Leverage

Question 1

Capital Asset Pricing Model (CAPM)

(Cost of R.E. Formula)

MEMORIZE FORMULA

Answer 1

=Risk-free Rate + [Beta x (Mkt return - Risk-free Rate)]

Question 2

Beta (defined)

Answer 2

Beta = Volatility (risk) of the stock relative to the volatility of the overall market.

the beta coefficient represents the measure of a particular stock’s percentage change compared to the percentage change in the market over the same period. The equation for the beta coefficient is as follows:

% change in stock price / % change in market price

if Beta = 1, the stock is as volatile as the market

if Beta > 1, the stock is more volatile than the market

if Beta < 1, the stock is less volatile than the market

Question 3

Discounted Cash Flow (DCF)
(determines the firm’s weighted-avg. cost of cap)

Assumes stocks are fairly priced

The Estimated expected rate of return will yield an estimated required rate of return

The expected growth rate may be based on Projections of PAST GROWTH RATES, a retention growth model or analysts’ forecasts.

MEMORIZE FORMULA

Answer 3

Formula is:

cost of R.E. = Div per share expected at yr end
__________________________ + rateof
Price per share growth in
dividends

i.e.

Dividend Yield + Growth

Question 4

Cost of Preferred Stock

MEMORIZE FORMULA

Answer 4

Formula:

Preferred Stock Div’s / Net Proceeds of Pref. Stock

i.e.

Par Value x % / Net Inflow

i.e.

Par Value x % / Stock Price - Flotation Costs

Question 5

Operating leverage is

Answer 5

the presence of fixed costs in operations, which allows a small change in sales to produce a larger relative change in profits.

Operating leverage is the presence of fixed costs in operations, which allows a small change in sales to produce a larger relative change in profits. (Fixed costs remain the same so the main thing that drives profits is sales and variable costs associated with them).

Question 6

WACC-Weighted Average Cost of Capital

Answer 6

It is the average cost of all forms of financing used by a company.

Often used as a “Hurdle Rate” for cap. investment decisions

Optimal capital structure is the mix of financing instruments that produces the lowest WACC.

Is determined by weighting the cost of each specific type of capital by its proportion to the firm’s total capital structure (after tax).