HM 435 Exam 3 Review - HM 435 Exam 3 Summary PDF

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HM 435 Exam 3 Summary...

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HM 435 Exam 3 Review Chapter 6 Value of Capital 1. What are four major capital sources for a corporation?  Debt o Bonds  Equity o Internal o External  Preferred Stocks  Common Stocks 2. What are various characteristics and terms for bonds?  Interest payment o Legally binding contractual obligation o Tax-deductible  The principal = Par (Maturity or Face) Value  Coupon rate = Interest rate on a bond  Coupon payment = Coupon rate * Par value o Typically paid our semi-annually  Mortgage bond o Secured by collateral  Debenture o Not secured by collateral  Indenture o Credit contract o Characteristics of the bond o Restrictions on the issuing corporation  Restrictions on the issuing corporation  Restrictive covenants  E.g. dividend payment limits & additional debt limitations  Call Feature o A bond is callable – the corporation can repay earlier o Interest rate change / Restrictive covenants 3. How to value bonds (annual/semi-annual coupon payments)?  Annual o PVA = PMT (Par value * Coupon rate) * PVIFA (% required rate of return, # of annual payment) PV = FV (Par value) * PVIF (% required rate of return, # of annual payment) Total value = PVA + PV  Semi-annual payment o PVA = PMT/2 * PVIFA (%/2, #PMT*2) PV = FV * PVIF (%/2, #PMT*2) Total value = PVA + PV 4. What are bonds selling for par value, a discount, or a premium?  Sells for par value

o Value of price is the same as the par value because the return that the company pays to investors (coupon rate) is exactly same as the return that investors require to receive from the company (required rate of return)  Sells for a discount o The value or price of the bond is less than par value because investors would not pay the full amount because the company gives out less return than investors require  Sells for a premium o Coupon rate > required rate of return o Value of bond > par value 5. What are zero-coupon bonds? How to value zero-coupon bonds?  A bond bought at a price lower than its par value, with the par value repaid at the time of maturity  Annual o PV = FV (Par value) * PVIF (% required rate of return, # of years to mature) 6. What are various characteristics and terms for preferred stock?  Preference over a firm’s cash flow and assets  Preferred dividends o Par value - $25, $50, or $100 o Paid by quarter & expressed by annual amount o Fixed and certain  Perpetual ownership 7. How to value preferred stock (annual or quarterly) using perpetuity concept and formula?  Annual dividend = Par value * %  Quarterly dividend = Annual dividend / 4  PV = Quarterly dividend / (% required rate of return / 4) 8. What is perpetuity and perpetuity formula?  Only one type of cash flow, the same fixed preferred dividend each year forever  PV = PMT / i 9. What are various characteristics and terms for common stock?  Ownership: owners of corporation  Residual (leftover) claim  Upside & downside returns o Dividends – typically paid quarterly o Capital gain  Voting rights  No set maturity  Possibly different classes (e.g. Class A or Class B – with or without voting rights)  Riskier and more costly 10. How to value common stock using “General Dividend Valuation Model”?  Expect to receive dividends of A, B, C at the end of years 1, 2, 3, respectively  Sell stock for $ at the end of 3 years  Require % rate of return  PV1 = FV1 * PVIF (%, 1) = A * PVIF (%, 1) PV2 = B * PVIF (%, 2)

PV3 = C * PVIF (%, 3) PV4 = $ * PVIF (%, 3) Total value = PV1 + PV2 + PV3 + PV4 11. How to value common stock using “Constant Dividend Valuation Model”?  Constant dividends (Perpetuity) o PV = PMT / i  Expects to pay $ annual dividends per share quarterly  % required rate of return  PV = ($/4) / % 12. How to value common stock using “Constant Growth Dividend Valuation Model”?  Constant growth dividends (perpetuity) o PV = d1 / (i-g)  Quarterly dividend expected to be $  Annual required rate of return = %  Expect dividend to grow i every quarter  PV = $ / [(%/4) - i] 13. How to value common stock using combined cases (multiple growth rates)?  Expect to receive $ of quarterly dividend per share for first 5 years  From year 6, dividend is expected to grow I every quarter  Annual required rate of return = %  PVA = PMT * PVIFA (%, #) = $ * PVIFA (%/4, 5*4) PV = FV / (% - i) = [$ * (1 + i)] / [(%/4) – i] PV0 = PV * PVIF (%/4, 5*4) Total value = PVA + PV0 Chapter 7 Cost of Capital 1. What is cost of capital?  Capital sources o Debt – Bonds o Equity – Internal: Retained earnings; External: Preferred/Common Stock  Interest rate / Rate of return 2. What are issuance or flotation costs?  Transaction costs paid by a company to investment bankers or lawyers 3. What are relevant components for estimating cost of debt and how to estimate it?  Interest cost of debt o Tax deductible o Effective after-tax interest rate cost of debt is different from before-tax interest rate cost o debt o Kd = Kdbt * (1 – t)  Issues a # year zero-coupon bond with par value $  Selling for the market value of P  Issuance costs per bond is C and effective tax rate is %  Net proceeds = P – C PV = FV * PVIF (i, n) Net proceeds = $ * PVIF (i, #) Find before-tax cost (i) of debt (Kdbt) from “simple present value table”

The after-tax cost of debt (Kd) = i * (1 – %) 4. What are relevant components for estimating cost of preferred stock and how to estimate it?  Use the constant dividend model o Constant dividend model: PV = PMT / i o The cost of preferred dividend is denoted by Kp  Need to consider issuance costs  Issues % preferred stock with par-value of $  Selling for P  Issuance costs is C per share  Net proceeds = P – C PV = PMT / i Net proceeds = ($ * %) / i Kp = i = ($ * %) / Net proceeds 5. What are relevant components for estimating cost of internal equity and how to estimate it?  If reinvested, what is the opportunity cost to the shareholders o Rate of return  No issuance costs  Denoted by Ke  Current price of common stock is $ with recently paying D of annual dividend by quarter which is expected to grow by % per quarter into the foreseeable future  PV = PMT / (i – g) $ = [(D/4) * (1+%)] / (i-%) i – % = [(D/4) * (1+%)] i = [(D/4) * (1+%)] + % (per quarter) Ke = i * 4 (per year) 6. What are relevant components for estimating cost of external equity and how to estimate it?  Common stock  Same with internal common equity except issuance costs  Kne  Current price of common stock is $ with recently paying D of annual dividend by quarter which is expected to grow by % per quarter into the foreseeable future  Issuance cost = C  PV = PMT / (i –g) $ - C = (D/4) / (i-%) i - % = (D/4) / ($-C) i = (D/4) / ($-C) + % (per quarter) Kne = i * 4 (per year) 7. What is weighted average cost of capital (WACC)? How to estimate WACC?  Estimate the overall cost of all capital and accomplish it using the concept of weighted average cost of capital  Ka = Wd*Kd + Wp*Dp + We*Ke + Wne*Kne 8. Why and how to use WACC?  Represents the average cost of all capital sources that a firm uses or plans to use

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As a minimum required rate of return to evaluate new possible projects Maintain its target capital structure b utilizing both debt and equity, but the company just happens to plan to fund one project by only debt and the other external equity Company uses a consistent tool to evaluate all projects with efforts to maintain its target capital structure...