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February-23-13 8:28 PM

**Cost of Capital WACC
**

Cost of Debt 1) Find yield (interest rate) of debt using financial calculator (bonds have pmt) 1) Apply tax savings After-Tax Component Cost of Debt = Interest Rate - Tax Savings = rd (Tax savings) = rd (1 - Tax Rate)

**Percentage Flotation Cost
**

M (1 - F ) = Where rd = Debt interest rate before tax (found using calculator ' i' ) INT ( 1 - T) + M . [1+rd (1-t)]^t (1+rd (1 - T)^N Where: M = Bond par value N = # of pmts f = % Flotation costs INT = $ interest per period t = Tax rate rd (1-t) = after tax cost of debt

**Using Calculator N = Number of payments PV = Bond Par Value ( 1 - F) PMT = Payment (1-T) FV = Bond Par Value
**

Solve for i/y

Cost of Preferred Stock Preferred stock are not tax deductible Component Cost of Preferred Stock (Rᵖˢ ) - The cost used in the weighted average cost of capital calculation Component Cost of Preferred Stock = Rᵖˢ = Dᵖˢ Pps (1 - F)

○ Dᵖˢ = Preferred Dividend ○ Pᵖˢ = The Preferred Stock Price ○ F = Flotation cost as a percentage of price, can also be dollar amount(Underwriting Cost)

Cost of Common Stock (Three Approaches) Use Average of All Three Methods in WACC

1) The CAPM Approach Step1: Estimate the risk-free rate (rrf) Step2: Estimate the current expected market risk premium (RPm) which is the expected market return minus the risk -free rate Step3: Estimate the stock's beta coefficient, (bi), and use it as an index of the stock's risk. Step 4: Plug in numbers into CAPM formula

CAPM Formula = rs = rRf + (RPm) X bi = rRF + (rM - rRF) X b = Real Risk-Free Rate of Interest (r*) + Inflation Premium (IP) + [ return on market (rm) - Real Risk-Free Rate of Interest (r*) + Inflation Premium (IP)] X beta (bi) {All three are same formulas}

2) Dividend-Yield-Plus-Growth-Rate (Discounted Cash Flow (DCF) Required Rate of Return on Equity: rs = D₁ + Expected g Where: P₀

P₀ = Current Price of Stock D₁ = Dividend expected to be paid at end of year 1 (If not given, apply growth rate to D ₀) g = Expected growth rate

Adjusting the Cost of Stock for Flotation Costs Cost of New Common Equity = (re) Flotation Costs = (F)

re = re = ___ D₁____ + g P₀ ( 1 - F )

**3) Bond-Yield-Plus-Risk-Premium Approach
**

rs = Bond Yield + Risk Premium

Calculating WAAC

WACC = wd (rd) ( 1 - T) + wps (rps) + wce (rs)

Where wd = Weight of debt wps = Weight preferred stock wce = Weight common equity rd = Cost of debt before tax rps = Cost of preferred stock rs = Cost of common stock

Capital Structure

Operating Break-Even Qbe =

F P- V

Where: F = Fixed Costs

P = Sales Price Per Unit

V = Variable Cost Per Unit

MM Theory: Zero Taxes Value of Leverage Firm = Value of Unleveraged Firm =

EBIT = EBIT WACC rsU

**MM Theory: Corporate Taxes Value of Unleveraged Firm Vu = S = EBIT (1-T) rsu
**

Value of Levered Firm

Where Vu = Value of Unleveraged firm EBIT = Earnings before interest and taxes

rsu = cost of equity for unleveraged firm

**VL = VU + V tax shield
**

MM Theory: Personal & Corporate Taxes VL = VU + [ 1 - (1 - Tc) (1 - Ts) ] D (1- Td)

Where VL = Value of Leveraged Firm

Vu = Value of Unleveraged Firm

V Tax Shield = Total Debt Used x Tax Rate (%)

Where: Tc = corporate tax rate Td = personal tax rate on debt income Ts = personal tax rate onstock income

Cashflows

Defining a Project's Free Cash Flows: FCF = Investment Outlay Cash Flow + Operating Cash Flow + NOWC Cash Flow + Salvage Cash Flow CCA Tax CCA tax shield

= CCA × tax rate

Capital Budgeting

Net Present Value Discounted Cash Flow Analysis 1. Prepare a table showing the cash flows during each year of the proposed project. 2. Compute the present value of each cash flow, using a discount rate (WACC) that reflects the cost of acquiring investment c pital. This discount rate is often called the hurdle rate or minimum desired rate of return . a 3. Compute the net present value , which is the sum of the present values of the cash flows. 4. Compare NPV of projects. Accept the project proposal with largest net present value (NPV) equal to or greater than zer . Reject other project. o

Internal Rate of Return 1) Enter the Initial Investment as a negative into CF register at Year 0 2) Enter cost savings in CF register for each year 3) Compute IRR Decision Rule 1) If the IRR is equal to or greater than the hurdle aka WACC (discount rate/cost of acquiring investment capital) , accept inve stment proposal

Modified Rate of Return Constant Flow 1) First, enter cash inflows in the financial calculator register 2) Find NPV 3) Find PV of inflows (NPV) 4) Find PV of outflows 5) Find i using PV of outflows as PV and PV of inflows as FV Payback Period Payback =

Number of Years that have passed before full recovery +

Unrecovered cost at start of year (cost after all previous cash inflows have been taken out from initial outflow) Cash Inflow during full recovery year (cash inflow for the year the project becomes positive)

Textbook Reading Notes Page 1

FM II Midterm Formula Sheet

FM II Midterm Formula Sheet

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