FIN 401 Study Guide - Midterm Guide: Tax Shield, Risk Premium, Dividend Policy

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18 Feb 2016
Ch.10: NPV Tax Shield
Y1 C machine Cost, D CCA tax Rate, K Discount Rate, T tax Rate, S Salvage
OCF=EBIT-Depr-Tax; OCF=NI+Depr; OCF=Sales-Cost-Tax;
Ch.14: WACC Dividend Growth model XT2Po=D1/(R-g); D1=Do*(1+g);
g=Retention ratio*ROE (stable dividend policy & no to raising new external
capital); **make sure to bring your dividend to this year
r - EAR, i - nominal rate, and n # periods per year
Rp= D/P; The par value of a preferred is $100
DDM - Re= D1/P0 +g; D1=D0*(1+g)
YT2 SML ApproachRe=Rfe*(Rm-Rf)
(Rm-Rf) - market risk premium; Rm - return of the market; the beta of the
market is 1 (one) and the beta of a risk-free asset is 0 (zero)
Advantages: 1) adjusts for systematic risk; 2) applicable to all companies;
Disadvantages: 1) expected Market Premium and is β vary; 2) reliance on past;
3) works only if company publicly trade.
Cost of preferred stock – Rp=D/Po
WACC - can be used only if the project has the same risk as firm. Rproject >
WACC – value is created.
YT3 Re= Cost of Equity (Q), Rp= Cost Preferred Stock (N),
Rd= Cost Debt (B) **if only two part question set one part as 0
EVA=Net Profit *(1-Tc)-(Capital*Cost of Capital).
Ch.22: Lease Operating lease – short-term, lessor is responsible for
insurance, taxes and maintenance, cancelable; “off- balance”. Financial
(Capital) lease – long-term, Lessee is responsible for insurance, taxes and
maintenance; debt financing – on BS shown as liability. It is FL if: 1) transfers
ownership by the end of the lease term; 2) Lessee can purchase asset at below
market price; 3) Lease term is for 75 percent or more of the life of the asset; 4)
PV of lease PMTs ≥ 90% of the fair market value.
Reasons for lease: Taxes may be reduced; May reduce some uncertainty; May
have lower transaction costs; May require fewer restrictive covenants; May
burden fewer assets than secured borrowing.
NAL= Investment – PV of (PMT *(1-Tc)) – Tax Shield – PV of SV, NAL>0!
If we do not have to pay taxes at the end of 5 years use what we can borrow %
If there is a salvage value make sure to use WACC for i
Ch.16: Capital Structure WACCL<WACCU
Indifference EBIT: EBIT/old # of shares = (EBIT-Interest)/new # of shares
If EBIT is greater than Ind. EBIT, the leverage is beneficial, otherwise not.
Homemade leverage: if a firm DECREASES leverage, the investor
BORROWS money and uses it to buy shares. If a firm INCREASES leverage,
the investor sells shares and puts money in the bank.
Prop 1. With a face and market value you need to subtract the market value
Prop.1 (Firm V) Vu=Vl; (with Tc)Vl=Vu+D*Tc; kou=keu=WACCu
Prop 2
Market Value= EBIT/Ru + (Debt x Tax) M=E/U+(DxT)
Degree of Fin Leverage (DFL)=%∆ in EPS/%∆ in EBIT=EBIT/(EBIT-
DFL measures how much EPS (ROE) respond to changes in EBIT.
Shareholders will take high-risk projects at the expense of bondholders.
If the firm does well, shareholders reap all of the benefits.
If the firm does poorly, stockholder losses are limited.
Stockholders expropriate value from bondholders by selecting high-risk
Bondholders know that shareholders have an incentive to do this. Therefore,
they put restrictive covenants in bond contracts and require a higher rate of
return on their bonds. Both of these are costly to the firm, and increase the
Optimal Capital Structure=firm value is Max=WACC is Min
Notes on the Static Theory:
The tax shield only has value if the firm is making money.
For firms with other substantial tax shields (i.e. CCA tax shields), the
interest tax shield is less important.
The higher the corporate tax rate, the greater the incentive to borrow.
The greater the risk of financial distress, the less the firm should borrow.
The greater the costs of financial distress in the event of bankruptcy, the less
you should borrow.
Key Point of Capital Structure: if corporate financing decisions are going to
increase corporate values, they are likely to do so only for the following
They reduce the taxes paid by the corporation or its investors.
They reduce the probability of costly bankruptcy.
They send a positive signal to investors about management’s view of the
firm’s prospects.
They provide managers with stronger incentives to invest wisely and operate
So=Co+E/(1+Rf)t; Intrinsic Value = IV =So-E; Time Value = TV = Premium-IV;
Call = Max (S-E,0), IVcall never <0, Max gain = S – E – Premium; Max loss =
Premium paid; C1=0, if S1≥E; C1=S1, if S1>E
Put = Max (E-S,0); Intrinsic Value = IV =E-So;
Which of the following is general true about a firm’s cost of debt?
It is equal to the yield to maturity on the firm’s outstanding bonds
The equity risk derived from the firm’s capital structure policy is called
Financial Risk
The unlevered cost of capital is: The cost of capital for a firm with no debt in
its capital structure
The use of an asset in a leasing arrangement is called the: Lessee
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