CMA Part 1 Financial Decision Making Study Unit 5 Financial Instruments and Cost of Capital Ronald Schmidt, CMA, CFM Adrien Dubourg, CMA

CMA Part 1 Financial Decision Making

Study Unit 5

Financial Instruments and Cost of CapitalRonald Schmidt, CMA, CFM

Adrien Dubourg, CMA

2

Cost of Capital - Defined• Corporations derive capital essentially from two sources: lenders and shareholders. The total

capital of a firm represents a combination of debt capital and equity capital. These capital components are described next.

– Debt capital is that portion of total capital derived from the issuance of interest bearing instruments such as notes, bonds, or loans.

– Equity capital is that portion of total capital derived from permanent investments by shareholders, as either paid-in capital or retained earnings. A firm may issue new shares of common or preferred stock, or it may choose to retain earnings instead of distributing them as dividends.

• Every activity a firm does to generate capital—either explicit or implicit—has a cost associated with it. The overall cost of capital represents a proportional average of the various components a firm uses for financing.

3

Cost of Capital – Defined (cont.)

The cost of capital should be considered in capital structure decisions. Corporations can benefit from using the cost of capital to benchmark investment decisions and to manage working capital (e.g., receivables, inventories, and payables) more efficiently. The cost of capital also can be valuable to use in measuring and evaluating performance. For example, the actual and expected return on capital or net assets may be compared with the cost of capital associated with each.

4

SU – 5.1 Bonds

• Term structure of interest rates – relationship between yield to maturity and time to maturity– Types of slopes or “yield curves”• The shape of the yield curve is closely scrutinized because it helps to give an

idea of future interest rate change and economic activity. • There are four main types of yield curve shapes:

– Upward– Flat– Downward sloping– Humped

Continued

5

SU – 5.1 Bonds

• A normal yield curve (upward sloping) is one in which longer maturity bonds have a higher yield compared to shorter-term bonds due to the risks associated with time.

• An inverted yield curve is one in which the shorter-term yields are higher than the longer-term yields, which can be a sign of upcoming recession.

Continued

6

SU – 5.1 Bonds

• A flat (or humped) yield curve is one in which the shorter- and longer-term yields are very close to each other, which is also a predictor of an economic transition.

• The slope of the yield curve is also seen as important: the greater the slope, the greater the gap between short- and long-term rates.

Continued

7

SU – 5.1 Bonds

– When plotting yield curves we hold the following constant:• Default risk• Taxability• Callability• Sinking fund

Why?

8

SU – 5.1 Bonds

• Bonds are the principal form of long-term debt financing for corporations and government.

• Features of Bonds• Par Value = Maturity amount = Face Amount• State rate = Coupon rate• Indenture = Terms of the bond

• Issuing bonds takes time and money• > Risk = > Return (yield) • How can you mitigate some of the market required return?

9

SU – 5.1 Bonds

• Following are means to reduce the required rate of return for bonds:– Sinking Fund – payments to a segregated and accumulate funds

which will equal the maturity value– Insured– Secured

10

SU – 5.1 Bonds

• Advantages of Bonds– Interest is tax deductible– Retain corporate control

• Disadvantages of Bonds– Interest is considered legal obligation– Raises risk level and ultimately cost of capital– Raises risk profiles– Contractual requirements (e.g. required debt to equity)– Debt financing limits

11

SU – 5.1 Bonds

• Types of Bonds– Maturity• Term bond – single maturity• Serial bond

– Valuation• Variable rate• Zero-coupon or deep-discount bonds• Commodity-backed bonds

Continued

12

SU – 5.1 Bonds

• Types of Bonds– Redemption Provisions• Callable bonds – by the issuer• Convertible bonds – into equities

– Securitization• Mortgage bonds – specific • Debentures – borrower’s general credit but not specific collateral

Continued

13

SU – 5.1 Bonds

• Types of Bonds– Ownership• Registered bonds• Bearer bonds

– Priority• Subordinated debentures• Second mortgage bonds

– Repayment Provisions• Income bonds• Revenue bonds

14

SU – 5.1 Bonds

• Bond Ratings – Moody’s, Standard and Poor’s, and Fitch

– Investment grade – AAA; Insurance companies and banks

– Non-investment grade – Junk bonds, sometimes used for leveraged buy-outs

Higher rating = lower interest rate

15

SU – 5.1 Bonds

• Bond valuation and sales price– Several components to determining the fair price of a bond:• Risk• Duration• Face amount• Interest payment• Other features such as callable, convertibility

16

SU – 5.1 Bonds

Stated versus Market rate

– Mkt rate is = state rate– Mkt rate is < state rate– Mkt rate is > state rate

17

SU – 5.1 Bonds

• Different tables nec. to calculate the value of a bond.– Present Value of a $1– Future Value of a $1– Present value of an ordinary annuity – Present value of an annuity due– Future value of an ordinary annuity

18

19

SU – 5.1 Bonds

• See examples on page 128 and 129 of the Gleim study book

20

SU – 5.1 Bonds Question 1

All of the following may reduce the coupon rate on a bond issued at par except a

A. Sinking fund.

B. Call provision.

C. Change in rating from Aa to Aaa.

D. Conversion option.

21

Question 1 Explanation• Correct Answer: B

A bond issued at par may carry a lower coupon rate than other similar bonds in the market if it has some feature that makes it more attractive to investors. For example, a sinking fund reduces default risk. Hence, investors may require a lower risk premium and be willing to accept a lower coupon rate. Other features attractive to investors include covenants in the bond indenture that restrict risky undertakings by the issuer and an option to convert the debt instruments to equity securities. The opportunity to profit from appreciation of the firm’s stock justifies a lower coupon rate. An improvement in a bond’s rating from Aa to Aaa (the highest possible) also justifies reduction in the risk premium and a lower coupon rate. However, a call provision is usually undesirable to investors. The issuer may take advantage of a decline in interest rates to recall the bond and stop paying interest before maturity.

22


A company issued a 15-year, $1,000 par value bond. The coupon rate on this bond is 9% annually, with interest being paid each 6 months. The investor who purchased the bond expects to earn a 12% nominal rate of return. The cash proceeds received by the company from the investor totaled

A. $619.43

B. $793.43

C. $875.38

D. $950.75

23

24

25

Question 2 Explanation

Correct Answer: B

The cash flows consist of interest of $45 every 6 months for 15 years (30 periods), and $1,000 at the end of the 30th interest period. The 12% discount rate translates to 6% every 6 months. Thus, the calculation is as follows:

Periodic interest 13.765(30 periods @ 6%) × $45 = $619.43

Maturity amount .174(6%) × $1,000 = 174.00

Total proceeds $793.43

26


Which one of the following statements concerning debt instruments is correct?

A. The coupon rate and yield of an outstanding long-term bond will change over time as economic factors change.

B.A 25-year bond with a coupon rate of 9% and 1 year to maturity has more interest rate risk than a 10-year bond with a 9% coupon issued by the same firm with 1 year to maturity.

C. For long-term bonds, price sensitivity to a given change in interest rates is greater the longer the maturity of the bond.

D. A bond with 1 year to maturity would have more interest rate risk than a bond with 15 years to maturity.

27


• Correct Answer: C

The longer a bond’s term, the more time there is for interest rate volatility to affect a bond’s price, and thus the more sensitive is its price to interest rate changes.

28

SU – 5.2 Equity

• Common Stock– Advantages to the issuer• No fixed dividend (Common Stock only)• No maturity date• Increases creditworthiness• More attractive to investors

Continued

29

SU – 5.2 Equity

• Common Stock– Disadvantages to the issuer• No tax deductible distribution• Diluted controlling rights• Diluted earnings• Higher underwriting costs• Increase average cost of capital

What is a preemptive rights?

30

SU – 5.2 Equity

• Preferred Stock = hybrid of debt and equity– Advantages to the issuer• Form of equity• Does not dilute control• Superior earning still go to CS

– Disadvantages to the issuer• No tax deductible distribution and therefore greater cost to bonds• Dividends in arrears can cause issues

31

SU – 5.2 Equity

• Characteristics of Preferred Stock– Priority in assets and earnings– Potential accumulation of dividends– Convertibility– Participation– Par value– Redeemability– Voting rights– Callability– Maturity – Sinking fund

32

SU – 5.2 Equity

• Stock Valuations– Preferred is similar to Bonds in valuation– Discount rate will probably be higher then bonds due to riskiness– Common stock valued also the same way except based on earnings

(per share)

33

SU – 5.2 Equity Question 1

Preferred stock may be retired through the use of any one of the following except a

A. Conversion.B. Call provision.C. Refunding.D. Sinking fund.

34



Preferred stock is equity. Only debt can be refunded

35

SU – 5.2 Equity Question 2Which one of the following describes a disadvantage to a firm that issues preferred stock?

A. Preferred stock dividends are legal obligations of the corporation.

B. Preferred stock typically has no maturity date.

C. Preferred stock is usually sold on a higher yield basis than bonds.

D. Most preferred stock is owned by corporate investors.

36



Preferred stock must usually be sold on a higher yield basis than bonds because preferred stock stands behind bonds in priority at liquidation. An incentive must therefore be added to induce investors to purchase preferred stock. Since preferred stock is a riskier investment than bonds, investors demand a risk premium.

37

SU – 5.2 Equity Question 3

Which one of the following situations would prompt a firm to issue debt, as opposed to equity, the next time it raises external capital?

A. High breakeven point.

B. Significant percentage of assets under capital lease.

C. Low fixed-charge coverage.

D. High effective tax rate.

38


• Correct Answer: D

The interest paid on indebtedness is deductible for tax purposes; dividends paid to equity holders is not. Thus, a firm with a high effective tax rate would prefer to issue debt, which would create an additional tax benefit.

39

Other Questions(on what we covered so far)

1. Debentures are ….2. From the investor’s viewpoint, the least risky type of bond in which to invest is

a ….3. All the following may reduce the coupon rate of a bond issued at par except a

1. Sinking fund2. Call provision3. Change in rating from Aa to Aaa4. Conversion option

4. Why do financial managers prefer to issue Preferred Stock rather than debt?5. See question 10 on page 150

40

SU – 5.3 Corporate/Stock Valuation Methods

• Dividend Discount Model– Based on PV of “expected” dividends per share– Can only be used when dividends are expected to grow at constant rate

Dividend per shareCost of Capital – dividend growth rate

See example on p 132 and 133

41


• Preferred Stock Valuation

Dividend per shareCost of Capital

42


• Common Stock with Variable Dividend GrowthSee example page 133

– 3 Step process• Step 1 – Calculate and sum the PV of Dividends in the period of high growth• Step 2 – Calculate the PV of the stock based on the period of steady growth

discounted back to year 1 using the dividend discount method.• Step 3 – Sum the totals from Step 1 and 2

43

Per-share Ratios

• EPS – NI available to CS/Average shares outstanding

• Book value per share – Shareholders’ equity/shares outstanding

• Dividend yield – Dividend per share/Mrkt value per share

44

Per-share Ratios

• Price-earnings (P/E) ratio – Mrkt price/EPS

• Price-book ratio – Mrket price per share/Book value per share

• Price-sales ratio – Mrkt price per share/sales per share– Value to analyst

45

SU – 5.3 Corporate/Stock Valuation Methods Question 1

A company had 150,000 shares outstanding on January 1. On March 1, 75,000 additional shares were issued through a stock dividend. Then on November 1, the company issued 60,000 shares for cash. The number of shares to be used in the denominator of the EPS calculation for the year is

A. 222,500 shares.

B. 225,000 shares.

C. 235,000 shares.

D. 285,000 shares.

46



The weighted-average of shares outstanding during the year is used in the EPS denominator. Shares issued in a stock dividend are assumed to have been outstanding as of the beginning of the earliest accounting period presented. Thus, the 75,000 shares issued on March 1 are deemed to have been outstanding on January 1. The EPS denominator equals 235,000 shares {[150,000 × (12 months ÷ 12 months)] + [75,000 × (12 months ÷ 12 months)] + [60,000 × (2 months ÷ 12 months)]}.

47


Frasier Products has been growing at a rate of 10% per year and expects this growth to continue and produce earnings per share of $4.00 next year. The firm has a dividend payout ratio of 35% and a beta value of 1.25. If the risk-free rate is 7% and the return on the market is 15%, what is the expected current market value of Frasier’s common stock?

A. $14.00B. $16.00C. $20.00D. $28.00

48

Question 2 ExplanationCorrect Answer: C

The first step is to determine the required rate of return on Frasier’s stock. The capital asset pricing model (CAPM) can be used:

Required rate of return = Risk-free rate + β(Market rate – Risk-free rate)

= .07 + 1.25(.15 – .07)= .07 + .10= .17

The second step is to calculate the next dividend. Next dividend = Projected EPS ÷ Dividend payout ratio

= $4 × .35= $1.40

Now the dividend growth model can be used to calculate the expected current market value of Frasier’s common stock:

Current market value = Next dividend ÷ (Required rate of return – Dividend growth rate)

= $1.40 ÷ (.17 – .10)= $1.40 ÷ .07= $20

49


The Hatch Sausage Company is projecting an annual growth rate for the foreseeable future of 9%. The most recent dividend paid was $3.00 per share. New common stock can be issued at $36 per share. Using the constant growth model, what is the approximate cost of capital for retained earnings?

A. 9.08%

B. 17.33%

C. 18.08%

D. 19.88%

50

Question 3 ExplanationCorrect Answer: B

The cost of capital can be found using the dividend discount model:

Price of stock = Current dividend ÷ (Cost of capital – Dividend growth rate)

$36 = $3.00 ÷ (CC – 9%)$36CC – $3.24 = $3.00

$36CC = $6.24CC = 17.33%

Incorrect Answers: A: This percentage is calculated by improperly multiplying the current dividend by the projected growth rate then dividing it by the current issue price per share of common stock. C: This percentage results from improperly subtracting the dividend from the price of the stock, or by adding in an additional year’s dividend change. D: This percentage overstates the cost of capital.

51

SU – 5.5 Other Sources of Long-term Financing

• Leases – long-term, contractual agreement– Can be a purchase-and-financing (capital lease)– Long-term rental contract (operating lease)

• Convertible Securities – debt or pref. stock– Contain provisions allowing the holder to convert to “specified” number of

common stocks• Stock Purchase Warrants – call options on the corp. common stock

• Retained Earnings – cumulative accrual-basis income (net of prior dividents)

52

SU 5.5 Question 1A major use of warrants in financing is to

A. Lower the cost of debt.

B. Avoid dilution of earnings per share.

C. Maintain managerial control.

D. Permit the buy-back of bonds before maturity

53

SU 5.5 Question 1 AnswerCorrect Answer: A

Warrants are long-term options that give holders the right to buy common stock in the future at a specific price. If the market price goes up, the holders of warrants will exercise their rights to buy stock at the special price. If the market price does not exceed the exercise price, the warrants will lapse. Issuers of debt sometimes attach stock purchase warrants to debt instruments as an inducement to investors. The investor then has the security of fixed-return debt plus the possibility for large gains if stock prices increase significantly. If warrants are attached, debt can sell at an interest rate slightly lower than the market rate.

Incorrect Answers:

B: Outstanding warrants dilute earnings per share. They are included in the denominator of the EPS calculation even if they have not been exercised.

C: Warrants can, if exercised, result in a dilution of management’s holdings.

D: A call provision in a bond indenture, not the use of warrants, permits the buyback of bonds.

54

SU 5.5 Question 1A major use of warrants in financing is to

A Lower the cost of debt.

B Avoid dilution of earnings per share.

C Maintain managerial control.

D Permit the buy-back of bonds before maturity.

55

SU 5.5 Question 2 Answer

Correct Answer: AWarrants are long-term options that give holders the right to buy common stock in the future at a specific price. If the market price goes up, the holders of warrants will exercise their rights to buy stock at the special price. If the market price does not exceed the exercise price, the warrants will lapse. Issuers of debt sometimes attach stock purchase warrants to debt instruments as an inducement to investors. The investor then has the security of fixed-return debt plus the possibility for large gains if stock prices increase significantly. If warrants are attached, debt can sell at an interest rate slightly lower than the market rate.

Incorrect Answers:

BOutstanding warrants dilute earnings per share. They are included in the denominator of the EPS calculation even if they have not been exercised.

C Warrants can, if exercised, result in a dilution of management’s holdings.

DA call provision in a bond indenture, not the use of warrants, permits the buyback of bonds.

56

Essay Question

57

58

SU 5 & 6 - Cost of Capital

The cost of capital is a composite of the costs of various sources of funds comprising a firm’s capital structure. It represents the

minimum rate of return that must be earned on new investments so that shareholders’ interests won’t be diluted. This topic focuses on the details of the cost of capital, including the

weighted average cost of capital, the cost of individual capital components, calculating the cost of capital, and the marginal cost

of capital.

59

SU – 5.6 Cost of Capital - Current

• Investor Required Rate of Return– If it is less than required, investors will expect dividend to redirect to

higher return investments.– Also called the opportunity cost

• Firms cost of capital is typically used to discount the future cash flows of long-term projects.– Investments with:• > return increase the value of company• < should be passed on

60


• Components of Capital– Debt – after-tax interest rate on the debt• Effective rate x (1.0 – Marginal tax rate)

– Preferred Stock – dividend yield ratio• Cash dividend on PS / Market price of PS

– Common Stock – dividend yield ratio• Cash dividend of CS / Market price of CS

61


Retained Earnings cost = Common Stock

Why?

62

SU 5.6 Practice Question 1

A major use of warrants in financing is to

A Lower the cost of debt.

B Avoid dilution of earnings per share.

C Maintain managerial control.

D Permit the buy-back of bonds before maturity.

63

SU 5.6 Practice Question 1 SolutionCorrect Answer: AWarrants are long-term options that give holders the right to buy common stock in the future at a specific price. If the market price goes up, the holders of warrants will exercise their rights to buy stock at the special price. If the market price does not exceed the exercise price, the warrants will lapse. Issuers of debt sometimes attach stock purchase warrants to debt instruments as an inducement to investors. The investor then has the security of fixed-return debt plus the possibility for large gains if stock prices increase significantly. If warrants are attached, debt can sell at an interest rate slightly lower than the market rate.

Incorrect Answers:

BOutstanding warrants dilute earnings per share. They are included in the denominator of the EPS calculation even if they have not been exercised.

C Warrants can, if exercised, result in a dilution of management’s holdings.

D A call provision in a bond indenture, not the use of warrants, permits the buyback of bonds.

64

SU 5.6 Practice Question 2Maloney, Inc.’s $1,000 par value preferred stock paid its $100 per share annual dividend on April 4 of the current year. The preferred stock’s current market price is $960 a share on the date of the dividend distribution. Maloney’s marginal tax rate (combined federal and state) is 40%, and the firm plans to maintain its current capital structure relationship. The component cost of preferred stock to Maloney would be closest to

A 6%

B 6.25%

C 10%

D 10.4%

65

SU 5.6 Practice Question 2 Solution

Correct Answer: DThe component cost of preferred stock is equal to the dividend yield, i.e., the cash dividend divided by the market price of the stock. (Dividends on preferred stock are not deductible for tax purposes; therefore, there is no adjustment for tax savings.) The annual dividend on preferred stock is $100 when the price of the stock is $960. This results in a cost of capital of about 10.4% ($100 ÷ $960).

Incorrect Answers:

A There is no tax deductibility of preferred dividends and the denominator is the current market price, not the par value.

B There is no tax deductibility of preferred dividends.

C The denominator is the current market price, not the par value.

66


The theory underlying the cost of capital is primarily concerned with the cost of

A Long-term funds and old funds.

B Short-term funds and new funds.

C Long-term funds and new funds.

D Short-term funds and old funds.

67

SU 5.6 Practice Question 3 Solution

Correct Answer: CThe theory underlying the cost of capital is based primarily on the cost of long-term funds and the acquisition of new funds. The reason is that long-term funds are used to finance long-term investments. For an investment alternative to be viable, the return on the investment must be greater than the cost of the funds used. The objective in short-term borrowing is different. Short-term loans are used to meet working capital needs and not to finance long-term investments.

Incorrect Answers:

A The concern is with the cost of new funds; the cost of old funds is a sunk cost and of no relevance for decision-making purposes.

B The cost of short-term funds is not usually a concern for investment purposes.

DThe cost of old funds is a sunk cost and of no relevance for decision-making purposes. Similarly, short-term funds are used for working capital or other temporary purposes, and there is less concern with the cost of capital and the way it compares with the return earned on the assets borrowed.

68


Osgood Products has announced that it plans to finance future investments so that the firm will achieve an optimum capital structure. Which one of the following corporate objectives is consistent with this announcement?

A Maximize earnings per share.

B Minimize the cost of debt.

C Maximize the net worth of the firm.

D Minimize the cost of equity.

69

SU 5.6 Practice Question 4 SolutionCorrect Answer: CFinancial structure is the composition of the financing sources of the assets of a firm. Traditionally, the financial structure consists of current liabilities, long-term debt, retained earnings, and stock. For most firms, the optimum structure includes a combination of debt and equity. Debt is cheaper than equity, but excessive use of debt increases the firm’s risk and drives up the weighted-average cost of capital.

Incorrect Answers:

A The maximization of EPS may not always suggest the best capital structure.

B The minimization of debt cost may not be optimal; as long as the firm can earn more on debt capital than it pays in interest, debt financing may be indicated.

D Minimizing the cost of equity may signify overly conservative management.

70


• Weighted Average Cost of Capital – WACC– See Gleim success tips

• Management designates a target capital structure for the firm• Target Capital Structure

• See example on page 143

71


“Firms WACC is a single, composite rate of return on its combined components of capital”.

Market value not book value

See example on page 144

72


See formula to calculate the after-tax WACC w/o PS

Min. WACC = Shareholder Wealth MaximizingSee graph on page 146

73


• Impact of taxes on Capital Structure and Capital Decisions– Taxes– Capital Gains– Interest– Multinational corporations

74

SU 5.6 – Question 1

Global Company Press has $150 par value preferred stock with a market price of $120 a share. The organization pays a $15 per share annual dividend. Global’s current marginal tax rate is 40%. Looking to the future, the company anticipates maintaining its current capital structure. What is the component cost of preferred stock to Global?

A. 6%

B. 7.5%

C. 10%

D. 12.5%

75

SU 5.6 – Question 1 Solution


The component cost of preferred stock is the dividend divided by the market price (also called the dividend yield). No tax adjustment is necessary because dividends are not deductible. Since the market price is $120 when the dividend is $15, the component cost of preferred capital is 12.5% ($15 ÷ $120).

76

SU 5.6 – Question 2

What is the weighted average cost of capital for a firm using 65% common equity with a return of 15%, 25% debt with a return of 6%, 10% preferred stock with a return of 10%, and a tax rate of 35%?

A. 10.333%

B. 11.275%

C. 11.725%

D. 12.250%

77

SU 5.6 – Question 2 SolutionCorrect Answer: C

The cost for equity capital is given as 15%, and preferred stock is 10%. The before-tax rate for debt is given as 6%, which translates to an after-tax cost of 3.9% [6% × (1.0 – .35)]. The rates are weighted as follows:

Component Weighted

Component Weight Cost CostLong-term debt 25% × 3.9% = .975%

Preferred stock 10% × 10.0% = 1.000%

Common stock 65% × 15.0% = 9.750%

11.725%

78

SU 5.6 – Question 3Joint Products, Inc., a corporation with a 40% marginal tax rate, plans to issue $1,000,000 of 8% preferred stock in exchange for $1,000,000 of its 8% bonds currently outstanding. The firm’s total liabilities and equity are equal to $10,000,000. The effect of this exchange on the firm’s weighted average cost of capital is likely to be

A. No change, since it involves equal amounts of capital in the exchange and both instruments have the same rate.

B. A decrease, since a portion of the debt payments are tax deductible.

C.A decrease, since preferred stock payments do not need to be made each year, whereas debt payments must be made.

D. An increase, since a portion of the debt payments are tax deductible.

79

SU 5.6 – Question 3 Solution


The payment of interest on bonds is tax-deductible, whereas dividends on preferred stock must be paid out of after-tax earnings. Thus, when bonds are replaced in the capital structure with preferred stock, an increase in the cost of capital is likely because there is no longer a tax shield.

80

SU – 5.7 Cost of Capital – New

• Marginal Cost of Capital– Companies can not solely rely on internally generated capital (which

is the cheapest)

– Marginal cost of capital is the cost to the firm of the next dollar of new capital raised after existing internal sources are exhaused

81


• Each additional dollar raised becomes increasingly expensive as investors demand higher returns.

Why?

82


• New debtholders will demand a higher interest rate to compensate for the increased risk.

Annual interest / Net issue proceeds

The higher the tax rates the more attractive debt becomes as capital

83


• Cost of new preferred stock

Next dividend / Net issue proceeds

Remember that the floatation costs raises the cost of capital

84


• Cost of new Common Stock

(Next dividend / net issue proceeds) + Dividend growth rate

See example on page 147

85

SU 5.7 – Practice Question 1A firm seeking to optimize its capital budget has calculated its marginal cost of capital and projected rates of return on several potential projects. The optimal capital budget is determined by

A Calculating the point at which marginal cost of capital meets the projected rate of return, assuming that the most profitable projects are accepted first.

B Calculating the point at which average marginal cost meets average projected rate of return, assuming the largest projects are accepted first.

C Accepting all potential projects with projected rates of return exceeding the lowest marginal cost of capital.

D Accepting all potential projects with projected rates of return lower than the highest marginal cost of capital.

86

SU 5.7 – Practice Question 1Correct Answer: AIn economics, a basic principle is that a firm should increase output until marginal cost equals marginal revenue. Similarly, the optimal capital budget is determined by calculating the point at which marginal cost of capital (which increases as capital requirements increase) and marginal efficiency of investment (which decreases if the most profitable projects are accepted first) intersect.Incorrect Answers:

BThe intersection of average marginal cost with average projected rates of return when the largest (not most profitable) projects are accepted first offers no meaningful capital budgeting conclusion.

C The optimal capital budget may exclude profitable projects as lower-cost capital goes first to projects with higher rates of return.

D Accepting projects with rates of return lower than the cost of capital is not rational.

87

SU 5.7 – Practice Question 2

The firm’s marginal cost of capital

A Should be the same as the firm’s rate of return on equity.

B Is unaffected by the firm’s capital structure.

C Is inversely related to the firm’s required rate of return used in capital budgeting.

D Is a weighted average of the investors’ required returns on debt and equity

88

SU 5.7 – Practice Question 2 SolutionsCorrect Answer: DThe marginal cost of capital is the cost of the next dollar of capital. The marginal cost continually increases because the lower cost sources of funds are used first. The marginal cost represents a weighted average of both debt and equity capital.

Incorrect Answers:

A If the cost of capital were the same as the rate of return on equity (which is usually higher than that of debt capital), there would be no incentive to invest.

B The marginal cost of capital is affected by the degree of debt in the firm’s capital structure. Financial risk plays a role in the returns desired by investors.

C The rate of return used for capital budgeting purposes should be at least as high as the marginal cost of capital.

89

SU 5.7 – Practice Question 3

Datacomp Industries, which has no current debt, has a beta of .95 for its common stock. Management is considering a change in the capital structure to 30% debt and 70% equity. This change would increase the beta on the stock to 1.05, and the after-tax cost of debt will be 7.5%. The expected return on equity is 16%, and the risk-free rate is 6%. Should Datacomp’s management proceed with the capital structure change?

A No, because the cost of equity capital will increase.

B Yes, because the cost of equity capital will decrease.

C Yes, because the weighted-average cost of capital will decrease.

D No, because the weighted-average cost of capital will increase.

90

SU 5.7 – Practice Question 3 Solutions

Correct Answer: CThe important consideration is whether the overall cost of capital will be lower for a given proposal. According to the Capital Asset Pricing Model, the change will result in a lower average cost of capital. For the existing structure, the cost of equity capital is 15.5% [6% + .95 (16% – 6%)]. Because the company has no debt, the average cost of capital is also 15.5%. Under the proposal, the cost of equity capital is 16.5% [6% + 1.05 (16% – 6%)], and the weighted average cost of capital is 13.8% [.3(.075) + .7(.165)]. Hence, the proposal of 13.8% should be accepted.

Incorrect Answers:

A The average cost of capital needs to be considered.

B The average cost of capital needs to be considered.

D The weighted average cost of capital will decrease.

91

Capital Asset Pricing Model IntroductionCAPM is also useful in measuring the cost of equity capital for a firm. The CAPM implies that the rate of return on any security equals the riskless rate of interest plus a premium for risk. The riskless rate is usually based on the current or anticipated rate on long-term U.S. Treasury bonds or short-term U.S. Treasury bills. The premium for risk is derived from the security’s beta. The formula for applying the CAPM to estimate the cost of equity capital is: Ks = Rf+ B(Km - Rf ) where:

ks = cost of internal equity capitalRf = risk-free rate (e.g., the rate on T-bonds or a 30-day T-bill)Beta = stock’s beta estimate (obtained from a brokerage firm or investment advisory service, or calculated by the firm)km = estimate of the return on the market as a whole or on an average stock value

92

Capital Asset Pricing Model Introduction (cont.)

The term (km - Rf ) is called the “market risk premium,” which is somewhere in the area of 5% to 7%, depending on the date of the estimate and the data sources used by the analysts. Firms often add 6% to the T-bond rate to obtain the rate of return for the market as a whole. For example: If the T-bond rate is 8%, a firm’s stock beta is 0.9, and the expected rate of return for the market is 14%, Blane Company’s cost of equity capital using the CAPM would be:

ks = 8% +0.9( 14% - 8%)

= 8% + 5.40%=13.40%

93

Capital Asset Pricing Model Introduction (cont.)

Using the CAPM involves estimates for each term in the equation. Challenges arise in deciding:

• Whether to use long-term or short-term T-bond rates for Rf .• Estimating the future beta investors expect.• Estimating the expected rate of return for the market as a whole.

94

Remaining Schedule

• January 10th – Class 5 – SU 5, Essays• January 17th – Class 6 – SU 7• January 24th – Class 7 – SU 8• January 31st – Class 8 – SU 9• February 14th – Cram Session

95

Quick memory test 1

By using the dividend growth model, estimate the cost of equity capital for a firm with a stock price of $30.00, an estimated dividend at the end of the first year of $3.00 per share, and an expected growth rate of 10%.

96

Quick memory test 1 Answer

Under the dividend growth model, the cost of equity equals the expected growth rate plus the quotient of the next dividend and the current market price. Thus, the cost of equity capital is 20% [10% + ($3 ÷ $30)]. This model assumes that the payout ratio, retention rate, and the earnings per share growth rate are all constant.

97

Quick memory test 2

Rogers, Inc., operates a chain of restaurants located in the Southeast. The company has steadily grown to its present size of 48 restaurants. The board of directors recently approved a large-scale remodeling of the restaurants, and the company is now considering two financing alternatives. • The first alternative would consist of

– Bonds that would have a 9% coupon rate and reissued at their base amount would net $19.2 million after a 4% flotation cost

– Preferred stock with a stated rate of 6% that would yield $4.8 million after a 4% flotation cost– Common stock that would yield $24 million after a 5% flotation cost

• The second alternative would consist of a public offering of bonds that would have a 9% coupon rate and an 11% market rate and would net $48 million after a 4% flotation cost.

98

Quick memory test 2

Rogers’ current capital structure, which is considered optimal, consists of 40% long-term debt, 10% preferred stock, and 50% common stock. The current market value of the common stock is $30 per share, and the common stock dividend during the past 12 months was $3 per share. Investors are expecting the growth rate of dividends to equal the historical rate of 6%. Rogers is subject to an effective income tax rate of 40%.

Question - The after-tax cost of the common stock proposed in Rogers’ first financing alternative would be

99

Quick memory test 2 AnswerTo determine the cost of new common stock, the dividend growth model is used.

Cost of new common stock = (Next dividend ÷ Net issue proceeds) + Dividend growth rate

= [($3.00 × 1.06) ÷ ($30.00 × .95)] + .06

= ($3.18 ÷ $28.50) + .06

= .1116 + .06

= 17.16%

100

Essay Question

101

102

SU 2 Review – Question 1Given an acid test ratio of 2.0, current assets of $5,000, and inventory of $2,000, the value of current liabilities is

A $1,500

B $2,500

C $3,500

D $6,000

103

SU 2 Review – Question 1 SolutionCorrect Answer: AThe acid test, or quick, ratio equals the quick assets (cash, marketable securities, and accounts receivable) divided by current liabilities. Current assets equal the quick assets plus inventory and prepaid expenses. (This question assumes that the entity has no prepaid expenses.) Given current assets of $5,000, inventory of $2,000, and no prepaid expenses, the quick assets must be $3,000. Because the acid test ratio is 2.0, the quick assets are double the current liabilities. Current liabilities therefore are equal to $1,500 ($3,000 quick assets ÷ 2.0).

Incorrect Answers:

BDividing the current assets by 2.0 results in $2,500. Current assets includes inventory, which should not be included in the calculation of the acid test ratio.

C Adding inventory to current assets rather than subtracting it results in $3,500.

D Multiplying the quick assets by 2 instead of dividing by 2 results in $6,000.

104

SU 2 Review – Question 2

Beatnik Company has a current ratio of 2.5 and a quick ratio of 2.0. If the firm experienced $2 million in cost of sales and sustains an inventory turnover of 8.0, what are the firm’s current assets?

A $1,000,000

B $500,000

C $1,500,000

D $1,250,000

105

SU 2 Review – Question 2 Solution

Correct Answer: DThe only major difference between the current ratio and the quick ratio is the inclusion of inventory in the numerator. If cost of sales is $2 million and inventory turns over 8 times per year, then average inventory is $250,000 ($2,000,000 ÷ 8). Since the only difference between the two ratios is inventory, then inventory must equal .5 (2.5 – 2.0) times current liabilities; therefore, current liabilities are $500,000. Thus, current assets divided by $500,000 equals 2.5. Therefore, current assets must equal $1,250,000 (2.5 × $500,000).

Incorrect Answers:

A The amount of quick assets is $1,000,000.

B The amount of current liabilities is $500,000.

C Adding inventory to current assets results in $1,500,000.

Documents

CMA Part 1 Financial Decision Making Study Unit 5 Financial Instruments and Cost of Capital Ronald Schmidt, CMA, CFM Adrien Dubourg, CMA