FNCE10002 Lecture Notes - Lecture 4: Coca-Cola Vanilla, Net Present Value, Classic Case

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tealcattle862

7 Oct 2018

School

University of Melbourne

Department

Finance

Course

FNCE10002

Professor

Howard

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Document Summary

Includes short-term, long-term, private, public: o(cid:396)di(cid:374)a(cid:396)(cid:455) sha(cid:396)es (cid:894)(cid:862)(cid:272)o(cid:373)(cid:373)o(cid:374) sto(cid:272)k(cid:863)(cid:895) a(cid:374)d p(cid:396)efe(cid:396)e(cid:374)(cid:272)e sha(cid:396)es, but to simplify the discussion, the assumption that there are just two kinds of capital will be made : debt and ordinary equity. The conventional wisdom on capital structure: three observations often made by managers and investors, capital structure and financing decisions are important, debt has significant tax advantages. The two types of corporate risk: business (or operational) risk, this risk derives from the variability of future net cash flows attributable to the (cid:374)atu(cid:396)e of the fi(cid:396)(cid:373)"s ope(cid:396)atio(cid:374)s o(cid:396) the assets it holds. What is financial leverage: financial leverage results from borrowing. The main evaluation methods: the most widel(cid:455) (cid:396)e(cid:272)o(cid:373)(cid:373)e(cid:374)ded e(cid:448)aluatio(cid:374) (cid:373)ethod is (cid:862)(cid:374)et p(cid:396)ese(cid:374)t (cid:448)alue(cid:863) (cid:894)npv(cid:895), there are also several other methods, including the payback period (pp) and the accounting. Internal rate of return (irr) is a closely related method rate of return (arr: many companies use more than one method.

Related Questions

F2 Q1-5

The return on equity of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm.

a. False.

b. True.

Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on assets to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a. False.

b. Partly true, partly false.

c. True.

Even in a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information â debt will always be preferred because cost of debt is always lower than cost of equity for a firm.

a. True.

b. False.

c. Partly true, partly false.

In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a. The return on equity is less than the weighted average cost of capital (WACC).

b. The return on equity is greater than the weighted average cost of capital (WACC).

c. The relationship between return on equity and the WACC cannot be determined because it depends on several factors.

In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, the returns on equity of the two firms will:

a. Will depend on the capital structures adopted by the firms.

b. Will depend on the capital structures adopted by the firms and the valuation method used.

c. Always be equal to each other.

d. Will depend on the method of valuation used.

V2 F1 Q1-5

Please give explanations

1) The return on assets of a typical firm may change over time because of changes in business and economic conditions, but it is unlikely to change based on the financing or capital structure of the firm with reasonable amounts of debt.

a) True

b) False

2) Your firm has been plodding along without much attention from the stock market. Your boss insists that he can (a) increase the return on equity to shareholders by taking on more debt, and (b) attract new investors to the firm due to the higher returns.

a) False

b) Partly true, partly false

c) True

Q3) In a world with no frictions â that is, taxes, costs of bankruptcy, asymmetric information - there is no optimal capital structure (that, is no optimal mix of debt and equity).

a) True

b) False

Q4) In a world with taxes and bankruptcy costs, and in which interest on debt is tax deductible, if a firm has some debt:

a) The relationship between return on assets and the WACC is indeterminate and depends on several factors.

b) Its return on assets is always greater than the weighted average cost of capital (WACC).

c) Its return on assets is always is equal to the weighted average cost of capital (WACC).

d) Its return on assets is always less than the weighted average cost of capital (WACC).

Q5) In the real world, where there are taxes and interest on debt is tax deductible, if two firms have the same cash flows as each other in all possible scenarios in the future, their valuation at any point will:

a) Will depend on the capital structures adopted by the firms.

b) Will depend on the method of valuation used.

c) Will depend on the capital structures adopted by the firms and the valuation method used

d) Will be the same as each other regardless of the method of valuation.

Franco Modigliani and Merton Miller (M & M) are two very famous financial economists that both won the Nobel Prize in Economics for their work in the finance area, particularly in capital structure theories (see the Description of this in the box on page 504 of your text). In their famous 1958 article (see footnote on page 490), they argued that with perfect capital markets, the total value of a firm should not depend on its capital structure. In other words, the total value of a frim would be the same with all equity, or financing with 100% debt. This is the basic MM Proposition I stated on p.493. But, as you should see, the "perfect capital markets" assumes 3 key assumptions, including no taxes or transactions costs dealing with equity or debt. Additionally, a key assumption is that individuals and firms can trade the same set of securities at competitive market prices equal to the present value of their future cash flows.

These assumptions are necessary for the M&M theory on capital structure.

For the Proposition M&M II beginning on page 498, still in a perfect capital market which includes no taxes, M&M state that the cost of capital of EQUITY increases with the firm's market value debt-equity ratio. But, when you examine this Proposition more closely, for a new investment the cost of capital will equal the weighted average of the firm's equity and debt costs. What does this mean in practical terms? It means that M&M "loosens" a part of the Proposition I, and admit that the cost of equity does increase as the debt-equity ratio increases. But, if you examine this closely, it means that the OVERALL cost of capital, captured in the WACC stays constant. And, the pre-tax WACC is the same as the after-tax WACC, since there is no tax! If the WACC stays constant while the equity cost increases, this means that the debt costs are going down,relatively; on the contrary, if the equity costs are going down, then the debt costs are going up. This is shown on page 500 in Figure 14.1. And, of course, the weights count.

But, in the real-world, the M&M Propositions do not hold....corporations and individuals do have taxes, and do have transactions costs for debt and equity...buying bonds and stocks, for example.

So, as we have learned, the Beta coefficient for equity does increase as the amount of debt level increases (due to increasing risks of default of interest payments or repayment of the bonds at maturity)...and the costs of debt increase, but as we weight those, the WACC actually varies, based on the real-world that includes taxes....we normally see the WACC being a U-shaped curved that varies as a function of the debt to equity ratio.

That is the background for this Written Assignment. Dr. Steadman

) Discuss the MM Proposition I and MM Proposition II (definition, assumptions, results and implications)? Remember, at the MBA level, more is better. But, to the point, and no "hot air."

FNCE10002 Lecture Notes - Lecture 4: Coca-Cola Vanilla, Net Present Value, Classic Case

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