) intersect.
Incorrect Answers:
B
The intersection of average marginal cost with average projected rates of
return when the largest (not most profitable) projects are accepted first
offers no meaningful capital budgeting conclusion.
C
The optimal capital budget may exclude profitable projects as lower-cost
capital goes first to projects with higher rates of return.
D
Accepting projects with rates of return lower than the cost of capital is
not rational.
86
SU 5.7 – Practice Question 2
The firm’s marginal cost of capital
A
Should be the same as the firm’s rate of return on equity.
B
Is unaffected by the firm’s capital structure.
C
Is inversely related to the firm’s required rate of return used in capital budgeting.
D
Is a weighted average of the investors’ required returns on debt and equity
87
SU 5.7 – Practice Question 2 Solutions
Correct Answer: D
The marginal cost of capital is the cost of the next dollar of capital. The marginal cost
continually increases because the lower cost sources of funds are used first. The
marginal cost represents a weighted average of both debt and equity capital.
Incorrect Answers:
A
If the cost of capital were the same as the rate of return on equity (which is
usually higher than that of debt capital), there would be no incentive to invest.
B
The marginal cost of capital is affected by the degree of debt in the firm’s capital
structure. Financial risk plays a role in the returns desired by investors.
C
The rate of return used for capital budgeting purposes should be at least as high
as the marginal cost of capital.
88
SU 5.7 – Practice Question 3
Datacomp Industries, which has no current debt, has a beta of .95 for its common
stock. Management is considering a change in the capital structure to 30% debt and
70% equity. This change would increase the beta on the stock to 1.05, and the after-tax
cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate
is 6%. Should Datacomp’s management proceed with the capital structure change?
A
No, because the cost of equity capital will increase.
B
Yes, because the cost of equity capital will decrease.
C
Yes, because the weighted-average cost of capital will decrease.
D
No, because the weighted-average cost of capital will increase.
89
SU 5.7 – Practice Question 3 Solutions
Correct Answer: C
The important consideration is whether the overall cost of capital will be lower for a
given proposal. According to the Capital Asset Pricing Model, the change will result in
a lower average cost of capital. For the existing structure, the cost of equity capital is
15.5% [6% + .95 (16% – 6%)]. Because the company has no debt, the average cost of
capital is also 15.5%. Under the proposal, the cost of equity capital is 16.5% [6% + 1.05
(16% – 6%)], and the weighted average cost of capital is 13.8% [.3(.075) + .7(.165)].
Hence, the proposal of 13.8% should be accepted.
Incorrect Answers:
A
The average cost of capital needs to be considered.
B
The average cost of capital needs to be considered.
D
The weighted average cost of capital will decrease.
90
Capital Asset Pricing Model Introduction
CAPM is also useful in measuring the cost of equity capital for a firm. The CAPM implies that the rate of return on
any security equals the riskless rate of interest plus a premium for risk. The riskless rate is usually based on the
current or anticipated rate on long-term U.S. Treasury bonds or short-term U.S. Treasury bills. The premium for risk
is derived from the security’s beta.
The formula for applying the CAPM to estimate the cost of equity capital is:
Ks = Rf+ B(Km - Rf )
where:
ks = cost of internal equity capital
Rf = risk-free rate (e.g., the rate on T-bonds or a 30-day T-bill)
Beta = stock’s beta estimate (obtained from a brokerage firm or investment advisory service, or calculated by the
firm)
km = estimate of the return on the market as a whole or on an average stock value
91
Capital Asset Pricing Model Introduction (cont.)
The term (km - Rf ) is called the “market risk premium,” which
is somewhere in the area of 5% to 7%, depending on the date
of the estimate and the data sources used by the analysts.
Firms often add 6% to the T-bond rate to obtain the rate of
return for the market as a whole.
For example: If the T-bond rate is 8%, a firm’s stock beta is 0.9,
and the expected rate of return for the market is 14%, Blane
Company’s cost of equity capital using the CAPM would be:
ks = 8% +0.9( 14% - 8%)
= 8% + 5.40%
=13.40%
92
Capital Asset Pricing Model Introduction (cont.)
Using the CAPM involves estimates for each term in the
equation. Challenges arise in deciding:
• Whether to use long-term or short-term T-bond rates for Rf .
• Estimating the future beta investors expect.
• Estimating the expected rate of return for the market as a whole.
93
Remaining Schedule
•
•
•
•
•
January 10th – Class 5 – SU 5, Essays
January 17th – Class 6 – SU 7
January 24th – Class 7 – SU 8
January 31st – Class 8 – SU 9
February 14th – Cram Session
94
Quick memory test 1
By using the dividend growth model, estimate the
cost of equity capital for a firm with a stock price of
$30.00, an estimated dividend at the end of the first
year of $3.00 per share, and an expected growth
rate of 10%.
95
Quick memory test 1 Answer
Under the dividend growth model, the cost of equity equals the
expected growth rate plus the quotient of the next dividend and
the current market price. Thus, the cost of equity capital is 20%
[10% + ($3 ÷ $30)]. This model assumes that the payout ratio,
retention rate, and the earnings per share growth rate are all
constant.
96
Quick memory test 2
Rogers, Inc., operates a chain of restaurants located in the Southeast. The company
has steadily grown to its present size of 48 restaurants. The board of directors
recently approved a large-scale remodeling of the restaurants, and the company is
now considering two financing alternatives.
• The first alternative would consist of
– Bonds that would have a 9% coupon rate and reissued at their base amount would net
$19.2 million after a 4% flotation cost
– Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation
cost
– Common stock that would yield $24 million after a 5% flotation cost
• The second alternative would consist of a public offering of bonds that would
have a 9% coupon rate and an 11% market rate and would net $48 million after a
4% flotation cost.
97
Quick memory test 2
Rogers’ current capital structure, which is considered optimal,
consists of 40% long-term debt, 10% preferred stock, and 50%
common stock. The current market value of the common stock is $30
per share, and the common stock dividend during the past 12 months
was $3 per share. Investors are expecting the growth rate of
dividends to equal the historical rate of 6%. Rogers is subject to an
effective income tax rate of 40%.
Question - The after-tax cost of the common stock proposed in
Rogers’ first financing alternative would be
98
Quick memory test 2 Answer
To determine the cost of new
common stock, the dividend
growth model is used.
Cost of new common stock = (Next dividend ÷ Net issue proceeds) + Dividend
growth rate
= [($3.00 × 1.06) ÷ ($30.00 × .95)] + .06
= ($3.18 ÷ $28.50) + .06
= .1116 + .06
= 17.16%
99
Essay Question
100
101
SU 2 Review – Question 1
Given an acid test ratio of 2.0, current assets of $5,000, and inventory of $2,000, the
value of current liabilities is
A
$1,500
B
$2,500
C
$3,500
D
$6,000
102
SU 2 Review – Question 1 Solution
Correct Answer: A
The acid test, or quick, ratio equals the quick assets (cash, marketable securities, and
accounts receivable) divided by current liabilities. Current assets equal the quick assets
plus inventory and prepaid expenses. (This question assumes that the entity has no
prepaid expenses.) Given current assets of $5,000, inventory of $2,000, and no prepaid
expenses, the quick assets must be $3,000. Because the acid test ratio is 2.0, the quick
assets are double the current liabilities. Current liabilities therefore are equal to $1,500
($3,000 quick assets ÷ 2.0).
Incorrect Answers:
B
Dividing the current assets by 2.0 results
in $2,500. Current assets includes
inventory, which should not be included in
the calculation of the acid test ratio.
C
Adding inventory to current assets rather
than subtracting it results in $3,500.
D
Multiplying the quick assets by 2 instead
of dividing by 2 results in $6,000.
103
SU 2 Review – Question 2
Beatnik Company has a current ratio of 2.5 and a quick ratio of 2.0. If the firm
experienced $2 million in cost of sales and sustains an inventory turnover of 8.0, what
are the firm’s current assets?
A
$1,000,000
B
$500,000
C
$1,500,000
D
$1,250,000
104
SU 2 Review – Question 2 Solution
Correct Answer: D
The only major difference between the current ratio and the quick ratio is the inclusion
of inventory in the numerator. If cost of sales is $2 million and inventory turns over 8
times per year, then average inventory is $250,000 ($2,000,000 ÷ 8). Since the only
difference between the two ratios is inventory, then inventory must equal .5 (2.5 – 2.0)
times current liabilities; therefore, current liabilities are $500,000. Thus, current assets
divided by $500,000 equals 2.5. Therefore, current assets must equal $1,250,000 (2.5 ×
$500,000).
Incorrect Answers:
A
The amount of quick assets is $1,000,000.
B
The amount of current liabilities is
$500,000.
C
Adding inventory to current assets results
in $1,500,000.
105