Corporate Issuers Flashcards
What is the capital asset pricing model?
aka what is the cost of equity using KAPM
ERi = Rf + B ( ERm - Rf)
In layman’s terms, the CAPM formula is: Expected return of the investment =
the risk-free rate + the beta (or risk) of the investment * the expected return on the market - the risk free rate (the difference between the two is the market risk premium)
In brooks terms RF + (Beta x Equity risk premium)
or RF + (Beta x ERM - RF)
all returns are as %’s
What is an alternative way to calculate the cost of debt?
It is the yield to maturity on a bond x 1-Tax
How do you estimate the cost of equity for a thinly traded stock?
- unlever a comparative stock beta
b asset = b equity ( 1 divided by (1+(1-t) D/e)
- re lever the beta to its unadjusted form. This is what you use in the CAPM
b target = b asset ( 1 + [(1-t) D/E)
- re lever beta to its adjusted form
2/3 x B target + 1/3
- use beta in CAPM formula
What is the weighted average cost of capital?
WACC
wd x [kd (-1)] + (wps )(kps) + (wke) (cke)
How do you calculate the cost of preferred stock?
Dps
/
Price
What is the structure for answering WACC questions
- Calculate the market values of debt and equity
Debt outstanding
Equity = outstanding stock - Calculate Weights
With the market values you can calculate the weights - Calculate the cost of debt and equity
Debt = YTM (1-T)
E = CAPM - Re-lever where necessary
Calculate the cost of equity using the bond-yield-plus-risk-premium approach
YTM + Risk Premium
Do not remove tax
How do you rearrange to calculate Beta from the CAPM?
Return - risk free
/
Risk premium
Calculate D/E Ratio based on weighting … e.g weighting of 60% debt
0.6 / 1-.6
=
.6 / .4 = 1.5
Explain the treatment of flotation costs
They should be deducted as one of the projects initial period cash flows
What is MM1 and what are the assumptions
Under certain assumptions, the value of a firm is unaffected by its capital structure.
Assumptions:
Capital markets are perfectly competitive: There are no transactions costs, taxes, or bankruptcy costs.
Investors have homogeneous expectations: They have the same expectations with respect to cash flows generated by the firm.
Riskless borrowing and lending: Investors can borrow and lend at the risk-free rate.
No agency costs: There are no conflicts of interest between managers and shareholders.
Investment decisions are unaffected by financing decisions: Operating income is independent of how the firm is financed.
What is MM2 and what are the assumptions
MM II states that the cost of equity increases linearly as a company increases its proportion of debt financing. EG as more debt is added, equity gets more expensive.
Same as MMI
Capital markets are perfectly competitive: There are no transactions costs, taxes, or bankruptcy costs.
Investors have homogeneous expectations: They have the same expectations with respect to cash flows generated by the firm.
Riskless borrowing and lending: Investors can borrow and lend at the risk-free rate.
No agency costs: There are no conflicts of interest between managers and shareholders.
Investment decisions are unaffected by financing decisions: Operating income is independent of how the firm is financed.
What is the MM Proposition II (No Taxes)
As leverage (the debt-to-equity ratio) increases, the cost of equity increases, but the cost of debt and WACC are unchanged.
re=r0+D/E(r0−rd)
r0 = cost of equity with no debt (all equity)
rd = cost of debt
What is the static trade off theory
The static trade-off theory seeks to balance the costs of financial distress with the tax shield benefits from using debt. There is an amount of debt financing at which the increase in the value of the tax shield from additional borrowing is exceeded by the value reduction of higher expected costs of financial distress. This point represents the optimal capital structure for a firm, where the WACC is minimized and the value of the firm is maximized.
What is the agency cost of debt?
during periods of financial distress, conflicts of interest between managers (who represent equity owners) and debtholders impose additional costs
