FINE 2000 Lecture Notes - Lecture 13: Dividend Discount Model, Capital Asset, Weighted Arithmetic Mean

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bluescorpion455

19 Apr 2016

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Value of the business = value of stock. Rate of return on business = rate of return on stock. Investors" required return from business = investors" required return from stock. Note: the choice of the discount rate is very important while taking a decision of undertaking a project or not and especially for large and long-lived capital expenditures. The company"s cost of capital is the minimum risk of return that a firm expects when the firm expands by investing in average risk projects. It is the opportunity cost of the firm"s existing assets. Therefore, the expected return on investments in financial markets determine the cost of capital for corporate investments. Capital structure is the balancing of debt and equity in the financing of a business. Calculating a company"s cost of capital as a weighted average. Calculating the cost of capital of a company with only common stock outstanding is really easy.

Related Questions

Answer the following question: A particular firm's shareholders demand a 15% return on their investment, given the firm's risk. However, this firm has historically generated returns in excess of shareholder expectations, with an average return on its portfolio of investments of 25%. a.) Looking back, what kind of stock price performance would you expect to see for this firm? b.) A new investment opportunity arises, and the firm's financial analysts estimate that the project's return will be 18%. The CEO wants to reject the project because it would lower the firm's average return and therefore lower the firm's stock price. How do you respond?

If a firm earns the WACC as an average return on its average-risk assets, then:

A: equityholders will be satisfied, but bondholders will not.

B: bondholders will be satisfied, but equityholders will not.

C: all investors will earn their minimum required rate of return.

D: the firm is investing in only positive NPV projects.

champagnetrout717

Consider a firm F that generates a single cash flow in one year which depends on the state of the economy:

-Boom (probability 1/2) 5m -Recession (probability 1/2) 1m

-F has 2,000 bonds outstanding with a face value of $1,000 and a 6% coupon, one-year maturity.
-There are no taxes, and the risk-free rate is 3%
-F has 1m cash at the beginning of year 1.

-F’s cost of debt is 4% regardless of the payout policy they choose.

F can distribute at the beginning of year 1 either 70% of its cash or 30% of its cash. The cash retained by the firm is invested at the risk-free rate.

Stockholders invest the dividend they receive at the beginning of year 1 at the risk-free rate as well.

Question:

Suppose instead that the market value of the bonds is 2m regardless of the payout policy chosen. The required return on the firm’s assets is 10%, and the required return on equity, if the firm had zero cash, is 12%. Which of the two payout policies will the firm’s shareholders optimally undertake and why?

rubyherring760

FINE 2000 Lecture Notes - Lecture 13: Dividend Discount Model, Capital Asset, Weighted Arithmetic Mean

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