FINS1613 Lecture Notes - Lecture 3: Corporate Bond, Discount Window, Weighted Arithmetic Mean

39 views4 pages

rosemink581

29 May 2018

School

Department

Course

Professor

For unlimited access to Class Notes, a Class+ subscription is required.

Valuatio of a Fir’s Securities: Bod

Valuatio

Capital Structure

• How a company finances itself is called its capital structure.

• Companies sell types of securities to investors in return for money.

• Owners of these securities have the rights to cash flows (profits) from

the firm.

• We focus on how to value the securities: BONDS and EQUITY.

• Assets = Liability + Equity

• Enterprise Value + Cash = Debt + Equity

Bonds

• Terms of the bond indicate that amounts and dates of all payments are

to be made.

• Obligation to make payments

• Form of debt financing

Equity

• Preference Shares

- Receive dividend payments generally dictated at issuance

- Receive before ordinary shares receive (but not guaranteed)

• Ordinary Shares

- Holders receive dividends (not guaranteed)

- Represents ownership and carries voting rights

Debt Vs Equity

• Bonds ➔ Preference Shares ➔ Ordinary Shares

• When paying out profits, bond owners get a set return with the

residual amounts going to equity

- When a company does well, Equity gets the most return.

- But when company does not do well, Equity payments stop.

• When company goes bankrupt and is liquidated, payments are made in

the order of preference.

find more resources at oneclass.com

Unlock document

This preview shows page 1 of the document.
Unlock all 4 pages and 3 million more documents.

Already have an account? Log in

Document Summary

Bonds: terms of the bond indicate that amounts and dates of all payments are to be made, obligation to make payments, form of debt financing. Receive dividend payments generally dictated at issuance. Receive before ordinary shares receive (but not guaranteed: ordinary shares. Debt vs equity: bonds preference shares ordinary shares, when paying out profits, bond owners get a set return with the residual amounts going to equity. When a company does well, equity gets the most return. But when company does not do well, equity payments stop: when company goes bankrupt and is liquidated, payments are made in the order of preference. Term structure of interest rates: relationship between length of investment and its interest rate, determined by expectations of future interest rates. Bond valuation: draw the timeline, discount all the promised cash flows to time 0 to figure out the pv of the bond.

Related Questions

I need help proof reading my assignment please, thank you in advance.

Cost of Debt

The cost of debt is the effective rate that a company pays on its total debt.

As a company acquires debt through various bonds, loans and other forms of debt, the cost of debt is a useful metric. It gives an idea as to the overall rate being paid by the company to use debt financing. This measure is also useful because it gives investors an idea as to the riskiness of the company compared with others. The higher the cost of debt, the higher the risk.

1. Cost of debt (before tax) = Corporate Bond rate of companyâs bond rating.

Pepsico 2.75% = 2.75%

Current cost of Debt as of February 17th 2014 = 2.75%

2. Current tax rate

In 2013 PepsiCoâs tax rate was = 23.66%

2013 PepsiCo averaged tax rate of 23.66%

3. Cost of Debt (After Tax) = (Cost of Debt Before Tax) (1 â Tax Rate)

The effective rate that a company pays on its current debt after tax.

.0275 x (1 â .2366) = Cost of debt after tax

The cost of debt after tax for PepsiCo is 2.10%

Cost of Equity or R Equity = Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

The cost of equity is the return a firm theoretically pays to its equity investors to compensate for the risk they undertake by investing in their company.

Risk Free Rate = U.S. 10-year bond = 2.74%

Average Market Return 1950 â 2014 = 7%

Beta = PepsiCoâs Beta = 0.37

Risk Free Rate + Beta Equity (Average Market Return â Risk Free Rate)

2.74 + 0.37 (7- 2.74)

2.74 + 0.37 x 4.26

2.74 + 1.58 = 4.31%

Currently, PepsiCoâs has a Cost of Equity or R Equity of 4.31%, so investors should expect to get a return of 4.31% per-year average over the long term on their investment to compensate for the risk they undertake by investing in this company.

Weighted Average Cost of Capital or WACC calculation

The WACC calculation is a calculation of a companyâs cost of capital in which each category of capital is equally weighted. All capital sources such as common stock, preferred stock, bonds and all other long-term debt are included in this calculation.

As the WACC of a firm increases, and the beta and rate of return on equity increases, this is an indicator of a decrease in valuation and a higher risk. By taking the weighted average, we can see how much interest the company has to pay for every dollar it finances. For this calculation, you will need to know the following listed below:

Tax Rate = 23.66%

Cost of Debt (before tax) or R debt = 2.75%

Cost of Equity or R equity = 4.31%

Debt (Total Liabilities) for 2013 TTM or D = $53.069 billion

Stock Price = $78.09 (Feb. 17th, 2014)

Outstanding Shares = 1.55 billion

Equity = Stock price x Outstanding Shares or E = $121.04 billion

Debt + Equity or D+E = $174.109 billion

WACC = R = (1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â Tax Rate) x R debt (D/D+E) + R equity (E/D+E)

(1 â .2366) x .0275 x ($53.069 /$174.109) + .0431 ($121.04 /$174.109)

.7634x .0275 x .3048 + .0431 x .6972

.0064 + .03

= 3.64%

Based on the calculations above, we can conclude that PepsiCo pays 3.64% on every dollar that it finances, or 3.64% cents on every dollar. From this calculation, we understand that on every dollar the company spends on an investment, the company must make $.0673 plus the cost of the investment for the investment to be feasible for the company.

Understanding the WACC of a company is important because securities analysts employ WACC all the time when valuing and selecting investments. In discounted cash flow analysis, for instance, WACC is used as the discount rate applied to future cash flows for deriving a businessâs net present value.

Investors use WACC as a tool to decide whether to invest. The WACC represents the minimum rate of return at which a company produces value for its investors. Letâs say a company produces a return of 20% and has a WACC of 11%. That means that for every dollar the company invests into capital, the company is creating nine cents of value. By contrast, if the companyâs return is less than WACC, the company is shedding value, which indicates that investors should put their money elsewhere.

Erwin Enterprises is a large publicly listed company and is the market leader in vacuum cleaner manufacturing. The company is looking to set up a manufacturing plant overseas to produce a new line of commercial vacuum cleaners. This will be a six-year project. The company bought a piece of land four years ago for $ 8 million in anticipation of using it for its proposed manufacturing plant. If the company sold the land today, it would receive $ 9.75 million after taxes. In six years the land can be sold for $7 million after taxes and reclamation costs. Erwin Enterprises wants to build a new manufacturing plant on this land. The plant will cost $320 million to build. The following market data on Erwinâs securities are current:

Debt	$120,000,000,7.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.
Equity	15,000,000ordinary shares, selling for $55 per share
Non-redeemable Preference shares	12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share

The following information is relevant:

Erwin Enterprisesâ tax rate is 28%

The company had been paying dividends on its ordinary shares consistently. Dividends paid during the past five years is as follows

Year (-4) ($)	Year (-3) ($)	Year (-2) ($)	Year (-1) ($)	Year (0) ($)
4.6	4.8	5.2	5.5	6.1

The project requires $ 8.25 million in initial net working capital investment in year 0 to become operational.

Work all solutions to the nearest two decimals.

Required:

Calculate the projectâs initial, (time 0) cash flows, taking into account all side effects.

(2 marks)

Compute the weighted average cost of capital (WACC) of Erwin Enterprises. Show all workings and state clearly the assumptions underlying your computations.

(10 marks)

Using the WACC computed in part (2) above and assuming the following, compute the projectâs Net Present Value (NPV), Internal Rate of Return (IRR) and the Profitability Index (PI)

The manufacturing plant has a ten-year tax life, and Erwin Enterprises uses Diminishing value method depreciation for the plant at 25% per annum. At the end of the project, (i.e. at the end of year 6), the plant can be scrapped for $ 42 million.

The project will incur $220 million per annum in fixed costs

Erwin Enterprises will manufacture 280,000 commercial vacuum cleaners per year in each of the years and sell them at $ 2,200 per vacuum cleaner.

The variable production costs are $ 800 per vacuum cleaner.

At the end of year 6, the company will sell the land.

(7 marks)

2.2. What are the pros and cons of using risk-adjusted costs of capital for individual investments?

(5 marks

sapphireworm671

Debt	$120,000,000,7.25% coupon bonds outstanding with 20 years to maturity redeemable at par, selling for 95 percent of par; the bonds have a $1000 par value each and make semi-annual coupon payments.
Equity	15,000,000ordinary shares, selling for $55 per share
Non-redeemable Preference shares	12,000,000 shares (par value $ 10 per share) with 6.5% dividends (after taxes), selling for $32 per share