Fin 331 Study Guide

Finance Final Study place FIN 331 Moser Study transcend for Exam 1 Spring 2011 Important Concepts * Forms of Business Organization * Proprietorship- an unorganised business owned by one individual * Partnership- legal establishment in the midst of both or very much people who decide to do business together * Advantages * Ease of organiseation * Subject to few regulations * No corpo set income evaluateationationes * Disadvantages * Limited life * Unlimited financial obligation * Difficult to grind away cap * Corporation- legal entity created by a call forth, and it is sepa treasure and distinct from its possessor and managers. Advantages * Unlimited life * Easy transfer of ownership * Limited liability * Ease of raising nifty * Disadvantages * Double taxation * Cost of set-up and cut across filing * Conflicts between Managers and Stockbe bers * Managers ar naturally inclined to act in their own best elicits (which ar not always the same as the sp atomic numb er 18-time activity of bank lineholders). * But the following factors affect managerial behavior * managerial fee packages * Direct intervention by sh arholders * The holy terror of firing * The threat of take everyplace * Sh arholder Value The damage at which the notepile would shell out if all investors had all knowable information closely a declension. * The uncreated financial goal of management is shargonholder wealth maximization, which translates to maximizing ocellus up management. * Value of any asset is give nourish of change execute stream to owners. * roughly significant decisions ar evaluated in terms of their financial consequences. * Stock tolls change all over clip as conditions change and as investors obtain new information about a familiaritys prospects. * Intrinsic value * In equilibrium, a stocks wrong should equal its true or intrinsic value. Intrinsic value is a languish-run concept. * To the extent that investor perceptions are inco rrect, a stocks price in the short run may deviate from its intrinsic value. * I wadly, managers should b force out actions that stifle intrinsic value, even if those decisions increase the stock price in the short run. * great allocation process * In a nearly-functioning economy, metropolis take to the woodss efficiently from those who supply majuscule to those who demand it. * Suppliers of roof individuals and institutions with excess money. These groups are saving money and looking for a position of getting even on their enthronization. Demanders or lend oneselfrs of seat of government individuals and institutions who need to turn up money to finance their coronation opportunities. These groups are free to wear a appraise of subject on the capital they borrow. * Direct transfers * enthronement funds banking house * monetary intermediaries * Types of financial commercializes * natural asset grocery stores versus financial asset marts * Physical asset markets are for products such(prenominal) as wheat, autos, real estate, computers, and machinery. * Financial asset markets, on the other hand, deal with stocks, bond certificates, notes, and mortgages. Spot markets versus after(prenominal)life markets * Spot markets are markets in which assets are bought or sold for on-the-spot delivery. * Future markets are markets in which participants agree straight morose to buy or grapple an asset at some rising date * Money markets versus capital markets * Money markets are the markets for short-term, full(prenominal)ly smooth-spoken debt securities. The New York, London, and Tokyo money markets are among the worlds largest. * Capital securities industrys are the markets for intermediate- or long-term debt and corpo identify stocks. The NYSE * Primary markets versus inessential markets Primary markets are the markets in which corporations raise new capital. If a confederacy were to sell a new issue of parking lot stock to raise capital. * Secondary markets are markets in which existing, already capital securities are traded among investors. * secret markets versus public markets * Private markets, where transactions are negotiated directly between two parties, are differentiated frompublic markets. Ex. park stock and corporate bonds * cosmos markets, where standardized contracts are traded on organized exchanges. Ex.Bank imparts and private debt allowances to an insurance order. * vastness of financial markets * Well-functioning financial markets facilitate the flow of capital from investors to the users of capital. * marketplaces provide draw itrs with bribes on their money saved/invested, which provides them money in the prox. * Markets provide users of capital with the requisite funds to finance their investment projects. * Well-functioning markets promote economic initiateth. * Economies with well-developed markets perform divulge than economies with curtly-functioning markets. * Deri vatives A derivative securitys value is derived from the price of other security (e. g. , options and forthcomings). * Can be used to hedge or reduce adventure. For example, an importer, whose profit falls when the dollar loses value, could purchase currency futures that do well when the dollar weakens. * too, speculators can use derivatives to bet on the direction of future stock prices, vex pass judgment, exchange rates, and commodity prices. In legion(predicate) cases, these transactions produce high returns if you label right field, provided large losses if you guess wrong. Here, derivatives can increase gamble. * Financial institutions Commercial banks * Bank of America, Citibank, Wells Fargo * Investment banks * Help companies raise capital * Financial services corporations * Conglomerates that combine many different financial institutions within a single corporation. * Credit unions * Employees, members or organization * Pension funds * Life insurance companies * M utual funds * Hedge funds * Largely unregulated * Large minimum investment * Exchange traded funds (ETFs) * Private loveliness companies * Like hedge funds * IPO * An initial public heading (IPO) is where a company issues stock in the public market for the first time. Going public enables a companys owners to raise capital from a wide mixture of outside investors. Once issued, the stock trades in the secondary market. * Public companies are quash to additional regulations and reporting requirements. * Efficient market hypothesis implications * Securities are conventionly in equilibrium and are fairly priced. * Investors cannot beat the market except through trustworthy luck or better information. * efficacy continuum * When markets are efficient, investors can buy and sell stocks and be confident that they are getting good prices.When markets are inefficient, investors may be afraid to iinvest and may put their money under the pillow, which bequeath lead to a poor allocati on of capital and economic stagnation. * parallelism sheet * Provides a stab of a firms position at a ad hoc point in time. The left side shows the assets that the company owns, while the right side shows the firms liabilities and stockholders equity, which are claims against the firms assets. * assets * period assets * gold and equivalents * A/R * Inventories * entirety Current additions * top rooted(p) assets good plan and equipment(cost minus depreciation) * Other assets try out to last more(prenominal) than a form * nitty-gritty positive(p)s * Liabilities and Equity * Current liabilities * A/P * Accruals * Notes Payable * Total current liabilities * Long-term bonds * Total debt * parking area equity * Common stock * Retained scoreing * Total joint equity * Total liabilities and equity * Income statement * Summarizes a firms revenues and put downs over a given period of time. * Sales * (COGS) * (Other Expenses) * (Depreciation) * EBIT * (Interest Expense) * EBT * (Taxes) * Net Income Statement of bills flows * Reports the restore of a firms activities on capital flows over a given period of time. Shows how much coin the firm is generating. * Cash end 2007 * O/A * I/A * F/A * Cash end 2008 * Working capital * Anything that is cash or can be converted to cash within a year. A/R and size up * Net working capital (NWC) * Current assets (A/R, Inventory, Cash) (Payables + Accruals) * Free cash flow (FCF) * Everything left over for investors. Amount of cash that can be recluse to investors without harming the ability of the company to operate and produce. FCF = EBIT(1-T) + Depreciation (Capital expenditures + Increase in NWC) (Income Statement) ( in gross FA/current) dimension Sheet * Corporate and personal taxes * Both flip a progressive grammatical construction (the higher the income, the higher the marginal tax rate). * Corporations * strides begin at 15% and rise to 35% for corporations with income over $10 million, although corporations with income between $15 million and $18. 33 million pay a marginal tax rate of 38%. * Also subject to state tax (around 5%). * Individuals * Rates begin at 10% and rise to 35% for individuals with income over $349,700. May be subject to state tax. * Tax treatment of amour and dividends * Interest pay tax deductible for corporations (paid out of pre-tax income), but usually not for individuals (interest on home loans creation the exception). * Interest take in usually fully taxable (an exception existenceness interest from a muni). * Dividends paid paid out of after-tax income. * Dividends received Most investors pay 15% taxes. * Investors in the 10% or 15% tax bracket pay 0% on dividends in 2008-2010. * Dividends are paid out of net income which has already been taxed at the corporate level, this is a form of double taxation. A hatful of dividends received by corporations is tax excludable, in order to avoid triple taxation. * Taxes continuebacks and carry forwards * Tax privation Carry-Back and Carry-Forward since corporate incomes can fluctuate wide, the Tax Code allows firms to carry losses back to offset profits in previous days or forward to offset profits in the future. * Taxes capital gains * define as the profits from the sale of assets not normally transacted in the normal course of business, capital gains for individuals are generally taxed as ordinary income if held for less(prenominal) than a year, and at the capital gains rate if held for more than a year.Corporations character somewhat different rules. * Importance of ratios * Ratios standardize numbers and facilitate comparisons. * Ratios are used to highlight weaknesses and strengths. * Ratio comparisons should be made through time and with competitors. * Trend analysis. * Peer (or industry) analysis. * 5 categories of ratios * Liquidity Can we make unavoidable payments? * Current = current assets/current liabilities * Quick = Current assets-inventories/current liabilities * Asset management right summation of assets vs. gross gross revenue? * Inventory T/O Ratio = Sales/Inventories * Days sales outstanding(DSO) = AR/(Sales/365) Fixed Asset T/O Ratio = Sales/Net Fixed AssetsNet FA=Balance Sheet * T/A Turnover = Sales/Total AssetsTA=Balance Sheet * How many times the PM is earned each year * Below avg. T/A T/O means that it has more assets than it needs * Debt management Right mix of debt and equity? * Debt Ratio = Total Debt/Total AssetsBalance Sheet * Times-Interest-Earned(TIE) = EBIT/Interest ExpenseIncome Statement * Profitability Do sales prices exceed unit cost, and are sales high enough as reflected in PM, roe, and ROA? * Operating Margin = EBIT/Sales * Profit Margin = Net income/Sales PM is how much a firm earns on its sales * Below avg. PM means that the firms costs are not being controlled as well as they should be, therefore they cannot charge premium prices * Basic Earning Power(BEP) = EBIT/Total Assets * ROA = Net Income/To tal Assets * ROE = Net Income/total commonplace equityBalance Sheet * ROE and careholder wealth are correlated, but problems can arise when ROE is the sole whole step of performance. * ROE does not consider attempt. * ROE does not consider the measuring of capital invested. * Might abet managers to make investment decisions that do not benefit shareholders. ROE directiones only on return and a better measure would consider endangerment and return. * Market value Do investors like what they mind as reflected in P/E and M/B ratios? * hurt/ stipend (P/E) ratio = Price per share/Earnings per share * Earnings per share * Market/Book Ratio (M/B)= Market price per share/Book value per share * Book Value per share = Common equity/Shares outstandingBalance Sheet * P/E How much investors are instinctive to pay for $1 of earnings. * M/B How much investors are leading to pay for $1 of book value equity. For each ratio, the higher the number, the better. * P/E and M/B are high if ROE is high and risk is low. * DuPont system * ROE = Profit Margin(PM) X Total Asset Turnover X Equity Multiplier(EM) NI/Sales Sales/TA TA/Total common equity I______ _______I I ROA * ROA Focuses on expense control (PM), asset utilization (TA TO), and debt utilization (equity multiplier). * Uses of freed up cash * gray-haired A/R * (New A/R) * Cash freed up * Uses * Repurchase stock * Expand business * Reduce debt * All these actions would believably improve the stock price. * Limitations of ratio analysis Comparison with industry numbers is difficult for a composite firm that operates in many different divisions. * Average performance is not necessarily good, perhaps the firm should aim higher. * Seasonal factors can extend ratios. * Window dressing techniques can make statements and ratios look better. * Different in operation(p) and accounting practices can distort comparisons. * Sometimes it is hard to tell if a ratio is good or bad. * Difficult to tell whether a company is, on balance, in strong or weak position. * Sales anticipate * Use historical sales data (approx. 5 years) Collect stimulus from product development, marketing, and operations * Sales growth has a cost * self-aggrandizing forecasts arrive a cost * Forecasting sales is the most Copernican input in predicting future financial performance * spare financial support Needed (AFN) * AFN = (A*/S0)? S (L*/S0) ? S M(S1)(RR) * = Projected asset increase offhanded liabilities increase Increase in retained earnings (How many assets to buy)L*(liab. Bs) M(S1)=future profits * A* = assets * L* = spontaneous liabilities * S = sales * M = profit margin * RR = retention ratio * FIN 331 Moser Study Guide for Midterm II Spring 2011Important Concepts * Time Value of Money * The sentiment that money available at the present time is worth more than the same amount in the future due to its potential earning capacity. This marrow principle of finance holds that, provided money can earn interest , any amount of money is worth more the sooner it is received. * Future Value (FV) * The amount to which a cash flow or series of cash flows will grow over a given period of time when compound at a given interest rate. * Finding the FV of a cash flow or series of cash flows is called compounding * What is the FV of an initial $ one hundred after 3 years, if I/YR = 10%? N=3I/YR=10PV= carbonPMT=0FV=CPT * Future Value = 133. 10 * Present Value (PV) * The value like a shot of a future cash flow or series of cash flows * What is the PV of $ speed of light due in 3 years, if I/YR= 10%? * N=3I/YR=10PV=CPTPMT=0FV= 100 * PV=-75. 13 * Solving for Interest Rate * Solving for I What interest rate would cause $100 to grow to 125. 97 in 3 years? * N=3I=CPTPV=100 PMT=0FV=125. 97 * Interest Rate = 8% * Solving for of Time Periods * N = mo of periods involved in the analysis. * If sales grow at 20% per year, how long before sales double? * N=? I/YR=20PV=-1PMT=0 FV=2 * N=3. 8 * Ordinary Annuity vs. Annuity payable Ordinary Annuity * Payments occur at the end of each year(deferred annuity) * personate calculator to END * FV * 3-year ordinary annuity of $100 at 10%? * N=3 I/YR=10 PV=0 PMT=100 FV=CPT * FV=331 * PV * N=3 I/YR=10 PV=CPT PMT=100 FV=0 * PV=-248. 69 * Annuity Due * Set calculator to BEGIN * The payments are made at the beginning of each year * FV * 3-year annuity due of $100 at 10%? * N=3 I/YR=10 PV=0 PMT=100 FV=CPT * FV=364. 10 * PV * N=3 I/YR=10 PV=CPT PMT=100 FV=0 * PV=273. 55 * Perpetuity * An annuity with an extended life. * N=infinity * PV of a perpetuity = PMT/I * PV=PMT/I=$100/0. 1 = $1,000 Compound Interest * A 20-year-old student wants to save $3 a day for her retirement. Every day she places $3 in a drawer. At the end of the year, she invests the accumulated savings ($1,095) in a brokerage account with an evaluate yearbook return of 12%. * How much money will she get when she is 65 years old? * N=45 I/YR= 12 PV=0 PMT= 1095 FV=CPT * FV = 1,487,262 * Solving for yearly payment * PV of uneven cash flows * * Effect of compounding more often * Compounding more often results in building interest upon interest * Nominal vs. Periodic vs. Effective Interest Rate * Written into contracts, quoted by banks and brokers.Not used in calculations or shown on time lines. * Nominal rate (INOM) also called the quoted or declared rate. An annual rate that ignores compounding effects. * INOM is stated in contracts. Periods must also be given, e. g. 8% every quarter or 8% daily interest. * Periodic rate (IPER) amount of interest supercharged each period, e. g. monthly or quarterly. * * IPER = INOM/M, where M is the number of compounding periods per year. M = 4 for quarterly and M = 12 for monthly compounding. * Effective (or equivalent) annual rate (EAR = EFF%) the annual rate of interest actually being earned, accounting for compounding. Used to compare returns on investments with different payments per year. Used in calculations when annu ity payments dont match compounding periods. * EFF% for 10% semiannual investment * EFF%= ( 1 + INOM/M )M 1 * = ( 1 + 0. 10/2 )2 1 = 10. 25% * Should be indifferent between receiving 10. 25% annual interest and receiving 10% interest, compounded semiannually. * biyearly/quarterly/monthly compounding * Annually * N=3 I/YR=10. 25 PV=0 PMT=100 FV=CPT * FV=331. 80 * 100(1. 025)3=331. 80 * Semiannual * N=6 I/YR=5. 125 PV=0 PMT = 100 FV=CPT * FV=682. 33 * 100(. 5125)6 * Quarterly * N=12 I=2. 6 PV=0 PMT=100 FV=CPT * * Loan Amortization * Amortization tables are widely used for home mortgages, auto loans, business loans, retirement plans, etc. * Financial calculators and spreadsheets are great for setting up amortization tables. * A loan that is to be repaid in equal amounts on a monthly, quarterly, or annual basis * Bonds * A long-term debt instrument in which a borrower agrees to make payments of principal and interest, on specific dates, to the holders of the bond. * Treasury * Govern ment bonds * No inattention risk * Municipal * Bonds issued by state and local governments * Some remissness risk Advantage Munis are exempt from Federal Taxes and from state taxes if the holder is resident of issuing state. * Corporate * Issued by business firms * Exposed to nonremittal risk * Higher the risk, the higher interest rate is demanded * Foreign * Issued by a foreign government * Currency exchange issues * Par value * daring amount of the bond, which is paid at adulthood (assume $1,000). * Coupon interest rate * Stated interest rate (generally refractory) paid by the issuer. cypher by par value to get dollar payment of interest. * adulthood date * Years until the bond must be repaid. * takings to adulthood Rate of return earned on a bond held until maturity (also called the promised subject). * Call Provision * Allows issuer to refund the bond issue if rates decline (helps the issuer, but hurts the investor). * Borrowers are willing to pay more, and lenders re quire more, for callable bonds. * Most bonds have a deferred call and a declining call premium. * sink Fund * Provision to pay off a loan over its life rather than all at maturity. * Similar to amortization on a term loan. * Reduces risk to investor, shortens average maturity. * But not good for investors if rates decline after issuance. * Convertible Bond May be exchanged for common stock of the firm, at the holders option. * case * Long-term option to buy a stated number of shares of common stock at a specified price. * Puttable bond * Allows holder to sell the bond back to the company prior to maturity. * Indexed bond * Interest rate paid is establish upon the rate of in flavourlession. * Valuing a bond * Problem * give the axe bond vs. Premium bond and how you can tell by compare the coupon and the YTM * Bond Values over time * Solving for YTM * evaluate Total return= YTM = ( judge Current Yield) + (Expected Capital Gains Yield) * CY=Annual coupon payment/Current Price . 09 (1000)/887 * CGY= Change in price/Beginning price * Or CGY = Current yield + Capital gains yield * Interest rate risk * The concern that rising interest rates will cause the value of a bond to fall. * 10year bond has more risk than however a 1 year bond * Reinvestment rate risk * Reinvestment rate risk is the concern that rd will fall, and future CFs will have to be reinvested at lower rates, hence reducing income. * EXAMPLE Suppose you nevertheless won $500,000 playing the lottery. You intend to invest the money and live off the interest. * You may invest in either a 10-year bond or a series of ten 1-year bonds.Both 10-year and 1-year bonds currently yield 10%. * If you read the 1-year bond strategy * After Year 1, you receive $50,000 in income and have $500,000 to reinvest. But, if 1-year rates fall to 3%, your annual income would fall to $15,000. * If you choose the 10-year bond strategy * You can lock in a 10% interest rate, and $50,000 annual income for 10 years, presumptuou s the bond is not callable. * Semiannual bonds * cypher years by 2 Number of periods = 2N * Divide nominal rate by 2 Periodic rate (I/YR) = rd/2 * Divide annual coupon by 2 PMT = Annual coupon/2 * Yield to Call * Problem * Default risk If an issuer default ons, investors receive less than the promised return. Therefore, the expected return on corporate and municipal bonds is less than the promised return. * Influenced by the issuers financial strength and the terms of the bond contract. * Mortgage bond vs. debenture * Mortgage bond- okay up by collateral e. g. house,car,jewelry * Debenture- Not backed up * Investment-grade vs. junk bond * Investment grade-GE bond, lower risk and thence lower return * Junk bond- Speculative bonds that have high risk, but sometimes higher return * Significant risk of going default * 2 chapters of bankruptcy Two main chapters of the Federal Bankruptcy bite * Chapter 11, Reorganization * If company cant meet its obligations * It institutionalise s under Chapter 11 to stop creditors from foreclosing, taking assets, and closing the business and it has 120 days to file a reorganization plan. * Court appoints a trustee to supervise reorganization. * way usually stays in control. * Company must demonstrate in its reorganization plan that it is worth more alive than dead. * If not, judge will order liquidation under Chapter 7. * Chapter 7, Liquidation * Typically, a company wants Chapter 11, while creditors may prefer Chapter 7. Priority of Claims in Liquidation * Secured creditors from sales of secured assets. * Trustees costs * Wages, subject to limits * Taxes * Unfunded pension liabilities * unlatched creditors * preferable stock * Common stock * Reorganization * In a liquidation, unsecured creditors generally get zero. This makes them more willing to participate in reorganization even though their claims are greatly scaled back. * miscellaneous groups of creditors vote on the reorganization plan. If both the majority of t he creditors and the judge approve, company emerges from bankruptcy with lower debts, reduced interest charges, and a chance for success.Formulas that will be provided * Chapters 5 and 7 from Appendix C * Instructions on switching your calculator from END to BGN mode Chapter 8 * Investment put on the line * Investment risk is related to the probability of earning a low or negative actual return. * The greater the chance of lower than expected or negative returns, the riskier the investment. * stand-alone risk * The asset is considered by itself * The risk an investor would face if he or she held only this one asset. * Portfolio risk * Asset is held as one of a number of assets in a portfolio * Average returns (stocks vs. bonds) Bonds press relatively low returns, but with relatively little risk * Stocks offer the chance of higher returns, but stocks are generally riskier than bonds * Expected return r * The rate of return expected to be realized from an investment the dull avera ge of the probability distribution of possible results * Standard variance (sigma) * A statistical measure of the variability of a set of observations * The tighter the probability distribution, the lower the risk * Measure of how far the actual return is likely to deviate from the expected return * Coefficient of variation (CV) The standardized measure of the risk per unit of return calculated as the standard deviation change integrity by the expected return * CV= ? /r * Risk wickedness * Assumes investors dislike risk and require higher rates of return to encourage them to hold riskier securities. * Risk premium * The difference between the return on a risky asset and a riskless asset, which serves as compensation for investors to hold riskier securities. * Portfolio expected return rp The weighted average of the expected returns on the assets held in the portfolio * The weights being the percentage of the total portfolio invested in each asset * Diversification effects on a po rtfolio * ? p decreases as stocks added, because they would not be perfectly correlated with the existing portfolio. * Expected return of the portfolio would remain relatively constant. * Eventually the diversification benefits of adding more stocks dissipates (after about 10 stocks), and for large stock portfolios, ? p tends to converge to 20%. * Market risk vs. diversifiable risk stand-alone risk = Market risk + Diversifiable risk * Market risk portion of a securitys stand-alone risk that cannot be eliminated through diversification. Measured by of import. * Diversifiable risk portion of a securitys stand-alone risk that can be eliminated through proper diversification. * Failure to diversify * If an investor chooses to hold a one-stock portfolio (doesnt diversify), would the investor be compensated for the extra risk they bear? * NO * Stand-alone risk is not important to a well-diversified investor. * Rational, risk-averse investors are concerned with ? , which is based upon m arket risk. * There can be only one price (the market return) for a given security. * No compensation should be earned for holding unnecessary, diversifiable risk. * Capital Asset Pricing Model (CAPM) * Model linking risk and essential returns. CAPM declare oneselfs that there is a Security Market Line (SML) that states that a stocks required return equals the risk-free return plus a risk premium that reflects the stocks risk after diversification. * ri = rRF + (rM rRF)bi * Primary conclusion The relevant riskiness of a stock is its function to the riskiness of a well-diversified portfolio. Beta * Measures a stocks market risk, and shows a stocks volatility relative to the market. * Indicates how risky a stock is if the stock is held in a well-diversified portfolio. * Can the beta of a security be negative? * Yes, if the correlation between Stock i and the market is negative (i. e. , ? i,m 0). * If the correlation is negative, the regression line would slope downward, and the b eta would be negative. * However, a negative beta is highly unlikely. * The Security Market Line (SML) (calculating required rates of return) * SML ri = rRF + (rM rRF)bi * ri = rRF + (RPM)bi Assume the yield curve is flat and that rRF = 5. 5% and RPM = 5. 0%. * Market risk premium * Additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk. * Its size depends on the perceived risk of the stock market and investors degree of risk aversion. * Varies from year to year, but most estimates suggest that it ranges between 4% and 8% per year. * Portfolio beta * The beta of a portfolio is the weighted average of each of the stocks betas. * bP = wHTbHT + wCollbColl * bP = 0. 5(1. 32) + 0. 5(-0. 87) * bP = 0. 225 * Portfolio required returns The required return of a portfolio is the weighted average of each of the stocks required returns. * Or, using the portfolios beta, CAPM can be used to solve for expected return. * rRF + (rpm)(stocks b eta) * Discounted dividend model * Value of a stock is the present value of the future dividends expected to be generated by the stock. * * Valuing stock with constant growth * A stock whose dividends are expected to grow forever at a constant rate, g. * D1 = D0(1 + g)1 * D2 = D0(1 + g)2 * Dt = D0(1 + g)t * If g is constant, the discounted dividend formula converges to * * Dividend yield vs. capital gains yield Dividend yield * = D1/P0 = $2. 12/$30. 29 = 7. 0% * Capital gains yield * = (P1 P0)/P0 * = ($32. 10 $30. 29)/$30. 29 = 6. 0% * Valuing stock with nonconstant growth * During nonconstant growth, dividend yield and capital gains yield are not constant, and capital gains yield ? g. * Corporate Valuation model * Also called the free cash flow method. Suggests the value of the entire firm equals the present value of the firms free cash flows. * Remember, free cash flow is the firms after-tax operating income less the net capital investment. * FCF = EBIT(1 T) Net capital invest ment * closing value Often preferent to the discounted dividend model, especially when considering number of firms that dont pay dividends or when dividends are hard to forecast. * Similar to discounted dividend model, assumes at some point free cash flow will grow at a constant rate. * Terminal value (TVN) represents value of firm at the point that growth becomes constant. * hard Multiple method * Analysts often use the following multiples to value stocks. * P/E * P/CF * P/Sales * EXAMPLE ground on comparable firms, estimate the appropriate P/E. Multiply this by expected earnings to back out an estimate of the stock price. favored stock * Hybrid security. * Like bonds, preferred stockholders receive a fixed dividend that must be paid before dividends are paid to common stockholders. * However, companies can omit preferred dividend payments without fear of pushing the firm into bankruptcy. Chapter 10 * Sources of capital * Long-term capital * Long-term debt * Preferred Stock * Common Stock * Retained earnings * New common stock * weighted average cost of capital (WACC) * WACC=Wdrd(1-T) + Wp rp + Wc rs * Ws refer to the firms capital structure weights * rs refer to the cost of each gene Before-tax vs. after-tax capital costs * Stockholders focus on A-T CFs. Therefore, we should focus on A-T capital costs, i. e. use A-T costs of capital in WACC. Only rd needs adjustment, because interest is tax deductible. * Historical costs vs. Marginal costs * The cost of capital is used primarily to make decisions that involve raising new capital. So, focus on todays marginal costs (for WACC). * How weights are obdurate * Use accounting numbers or market value (book vs. market weights)? * Use actual numbers or target capital structure? * Cost of debt * WACC = wdrd(1 T) + wprp + wcrs rd is the marginal cost of debt capital. * The yield to maturity on outstanding L-T debt is often used as a measure of rd. * Why tax-adjust i. e. , wherefore rd(1 T)? * Cost of preferre d stock * rp is the marginal cost of preferred stock, which is the return investors require on a firms preferred stock. * Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp. * Our calculation ignores possible flotation costs. * The cost of preferred stock can be solved by using this formula * rp= Dp/Pp * = $10/$111. 10 * = 9% * Cost of equity * Is there a cost of retained earnings? Earnings can be reinvested or paid out as dividends. * Investors could buy other securities, earn a return. * If earnings are retained, there is an opportunity cost (the return that stockholders could earn on alternative investments of equal risk). * Investors could buy similar stocks and earn rs. * whole could repurchase its own stock and earn rs. * CAPM * CAPM rs = rRF + (rM rRF)b * DCF * DCFrs = (D1/P0) + g * Bond-yield-plus-risk-premium * rs = rd + RP * Flotation costs * Flotation costs depend on the firms risk and the type of capital being raised. * Flo tation costs are highest for common equity.However, since most firms issue equity inofttimes, the per-project cost is fairly small. * We will frequently ignore flotation costs when calculating the WACC. * What affects WACC * Market conditions. * The firms capital structure and dividend policy. * The firms investment policy. Firms with riskier projects generally have a higher WACC. * The composite WACC reflects the risk of an average project undertaken by the firm. Therefore, the WACC only represents the hurdle rate for a typical project with average risk. * Different projects have different risks. The projects WACC should be modify to reflect the projects risk.