rwjch14

This chapter focuses on determining the required returns on capital budgeting projects. In Chapter 14, we assume the risk of the project is not known. In that case, we use the required return on Liabilities and Equity, known as the Weighted Average Cost of Capital, as a proxy for the required return on average-risk projects. In FINC 4532, we investigate whether we can impact a firm’s Weighted Average Cost of Capital by adjusting the mix of Debt and Equity.  Other than the Capital Asset Pricing Model in FINC 3511, this is the first time we will discuss Finance theory. In FINC 4532, we discuss M&M’s Perfect Capital Markets Theory of Capital Structure. The 1958 paper that contained this theory is generally regarded as the first Corporate Finance paper.

All page numbers are references to Fundamentals of Corporate Finance, 11th edition by Ross, Westerfield, and Jordan (McGraw Hill, 2016)

Chapter 14

Things to Absorb

Remember some material from previous chapters in BA 530. This module applies Ehrhardt and Brigham's Chapter’s 5, 6, 7, and 9, Risk and Return concepts to the market value Balance Sheet of Corporations. The basic task is to calculate the return on a portfolio, where the portfolio consists of the securities issued by a single company (i.e., their long term debt and equity). This is a review chapter in that we previously applied these techniques BA 530. All of the general material to estimate Cost of Capital, including after-tax cost of debt, cost of preferred stock, and the two methods of calculating the cost of common equity. Understand how to calculate all of the components of Table 14.1 on page 474. You should be able to convert a book value balance sheet to a market value balance sheet. You should be able to calculate the Weights in the equation using a market value balance sheet. Pay particular attention to the concepts related to risk and return, as this topic is often the source of concept questions. I will use this chapter to relate Risk and Return for Capital Budgeting problems, so expect to see some past materials in the Chapter 14 Quiz.  Quiz and Exam questions often require you to use valuation techniques from Ross' Chapter 9.

Things to Not Absorb

I am unlikely to ask about Floatation Costs (Section 14.7) on the Exam.

Things to Read

Read Chapter 14, and be prepared to re-read parts of Chapters 7, 8, 9, and 13 of Ross Westerfield and Jordan. The Chapter 14 End of Chapter Problems Solutions and Spreadsheets are available under Content.

Things to Do

Make 100 on the quiz. Be able to answer Chapter Review Problems 1 and 2, all of the Concepts Review and Critical Thinking Questions, and End of Chapter Questions and Problems 1-17.  Note that I regard Problems 14-17 as Exam level problems.

  1. Watch the Chapter 14 Overview video. The Powerpoints for all of this chapter’s videos are located here. In this chapter, it does not matter if you read the chapter or watch the videos first. Read pages 458-464.
  2. Watch the Computing the Cost of Equity Lecture. This video covers the Constant Growth Model and the Capital Asset Pricing Model.
  3. Read pages 464-468. Watch the Computing Cost of Debt, Cost of Preferred Stock and Weighted Average Cost of Capital video. At this point, you should be able to solve all of the suggested end of chapter problems.
  4. Read the rest of the chapter.
  5. You might want to watch the Comprehensive Problem and a discussion of the Components of the WACC video. But you already know how to do this from BA 530. You probably should watch the video on Adjustments for Project Risk, Floatation Costs, and a Chapter Summary. This video also has a short discussion of how to value an entire company using WACC. Both of these videos have comprehensive problems that are exam level problems.
  6. Verify you could solve the End of Chapter problems listed at the top of the page. You can find the solutions to these problems under Chapter 14 Content. If you plan to take the exam using Excel or need this skill, use the provided spreadsheets for End of Chapter Problems also in Content.
  7. If you need additional instruction, here are audio solutions to the most common types of WACC problems. Here are audio solutions, created by Dr. Hodges and Dr. Ronald Best, to several types of WACC problems;
    1. Costly Corporation plans a new issue of bonds with a par value of $1,000, a maturity of 28 years, and an annual coupon rate of 16.0%. Flotation costs associated with a new debt issue would equal 9.0% of the market value of the bonds. Currently, the appropriate discount rate for bonds of firms similar to Costly is 17.0%. The firm's marginal tax rate is 30%. What will the firm's true cost of debt be for this new bond issue? | Review Audio Solution
    2. Costly Corporation is also considering using a new preferred stock issue. The preferred would have a par value of $400 with an annual dividend equal to 18.0% of par. The company believes that the market value of the stock would be $968.00 per share with flotation costs of $68.00 per share. The firm's marginal tax rate is 40%. What would the firm's cost of preferred be for this new preferred stock issue? | Review Audio Solution
    3. You are considering buying a stock with a beta of; 0.73. If the risk-free rate of return is 6.9 percent, and the expected return for the market is 12.2 percent, what should the expected rate of return be for this stock? (State your answer as a percentage.) | Review Audio Solution
    4. You are considering buying a stock with a beta of 2.05. If the risk-free rate of return is 6.9 percent, and the market risk premium is 10.8 percent, what should the expected rate of return be for this stock? (State your answer as a percentage.) | Review Audio Solution
    5. Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $47.00 per share. The firm's dividend for next year is expected to be $3.40 with an annual growth rate of 5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 14.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of internal equity? | Review Audio Solution
    6. Costly Corporation is considering using equity financing. Currently, the firm's stock is selling for $31.00 per share. The firm's dividend for next year is expected to be $5.50 with an annual growth rate of 5.0% thereafter indefinitely. If the firm issues new stock, the flotation costs would equal 15.0% of the stock's market value. The firm's marginal tax rate is 40%. What is the firm's cost of external equity? | Review Audio Solution
    7. Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $155 million? | Review Audio Solution
    8. Marginal Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $247 million? | Review Audio Solution
    9. Marginal Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $157 million? | Review Audio Solution
    10. Marginal Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its cost of external equity is 19.0%. Currently, the firm's capital structure has $378 million of debt, $63 million of preferred stock, and $459 million of common equity. The firm's marginal tax rate is 45%. The firm is currently making projections for next period. Its managers have determined that the firm should have $92 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at a total investment level of $247 million? | Review Audio Solution
    11. Marginal Incorporated (MI) has determined that its before-tax cost of debt is 7% for the first $112 million in bonds it issues, and 8% for any bonds issued above $112 million. Its cost of preferred stock is 10%. Its cost of internal equity is 14%, and its cost of external equity is 17%. Currently, the firm's capital structure has $400 million of debt, $100 million of preferred stock, and $500 million of common equity. The firm's marginal tax rate is 30%. The firm is currently making projections for next period. Its managers have determined that the firm should have $59 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at each of the following total investment levels? (A) Total investment level of $380 million? (B) Total investment level of $199 million? (C) Total investment level of $69 million? | Review Audio Solution
    12. Marginal Incorporated (MI) has determined that its after-tax cost of debt is 6% for the first $100 million in bonds it issues, and 8% for any bonds issued above $100 million. Its cost of preferred stock is 9%. Its cost of internal equity is 12%, and its cost of external equity is 14%. Currently, the firm's capital structure has $600 million of debt, $100 million of preferred stock, and $300 million of common equity. The firm's marginal tax rate is 30%. The firm is currently making projections for next period. Its managers have determined that the firm should have $75 million available from retained earnings for investment purposes next period. What is the firm's marginal cost of capital at each of the following total investment levels?(A) Total investment level of $280 million? (B) Total investment level of $200 million? (C) Total investment level of $77 million? | Review Audio Solution
    13. You are considering buying common stock in Grow On, Inc. You have calculated that the firm's free cash flow was $8.10 million last year. You project that free cash flow will grow at a rate of 6.0% per year indefinitely. The firm currently has outstanding debt and preferred stock with a total market value of $9.22 million. The firm has 1.20 million shares of common stock outstanding. If the firm's cost of capital is 25.0%, what is the most you should pay per share for the stock now? | Review Audio Solution
    14. You are considering buying common stock in Super Growth, Inc. You have calculated that the firm's free cash flow was $6.20 million last year. You project that free cash flow will grow at a rate of 20.0% per year for the next three years, and then 6.0% per year indefinitely thereafter. The firm currently has outstanding debt and preferred stock with a total market value of $26.60 million. The firm has 1.68 million shares of common stock outstanding. If the firm's cost of capital is 19.0%, what is the most you should pay per share for the stock now? | Review Audio Solution
  8. Be prepared for a 40-60 minute quiz over Chapter 14.
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