Basic Finance Exam #2

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1 Basic Finance Exam #2 Chapter 10: Capital Budget list of planned investment project Sensitivity Analysis analysis of the effects on project profitability of changes in sales, costs and so on Fixed Cost costs that does not depend on the level of output Variable Costs costs that change as the level of output changes Scenario Analysis project analysis given a particular combination of assumptions Simulation Analysis estimation of the probabilities of different possible outcomes, e.g., from an investment project Break Even Analysis analysis of the level of sales at which the project breaks even NPV Break Even Point level of sales at which project net present value becomes positive Operating Leverage degree to which costs are fixed Degree of Operating Leverage percentage change in profits given a 1% change in sales Real Options options to invest in, modify, or dispose of a capital investment project Decision Tree diagram of sequential decisions and possible outcomes Break Even Level of Revenues fixed costs including depreciation / additional profit from each additional dollar of sales DOL: percentage change in profits / percentage change in sales DOL: 1 + (fixed costs/profits) Chapter 11: Market Index measure of the investment performance of the overall market Dow Jones Industrial Average index of the investment performance of a portfolio of 30 blue chip stocks Standard & Poor s Composite Index index of the investment performance of a portfolio of 500 large stocks. Also called the S&P 500 Maturity Premium extra average return from investing in long versus short term treasury securities Risk Premium expected return in excess of risk free return as compensation for risk Variance average value of squared deviations from mean. A measure of volatility Standard Deviation square root of variance. Another measure of volatility Diversification strategy designed to reduce risk by spreading the portfolio across many investments Specific Risk risk factors affecting only that firm; also called diversifiable risk Market Risk economy wide (microeconomic) sources of risk that affect the overall stock market; also called systematic risk Percentage Return: (capital gain + dividend) / initial share price Variance: average of squared deviations around the average Standard Deviation: square root of variance Portfolio Rate of Return: (fraction of portfolio in first asset X rate of return on first asset) + (fraction of portfolio in second asset X rate of return on second asset) Chapter 12:

2 Market Portfolio portfolio of all assets in the economy. In practice a broad stock market index is used to represent the market Beta sensitivity of a stock s return to the return on the market portfolio Market Risk Premium risk premium of market portfolio. Difference between market return and return on risk free treasury bills Capital Asset Pricing Model (CAPM) theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium Security Market Line relationship between expected return and beta Company Cost Of Capital expected rate of return demanded by investors in a company, determined by the average risk of the company s securities Project Cost of Capital minimum acceptable expected rate of return on a project given its risk Beta of Portfolio: (fraction of portfolio in first stock X beta of first stock) + (fraction of portfolio in second stock X beta of second stock) Expected Return: risk free rate + premium R=rf + B (rm rf) Chapter 13: Capital Structure the mix of long term debt and equity financing Weighted Average Cost of Capital (WACC) expected rate of return on a portfolio of all the firm s securities, adjusted for tax savings due to interest payments Free Cash Flow cash flow that is not required for investment in fixed assets or working capital and is therefore available to investors WACC: [D/V X(1 Tc)Rdebt] + (E/V x Requity) Add preferred which is (P/V x Rpreferred) + (E/V x Requity) R equity: (DIV1/Po) + g R preferred: dividend/ price of preferred Chapter 14: Internationally Generated Funds cash reinvested in the firm: depreciation plus earnings not paid out as dividends Financial Deficit difference between the cash companies need and the amount generated internally Treasury Stock stock that has been repurchased by the company and held in its treasury Issued Shares shares that have been issued by the company Outstanding Shares shares that have been issued by the company and are held by investors Authorized Share Capital maximum number of shares that the company is permitted to issue Par Value value of security shown in the company s accounts Additional Paid In Capital difference between issue price and par value of stock. Also called capital surplus. Retained Earnings earnings not paid out as dividends Majority Voting voting system in which each director is voted on separately

3 Cumulative Voting voting system in which all votes that one shareholder is allowed to cast can be cast for one candidate for the board of directors Proxy Contest takeover attempt in which outsiders compete with management for shareholders votes Preferred Stock stock that takes priority over common stock in regard to dividends Net Worth book value of common stockholders equity plus preferred stock Floating Rate Preferred preferred stock paying dividends that varies with short term interest rates Prime Rate benchmark interest rate charged by banks Funded Debt debt with more than 1 year remaining to maturity Sinking Fund fund established to retire debt before maturity Callable Bond bond that may be repurchased by firm before maturity at specified call price Subordinated Debt debt that may be repaid in bankruptcy only after senior debt is paid Secured Debt debt that has first claim on specified collateral in the event of default Eurodollars dollars held on deposit in a bank outside the United States Eurobond bond that is marketed internationally Private Placement sale of securities to a limited number of investors without a public offering Protective Covenant restriction on a firm to protect bondholders Lease long term rental agreement Warrant right to buy shares from a company at a stipulated price before a set date Convertible Bond bond that the holder may exchange for a specified amount of another security Chapter 15: Venture Capital money invested to finance a new firm Initial Public Offering (IPO) first offering of stock to the general public Underwriter firm that buys an issue of securities from a company and resells it to the public Spread difference between public offer price and price paid by underwriter Prospectus formal summary that provides information on an issue of securities Underpricing issuing securities at an offering price set below the true value of the security Flotation Costs the costs incurred when a firm issues new securities to the public Seasoned Offering sale of securities by a firm that is already publicly traded Rights Issue issue of securities offered only to current stockholders Shelf Registration a procedure that allows films to file one registration statement for several issues of the same security Private Placement sale of securities to a limited numbers of investors without a public offering Chapter 16: Capital Structure the mix of long term debt and equity financing Restructuring process of changing the firm s capital structure without changing its real assets

4 MM s Proposition 1 (Debt Irrelevance Proposition) the value of a firm is unaffected by its capital structure Operating Risk (Business Risk) risk in firm s operating income Financial Leverage debt financing to amplify the effects of changes in operating income on the returns to stockholders Financial Risk risk to shareholders resulting from the use of debt MM s Proposition II the required rate of return on equity increases as the firm s debtequity ratio increases Interest Tax Shield tax savings resulting from deductibility of interest payments Costs of Financial Distress costs arising from bankruptcy or distorted business decisions before bankruptcy Trade Off Theory debt levels are chosen to balance interest tax shields against the costs of financial distress Loan Covenant agreement between firm and lender requiring the firm to fulfill certain conditions to safeguard the loan Pecking Order Theory firms prefer to issue debt rather equity if internal finance is insufficient Financial Slack ready access to cash or debt financing R:equity: Rassets + D/E (Rassets Rdebt) PV Tax Shields: annual tax shield/rdebt = Tc x (Rdebt x D) / Rdebt = TcD Value of Levered Firm= value if all equity financed + TcD True/False: 1. Real options usually add value to a project due to flexibility in capital budgeting T 2. The standard deviation of returns is generally lower on individual stocks than it is on the market F 3. Businesses that are less affected by the business cycle tend to have low betas and a low cost of capital T 4. The WACC is the correct discount rate for a company s capital investments given any risk profile F (if true, average) 5. A project that breaks even on an accounting basis just covers the OCC tied up in the project F (if true, NPV) 6. If a company has no debt, the required return on the stock is the cost of capital T 7. Projects earning IRRs less than the cost of capital produce negative NPVs T (make IRR 0, NPV=T) 8. A portfolio s beta is an un weighted average of the betas of the securities in portfolio F (if true it has to be weighted) 9. If a firm increases its debt ratio, both debt and equity holders will require a higher return T 10. If we ignore taxes, the overall cost of capital will not change as debt and equity proportions change T 11. The security market line relates the expected return of investors on a security to its market risk premium F(to its beta if true)

5 12. Debt financing does not affect a company s operating risk in the absence of taxes T 13. The value of a levered firm is its value if all debt financed plus the PV of the tax shield F(equity if true) Matching: Funded Debt >1yr. maturity Secured Debt First claim on collateral Protective Covenant Bondholders restrictions on a firm Preferred Stock Dividend Priority Governance Majority Vote Debenture Unsecured Bond Warrant Right to buy stock Private Placement Limited # of investors LIBOR Benchmark international rate Sinking Fund Retire debt early Security Market Line Graph of CAPM Cyclical Business High cost of capital Unique Risk Lessened through diversification Standard Deviation of Stock s Market Beta WACC Use as discount rate for average risk investments Free Cash Flow (FCF) Use WACC to DCF Implicit Debt Cost Increases required return of equity Maturity Premium Compensation for risk Zero Project NPV CFs give debt/equity the expected returns required by investor Market Risk Macro economic changes Security Market Line graphical representation of CAPM theory Right s Issue only current stockholders get stock offering Quant: 1. A Company stock sells for $36 a share and there are 45 million shares authorized with 25 million shares outstanding. There is perpetual debt outstanding with a market value of $600 million and a yield of 6%. Risk free rate is 6% and market risk premium is 8%. The stock has a 1.75 beta and the corporate tax rate is 40%. If the company wants to maintain a constant debt to value ration, what is the appropriate discount rate for a current plant expansion? CAPM= 6% (8%) = 20% Ve= 25mill x $36 = 900mill Vp+e=1500mill MKvd=600 mill D/V= 600/1500= 40% WACC+ (6%)(.4) + (.6)(20%) = 1.44% + 12% = 13.44% 2. A company goes public. In its IPO, the company sells 1 million shares to its investment banker for $20 a share. The underwriting fee is 8% and administrative

6 costs are 4%. The stock closes at $22 a share in the first trading day. Of the IPO shares, 20% are being sold by the founding family. a) How much did the IPO cost the company? $20 a share x 1mill shares= 20mill V/W fee $20mill x.08 = 1.6mill Admin Cost $20 mill x.04 =.8mill Underprice $2 x 1mill shares = 2mill Total = 4.4mill b) What did the company net? (selling shareholder family) = 13.6mill 3. A company sells 80,000 shares of stock at a current price of $50/share. The firm has 200,000 shares outstanding with a BV of $60 per share. What is the new BV of each share after the new stock issuance? 80,000shares x $50/share = 4mill add to 200,000 x 60 = 12mill Total BV= 16mill BVsh=16,000,000/280,000 = $ What is the PV of the interest tax shield for a firm with $1mill of an 8% perpetual debt issue with a tax rate of 40%, a discount rate of 8% and a YTM of 6%? Year debt cost.08 x 1mill = 80,000/yr Tax Shield.4 x 80,000 = 32,000/yr PV= 32,000/.08 = $400, Balance Sheet End 2009 Cash 20 Current Liabilities 20 Other current Assets 20 Bank Debt 50 Fixed Assets % bond due TOTAL 290 Stockholders Equity 120 TOTAL 290 Income Statement Gross Profit 57.5 Depreciation 20 Interest 7.5 Pretax Profit 30 Tax 10.5 Net Profit 19.5 Dividend 6.5 The yield to maturity on debt currently is 5% 10 million shares outstanding, with a market price of $10 a share. Equity beta is estimated at 1.25, the market risk premium is 8%, and the treasury bill rate is 4% a) What is the company s required rate of return? Make assumption end of 2010 DEBT= 50mill + 162mill = 212mill

7 EQ=Vsh=10 x 10 mill = 100mill Vd+e= 312mill MVdebt=100AF 19/5% + 100millDF 19/5% = 162mill D= 212/312= 68% E= 32% Exp Rd= 5% Re= 4% (8%) = 14% WACC=.68 x.05 x x 14% WACC= 2.21% % = 6.7% 6. Modern artifacts can produce keepsakes that will be sold for $80 each. Nondepreciation fixed costs are $1,000 per year and variable costs are $60/unit. If the project requires an initial investment of $3,000 and is expected to last for 5 years and the firm pays no taxes, what is the NPV break even level of sales? The initial investment ill be depreciated straight line over 5 years to a final value of zero, and the discount rate is 10%. VC=60/80=.75=75% sales So, $1 adds.25 sales No tax CF yr=.25 sales % 5 yr annuity is 3.79 PVcf investment = 0 NPV for break even 3.79 (.25 sales 1000) 3000 = 0 NPVsales= 7166 = 7166/80 = 90 units 7. A project has fixed costs of $500 semiannually, depreciation at $500 annually, revenue of $500 month and variable costs equal to 2/3 of revenues. a) If sales increase by 10% annually, what is increase in pretax profits? Rev VC Dep Fixed = 500 Increase by 10% =6000 x.1 = 600 Up 600, expense goes up 400 and pretax profits increase by $200 or 40% b) What is the DOL for this project? % profits/% sales = 40%/10% = 4 OR 1 + (fixed + Dep)/profits= = 1 + ( )/ 500 = 4 8. A stock with the same market risk as the S&P 500 will sell at a year from now price of $50. The stock will pay a dividend at the year end of $2. What price would you be willing to pay for the stock today if 1 year treasuries are 3.5 percent? 7.6%= historical equity premium over treasuries Beta= 1 MRP= 3.5% + 7.6% = 11.1% 3.5% =Rrf Po= (2+50)/1.11 = $46.80

8 9. Hit or Miss Sports is introducing a new product this year. The firm expects to be able to sell 50,000 units a year at a price of $60 each. The variable cost of each ball is $30, and fixed costs are zero. The cost of the manufacturing equipment is $6 million, and the project life is estimated at 10 years. The firm will use straightline depreciation over the 10 year life of the project. The firm s tax rate is 35%, and the discount rate is 12%. a) What is expected NPV? 1.35=.65 CF=.65 [(60 30) x 50000] +.35(600,000) = 1,185,000 NPV= 6,000,000 + (1,185,000 x AF 12%/10yrs) equals 5.65 NPV= $695,514 b) Suppose now that the firm can abandon the project and sell off the manufacturing equipment for $5.6 million at the end of the first year. The firm will make the decision to continue or abandon after the first year of sales. Does the option to abandon change the firm s decision to accept the project? CF= 1,185, ,600, ,000 x.35(depr overage) = 6,785,000 70,000 = $6,715,000 PVcf= 6,715,000/1.12(1+discount rate) = 5,995,535 NPV= 5,995,535 6,000,000 = 4,465 Breakeven an option no change to decision to accept Notes: Project authorization: 1. Outlays required by law or company policy 2. Maintenance or cost reduction 3. Capacity expansion in existing businesses 4. Investment for new products The accounting break even point is the level of sales at which profits are zero or equivalently at which total revenues equal total costs The historical record shows that investors have received a risk premium for holding risky assets. Average returns on high risk assets are higher than those on low risk assets Specific risk arises because many of the perils that surround an individual company are peculiar to that company and perhaps its direct competitors. Market risk stems from economy wide perils that threaten all businesses. Market risk explains why stocks have a tendency to move together, so even well diversified portfolios are exposes to market movements For a reasonably well diversified portfolio, only market risk matters Four determinants of Value: 1. S/D 2. TVM 3. Risk/Return 4. Tax Beta has an upward slope More beta = more risk A positive NPV is plausible only if the company has some competitive advantage that prevents its rivals from stealing most of the gains Optimal Capital Structure Bankruptcy: 1. Tax Situations 2. Pay creditors/equity holders 3. Agency problems 4. Lawsuits

Chapter 15. Topics in Chapter. Capital Structure Decisions

Chapter 15. Topics in Chapter. Capital Structure Decisions Chapter 15 Capital Structure Decisions 1 Topics in Chapter Overview and preview of capital structure effects Business versus financial risk The impact of debt on returns Capital structure theory, evidence,