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Lecture 7

MGT 181 Lecture Notes - Lecture 7: Preferred Stock, Financial Risk, Underwriting


Department
Rady School of Management
Course Code
MGT 181
Professor
L Jean Dunn
Lecture
7

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November 10th, 2015
The return earned on assets depends on the risk of those assets. The return to an investor is
the same as the cost to the company.
The required return is the same as the appropriate discount rate and is based on the risk of the
cash flows.
The cost of equity is the return required by equity investors given the risk of the cash flows from
the firm.
Business risk: the risk of the firm’s assets when no debt is used.
Financial risk: takes into account a company’s leverage.
There are two major methods for determining the cost of equity: dividend growth model and
SML/CAPM.
The Security Market Line Approach: RE = Rf + BE(E(RM)-Rf)
The cost of debt is the required return on our company’s debt. It focuses on the cost of long-
term debt or bonds. The cost of debt is not the coupon rate.
Preferred stock generally pays a constant dividend each period. Dividends are expected to be
paid every period forever.
Preferred stock is a perpetuity so : Rp = D/P0
Weighted Average Cost of Capital:
E = market value of equity = number of outstanding shares * price per share
D = market value of debt = number of outstanding bonds * bond price
V = D + E
WE = E/V = percent financed with equity
WD = D/V = percent financed with debt
Interest expense reduces our tax liability.
This reduction in taxes reduces our cost of debt = RD (1-TC)
Dividends are not tax deductible so there is no tax impact on the cost of equity.
WACC = WERE + WDRD(1-TC)
Using the WACC as our discount rate is only appropriate for projects that have the same risk as
the firm’s current operations. Divisions often require separate discount rates.
Pure Play Approach: choose one or more companies that specialize in the product or service we
are considering.
Subjective Approach: If the project has more risk than the firm, use a discount rate greater than
the WACC.If the project has less risk than the firm, use a discount rate less than the WACC.
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