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

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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