FIN 401 Study Guide - Midterm Guide: Tax Bracket, Systematic Risk, Tax Shield

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15 Apr 2012
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Course
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Weight Average Cost of Capital (WACC) Combination of Cost of Debt (Bonds) and Cost of Equity (Stocks)
Solving for Cost of Equity (Stock Valuation) 2 Methods
Dividend Discount/Growth Model Approach (DDM)
o
  and    
         
Estimating “ 4 Methods
o Method 1: Compound Growth Rate Use Compound Interest Function
o Method 2: Historical Growth Rate 
  then   

o Method 3: Retention Ratio        

o Method 4: Analysts’ Forecast
Advantages
Disadvantages
Easy to understand and use
Only applicable to companies paying dividends
Not applicable if dividends aren’t growing at constant rate
Sensitive to estimated growth rate change
Does not explicitly consider risk
Security Market Line (SML) / Capital Asset Price Model (CAPM) Approach
o      and    
       
Advantages
Disadvantages
Adjusts for systematic risk
Applicable to all companies if we can compute
Have to estimate expected market risk premium which vary over time
Have to estimate which also varies over time
Relying on past to predict future which is not always reliable
Solving for Cost of Debt (Bond Valuation)
Use Compound Interest Function:     
   solve for I%
Solving for Cost of Preferred Stock:
Solving WACC: Accept project if IRR > WACC
Calculate Weights:
and     where    
         
       and     
Leasing/Buying Minimizing cost by deciding to lease or buy an asset
Solving for Net Advantage to Leasing (NAL): Same as NPV of the incremental cash flows
     

o Calculating PV of After Tax Lease Payments (PVATL) Use Compound Interest Function
            solve for PV
o Calculating PV of CCA Tax Shields (PVCCA) PGRM CCA
      
o Calculating PV of Salvage Use Compound Interest Function
           solve for PV
o If NAL > 0, the firm should Lease ; if NAL < 0, the firm should Buy
Solving for Break-Even Lease
Set    solve for PVATL
o Solving for Max Lease Payment
           solve for PMT
    
A Leasing Paradox
If the lessor and lessee have the same effective tax rate, then leasing is a zero sum game.
When their tax rates differ, then leasing has benefits for both parties
The company in the higher tax bracket can benefit from being a lessor, because they can use the CCA tax shields.
The CCA tax shields are worth less to the lessee because he faces a lower tax rate or may not have enough taxable income to absorb the
accelerated tax shields in the early years
Good Reasons for Leasing
Bad Reasons for Leasing
If a lessee goes bankrupt, the lessor can repossess the item without major
hassles
If the tax rates for the lessor and the lessee are equal, there is no tax benefit or
cost to leasing, but if the tax benefits are greater for the lessor, then it may make
sense for both sides to do the lease.
If the lessor can more cheaply take on the risks of obsolescence and inflexibility
than the lessee, then a lease makes sense in comparison to a purchase for the
lessee.
Works as a form of insurance for lessee; another form of risk management
Balance sheet, especially leverage ratios, may look better
if the lease does not have to be accounted for on the
balance sheet
100% financing leases normally do not require either a
down-payment or a security deposit
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