FINC3015 Lecture Notes - Lecture 10: Financial Statement, Risk Premium, Income Approach

39 views7 pages

peachcoyote549

30 Jul 2018

School

Department

Course

Professor

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

Document Summary

Works best for projects and companies that manage their capital structure to a desired target. Works best for projects and companies with changing capital structures. Captures interest tax shield in the cash flow so works best with firms or projects with changing capital structures. =(cid:1848)(cid:1853)(cid:1864)(cid:1873)(cid:1857) (cid:1867)(cid:1858) (cid:1872) (cid:1857) (cid:1847)(cid:1866)(cid:1864)(cid:1857)(cid:1874)(cid:1857)(cid:1870)(cid:1857)(cid:1856) (cid:1831)(cid:1869)(cid:1873)(cid:1872)(cid:1877) (cid:1832)(cid:1870)(cid:1857)(cid:1857) (cid:1829)(cid:1853)(cid:1871) (cid:1832)(cid:1864)(cid:1867)(cid:1875)(cid:1871) If the tax savings are viewed as a perpetuity, then: (cid:1848)(cid:1853)(cid:1864)(cid:1873)(cid:1857) (cid:1867)(cid:1858) (cid:1846)(cid:1853)(cid:1876) (cid:1828)(cid:1857)(cid:1866)(cid:1857)(cid:1858)(cid:1872)(cid:1871)=(cid:1846)(cid:1853)(cid:1876) (cid:1844)(cid:1853)(cid:1872)(cid:1857) (cid:1829)(cid:1867)(cid:1871)(cid:1872) (cid:1867)(cid:1858) (cid:1830)(cid:1857)(cid:1854)(cid:1872) (cid:1830)(cid:1857)(cid:1854)(cid:1872) (cid:1829)(cid:1867)(cid:1871)(cid:1872) (cid:1867)(cid:1858) (cid:1830)(cid:1857)(cid:1854)(cid:1872) If there is a net benefit from debt financing (t > 0), then wacc < unlevered cost of equity: wacc effectively bundles the net benefits of the interest tax shield. Residual income models: widely recognised tools in both investment practice and research, conceptually, residual income is net income less a charge (deduction) for common shareholders(cid:859) opportu(cid:374)ity cost in generating net income. It is the residual or re(cid:373)ai(cid:374)i(cid:374)g i(cid:374)(cid:272)o(cid:373)e after (cid:272)o(cid:374)sideri(cid:374)g the (cid:272)osts of all a (cid:272)o(cid:373)pa(cid:374)(cid:455)(cid:859)s (cid:272)apital.

Related Questions

V2 A7 Q11-20

Note: Questions 11 - 20 relate to the same "mega" problem. For convenience we have included the entire set of information in every question. For purposes of the questions that follow, assume that changes in working capital are negligible and capex and depreciation are of the same magnitude and therefore cancel each other. This is the assumption we made in most of the videos to focus on valuation effects of borrowing and taxes and to figure out the key differences between alternative valuation methods.

Q11

You are an analyst at Goldman Sachs tasked with valuing a company, Incline, Inc., a private company. You estimate that the earnings of Incline (or EBIT) will be $100,000 next year (at t = 1) and then grow at 2% for the foreseeable future. Specifically, $100,000 at t = 1 and $102,000 at t = 2, etc. Your due diligence and analysis of comparable firms in the same industry have revealed that the beta

asset in the business of Incline, Inc. is 1.50. The risk free rate is 2.50% and the expected market risk premium (the premium that the market is expected to earn over the risk free rate) is 5.00%. The balance sheet of Incline shows that it has $250,000 of debt that it plans to maintain for the foreseeable future and the interest on the debt is 5%. The corporate tax rate is 35%, interest payments on debt are tax deductible and it is reasonable to assume that the riskiness of the

tax shield is the same as the debt. You estimate that the chances that Incline, Inc. will go bankrupt in the future are negligible. Given the above information which method is the most applicable (and easiest) to use to calculate the value of Incline, Inc.?

a) Equity Valuation Method

b) Adjusted Present Value Method

c) Enterprise Value (WACC) Method

d) Multiples Method

Q12

Use the method you chose above to obtain an estimate of the value is??

Q13

The growth rate in the cash flows to equity holders for the foreseeable future will be:

What capital structure (debt-to-equity ratio) does the valuation in Q. 12 imply for Incline, Inc. today (t=0)?

Q15

What capital structure (debt-to-equity ratio) will exist at t = 1?

a) A lower D/E ratio than t = 0.

b) Cannot evaluate given the information.

c) A higher D/E ratio than t = 0.

d) The same as t = 0.

Q16

The Enterprise Valuation method cannot be applied to this situation unless:

a) The debt to equity ratio is gxed upfront and never changed.

b) The WACC is adjusted each year for the change in capital structure.

c) The return on asset is adjusted every year for the change in capital structure.

Q17

What will be the value of Incline, Inc. one year from now (at t = 1)??

Q18

What is the return on equity to shareholders of Incline, Inc. from t = 0 to t = 1???

Q19

What is the weighted average cost of capital (WACC) of Incline, Inc. from t = 0 to t = 1 ???

Enter answer here

Q20

What will be the weighted average cost of capital (WACC) of Incline, Inc. one year from from t = 1 to t = 2?

Eco Plastics Company: The target capital structure for ECO is given by the weights in the following table:

Source of Capital	Weight
Long-term debt	30 %
Preferred stock	20
Common stock equity	50
Total	100 %

At the present time, Eco can raise debt by selling 20 year bonds with a $1,000 par value and a 10.5% annual coupon interest rate. Eco's corporate tax rate is 40%, and its bonds generally require an average discount of $45 per bpnd and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9 % dividend and has a $95-per-share par value. The cost of issuing and selling additional preferrerd stock is expected to be $7 per share. Because ECO is a young firm that requires lots of cash to grow it does not currently pay a dividend to common stockholders. To track the cost of common stock the CFO uses the capital asset price model (CAPM). The CFO and the firm's investment advisors believe that the appropriate risk-free rate is 4 % and that the market's expected return equals 13%. Using data from 2012 through 2015, Eco's CFO estimates the firm's beta to be 1.3. Although Eco's current target capital structure includes 20 % preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital struture to 50% long term debt and 50% common stock. If Eco shifts its capital mix from preferred stock to debt, its financial advisors expect its beta to increase to 1.5. A) Calculate Eco's current after-tax cost of long term debt. B) Calculate Eco's current cost of preferred stock C) Calculate Eco's current cost of common stock D) Caluclate Eco's current weighted average cost capital E (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long term debt, 0% perferred stock, and 50% common stock have on the risk premium for Eco's common stock? What would be Eco's new cost of common equity? (2) What would be Eco's new weighted average cost of capital? (3) Which capital structure-the original one or this one-seems better? Why?

ECO PLASTICS COMPANY

Since its inception, Eco Plastics Company has been revolutionizing plastic and trying
to do its part to save the environment. Eco's founder, Marion Cosby, developed a
biodegradable plastic that her company is marketing to manufacturing companies
throughout the southeastern United States. After operating as a private company for
6 years, Eco went public in 2012 and is listed on the Nasdaq Stock Exchange.

As the chief financial officer of a young company with lots of investment opportunities
Eco's CFO closely monitors the firm's cost of capital. The CFO keeps tabs on each of the
individual costs of Eco's three main financing sources: Long-term debt, preferred stock
and common stock. The target capital structure for ECO is given by the weights in the
following table:

Source of capital: Weight
Long term debt: 30%
Preferred Stock: 20%
Common Stock Equity: 50%
Total 100%

At the present time, Eco can raise debt by selling 20 year bonds with a $1,000 par value and a 10.50% annual coupon interest rate. Eco's corporate tax rate is 40% and its bonds
generally require an average discount of $45 per bond and flotation costs of $32 per bond when being sold. Eco's outstanding preferred stock pays a 9% dividend and has a
$95 per share par value. The cost of issuing and selling additional preferred
stock is expected to be $7 per share. Because Eco is a young firm that requires lots
of cash to grow it does not currently pay a dividend to common stockholders. To track the cost of common stock the CFO uses CAPM. The CFO and the firm's investment advisors believe that the appropriate risk free rate is 4% and that the market's expected return equals 13%. Using data from 2012 to 2015, Eco's CFO estimates the firm's beta to be 1.3. Although Eco's current target capital structure includes 20% preferred stock, the company is considering using debt financing to retire the outstanding preferred stock, thus shifting their target capital structure to 50% long term and 50% common stock equity. If Eco shifts its capital mix from preferred stock to debt, its financial advisors
expect its beta to increase to 1.5.

To Do:

a. Calculate Eco's current after-tax cost of long term debt.

b. Calculate Ecoâs current cost of preferred stock.

c. Calculate Ecoâs current cost of common stock.

d. Calculate Ecoâs current weighted average cost capital.

e. (1) Assuming that the debt financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 0% preferred stock, and 50% common stock have on the risk premium for Ecoâs common stock? What would be Ecoâs new cost of common equity?

(2) What would be Ecoâs new weighted average cost of capital?

(3) Which capital structure-the original one or this one-seems better? Why?

coppermallard475

FINC3015 Lecture Notes - Lecture 10: Financial Statement, Risk Premium, Income Approach

Document Summary

Get access

Related Documents

FINC3015 Lecture Notes - Lecture 5: Net Income, Fixed Capital, Market Power

FINC3015 Lecture Notes - Lecture 8: Cash Flow, Reinvestment Risk, Operating Leverage

FINA 410 Lecture Notes - Lecture 15: Tax Rate, Interest Expense, Today Extra

Related Questions