ADM 3350 Lecture Notes - Lecture 3: Risk Premium, Opportunity Cost, Adverse Selection

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21 Nov 2017

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The cost of equity capital: whenever a firm has extra cash, it can, pay out the cash immediately as a dividend. Invest cash in a project (the project should only be undertaken if its expected return is greater than that of a financial asset of comparable risk) A firm with excess cash can either pay a dividend or make a capital investment. F is the excess market return, the rf is the risk free rate. To esti(cid:373)ate a fi(cid:396)(cid:373)"s (cid:272)ost of e(cid:395)uit(cid:455) (cid:272)apital, we need to know three things: the risk-free rate, rf. M: the market risk premium, the company i. Example: suppose the shares of stansfield enterprises, a publisher of powerpoint presentations, has a beta of 2. 5. Suppose stansfield enterprises is evaluating the following non-mutually exclusive projects. Npv breakeven (rate that would make me indifferent), r = x, npv = 0, Npva = 0 = -c + cfa(1 + r)

Related Questions

The major components that determine the risk premium on a specific security at any point in time include all of the following except

interest rate risk

business risk

financial risk

real rate of return risk

If a firm sells assets, generating cash flows, the cost of these funds is ____.

the firm's cost of cash flows

the firm's weighted cost of capital

zero

the firm's cost of equity

Which of the following statements (if any) is (are) true concerning companies that do not pay dividends?

The cost of equity capital cannot be determined by using the CAPM, the risk premium on debt approach, or by estimating ke for comparable dividend-paying stocks in their industry.

The dividend capitalization model can be used to determine an accurate cost of equity capital.

The cost of equity capital is equal to the growth short-term rate of earnings per share.

The cost of equity capital can be estimated using the Capital Asset Pricing Model.

Cascade water Company (CWC) currently has 30,000,000 shares of common stock outstanding that trade at a price of $42 per share. CWC also has 500,000 bonds outstanding that currently trade at $023.38 each. CWC has no preferred stock outstanding nad has an equity bets of 2.639. The risk-free rate is 3.5%, and the market is expected to return 12.52%. The firm's bonds have a 20 year life, a $1,000 per value, a 10% coupon rate, and pay interest semiannually.

CWC is considering adding to its product mix a healthy bottled water geared toward children. The initial outlay for the project is expected to be $3,000,000, which will be depreciated using the straight-line mthod to a zero salvage value, and sales are expected to be 1,250,000 units per year at a price of $1.25 per unit. Variable costs are estimated to be $0.24 per unit, and fixed costs of the project are estimated at $200,000 per year. The project is expected to have a 3-year life and a terminal value (excluding the operating cash flows in year 3) of $500,000. CWC has a 34% tax rate. For the purposes of this project, working capital effects will be ignored. Bottled water targeted at child is expected to have a different risk characteristics from the firms' current products. Therefore, CWC has decided to use the "pure play" approach to evalue this project. After researching the market CWC managed to find two pure play firms. the specifics for those two firms are

Firm	Beta	D/E	Tax rate
Fruity Water	1.72	.43	34%
Ladybug Drinks	1.84	.35	36%

1) Determine the current weighted average cost of capital, cost of equity and the debt to equity ratio for CWC

2) Determine the appropriate discount rate for the healthy bottled water product

ivoryguinea-pig63

The goal of the firm is to ____ because _____. Answer maximize shareholders' wealth; it considers all risks invest funds in real estate; the return is longer maximize shareholders' profit; it is a short term outlook closely matching management goals Mike is paying $8,000 a year on his mortgage at 6% nominal annual interest. He has 15 more years to make payments. He wants to sell his house today. The lowest [minimum] price he can sell the house without losing any money on the house would be about ___. Answer $120,000 $ 50,000 $77,698 $ 186,208 A firm's net income before tax, EBT [NIBT] (on the income statement) is affected by _____. Answer taxes interest dividends Common Stock as listed on the Balance Sheet could include which of the following? Answer A) retained earnings B) additional paid in capital over par value C) preferred capital Both A) and B) If an asset is sold for ___ than its basis, the tax effect would be ____. Answer A) more; capital gain and depreciation recapture B) less; depreciation recapture C) more; capital loss Both A) and B) The main reason for a firm to have assets is to _______. Answer generate revenue match the liabilities and equity both of the above be able to borrow money and pay its debts none of the above The only risk you would NOT have in loaning money to the United States Government (Uncle Sugar) is _____ risk. Answer liquidity maturity default A(n) ____ shows _____. Answer balance sheet; sources and uses of funds income statement; net income as of a specific date cash flow statement; how well the firm is doing relative to its competition You can compare dollars _____ because ______. Answer computed using equations; any math is always correct at any point in time; time is never a factor if they are at nominal value; that is when decisions are made only at the same point in time; dollars can be invested to earn interest There ___ a tax benefit to the company with paying preferred dividends because _______. Answer is; investors can write them off is not; investors declare them as income is; the company can use the payments as an expense is not; the company cannot use the payments as an expense XYZ issued a 6% coupon, $1,000 par, 30 year to maturity bond. It is now 6 years to maturity. What is the price of the bond if the yield to maturity [market interest rate] is 10%? Answer $1,000 $659.46 $825.79 $705.33 The valuation process can be described as ______. Answer calculating the present value of an expected future cash flow using the investor's required rate of return as the discount rate calculating the future value of an expected future cash flow using the investor's required rate of return as the discount rate amortizing the value of the asset over its holding period The ______ is the minimum required rate of return a firm must earn on its investments. Answer net present value opportunity cost of capital or weighted average cost of capital. internal rate of return gross profit margin The value of an asset is the _____ dollar price someone is willing to pay for it. Answer usual maximum minimum Companies use ____ in capital budgeting project analysis because ________. Answer accounting profit; that is the total net income after tax cash flow; that is what the owners would receive from the project and reinvest accounting profit; that is what the owners would receive from the project and reinvest after tax cash flow; that is the result of prudent accounting When borrowing money, you want to know the ____ interest rate because ____. Answer nominal; it is the easiest to find. effective; it is the true cost of borrowing risk free; that is what the government pays Fed funds; that is what you would pay the bank Cash available to pay out to the investors after the firm pays for new investments or additions to working capital is _____. Answer a statement of cash flows operating after tax cash flow free cash flow net income An organization that raises money from investors and provides financing for individuals and businesses is a ___. Answer factor federal government regulatory unit state government taxing authority financial intermediary Negatives/cons of the Net Present Value (NPV) technique include: Answer least conservative reinvestment assumption multiple rates of return for non-conventional cash flows all of the above none of the above A fixed exchange rate means a country _____. Answer can only use gold coins as money is limited in the amount of paper money it can print can print money as the economy demands Your company is considering an investment with the following expected cash flows: Initial Investment = $407,596 Operating Cash Flows = $73,428 per year Terminal Cash Flow = $11,872. The company's WACC is 11% for similar risk projects. The proposed project would have an expected life of 9 years. Your boss asks you to do the analysis. You would tell your boss this proposed project ___ because ____. Answer is acceptable; NPV is about $3,620 is acceptable; NPV is zero should be rejected; NPV is about -$5,660 [negative $5,660]. should be rejected; NPV is zero All ratios are ___ and a reason to analyze ratios is ____. Answer good; to continue to look productive good and bad; because seemingly good ratios can be masking something bad bad; to try to rework the numbers to have them look good basically irrelevant; there really is no need to analyze financial statements When analyzing financial statements, ratio analysis gives ____ and provides insight into ____. Answer very little useful information; practically nothing good practice in logical thinking; what has occurred and the logic behind it financiers something to do during slow periods; how the financier spends his time accountants a reason to provide financial statements; why accountants do what they do while at work Given: Economic State[i]: Good Average Expected Return[i]: 10% 8% Probability[i]: 30% 70% What is the Standard Deviation? Answer 3% 8.4% 0.92% 5.6% Chapter 9: XYZ has a projected project to install a new press. The expected cash revenue is $175,000 per year. Expected yearly expenses are: Operatinf costs of $50,000; Rental of $17,000; Utilities of $20,500; and Depreciation of $10,000. The tax rate is 35%. What is the expected After-Tax Operating Cash Flow for the first year? Answer $65,500 $60,375 $77,500 $97,500 A stock just paid a dividend of $1.60 per year. The dividend is expected to grow at 3% per year indefinately. Equally risky stocks offer expected rates of return of 8%. What should be the stock price? Answer 53.33 $16.00 $32.96 None of the above. A plot of the CAPM is the _____. Answer wrong thing to do Security Market Line a function showing how to calculate TVM All of the above. Derivatives are used to ___. Answer divide one number by another find old ways to do things hedge risk none of the above With the end of the Gold Standard in the 1970's, what new risk did business face in the international market? Answer Comjpetition Exchange rate Worker compensation Property taxes One of the positive aspects [pros] of a Floating Exchange Rate System is ____. Answer money can be printed as needed to support financial/economic growth no/reduced inflation economic growth is reduced as a result of reduced liquidity [lower money supply] business planning is more difficult A(n) ____ contract obligates the seller to execute the contract and the contract is executed. Answer backwards forward future option What policies did countries institute after the Great War that help lead to the Great Depression? Answer A. Mandatory military service B. Trade restrictions C. High tariffs D. Isolationism Only B., C. and D. All of the above

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ADM 3350 Lecture Notes - Lecture 3: Risk Premium, Opportunity Cost, Adverse Selection

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