0 views

Uploaded by Miftahudin Miftahudin

Homework solution

- Bond Basics-All You Wanted to Know About Bonds-VRK100-05102009
- Understanding the Yield Curve Part 3 Salomon Brothers 1995
- fins2624 online question bank ch 15
- Dynamics of Swaps Spreads
- CFO SVP Vice President Finance in St Louis MO Resume Matt Strate
- Chapter 7 Corporate Finance
- Central Bank Liquidity Rates
- 935-2567-1-PB
- Bonds Valuation
- Federal Reserve - Slow Ride on the Stimulus Withdrawal Plan, 19th June 2013
- Assignment FIN205 S2_ 2017
- Case Digest on Civil Law Review
- Is Government Spending Too Easy an Answer
- When Will the Fed End Its Zero Rate Policy?
- Borio - Monetary policy and bank lending.pdf
- Bernanke Makes Two
- macro-bond feb wk 4-17
- 2016 Stein Greenwood Hanson
- INR Term Deposit Fact Sheet - dec 2010
- CA11_Sol_1108

You are on page 1of 8

Chapter 7

1. Describe how the costs of debt and equity differ from the perspective of accounting

measures.

While accountants recognize that financial capital has a cost and recommend its complete

inclusion in performance appraisal and decision making, historical accounting for this cost

is incomplete, at least in formal financial statements. Unlike debt, much of equity’s cost is

not an expense in a traditional accounting sense (with documentation); only a part of this

cost (e.g., dividends) is reflected in historical financial statements. There is virtually no

historical accounting for the nondividend component of equity cost, even though it is clear

that the nondividend cost component increases with cuts in dividends.

Private financial markets are those involving direct two-party negotiations over illiquid

non-standardized contracts. Public financial markets are those where transactions involve

more liquid securities with standardized contract features.

In general, early-stage ventures raise debt capital from individuals, venture lenders, and

when profitably entering rapid-growth, possibly other financial institutions.

The founding entrepreneurial team, business angels, and venture capitalists are the primary

sources of early-stage equity capital. In some instances, debt and/or preferred stock

convertible into shares of common equity is held by venture investors.

An interest rate is the rate one must pay to borrow capital. Default risk is risk that a

borrower will not pay the interest and/or principal on a loan.

5. What is a nominal interest rate? Describe a risk-free interest rate and a real rate of

interest.

A nominal interest rate is stated rate of interest. The risk-free interest rate is interest rate for

a debt security that is virtually free of default risk. A real rate of interest is rate of return

adjusted for the expected inflation.

120 Chapter 7: Types and Costs of Financial Capital

Inflation is the general rise in prices that is not due to increases in product quality. An

inflation premium is the additional interest required due to the expectation of future

inflation

Default risk premium is the additional premium required to compensate for the possibility

of the firm’s defaulting on the loan.

Prime rate: interest rate charged by banks to their highest quality (lowest default risk)

business customers

Bond rating: reflects the default risk of a firm’s bonds as judged by a bond-rating agency

Liquidity risk premium is the additional rate charged when a debt instrument cannot be sold

quickly at a fair price.

Maturity risk premium is charged for the inherent increased risk in long-term debt

contracts.

11. What is meant by the term structure of interest rates? What is a yield curve?

Term structure of interest rates: relationship between nominal interest rates and time to

maturity when default risk is held constant

12. Describe the differences between senior debt and subordinated debt.

Subordinated debt: debt with an inferior claim (relative to senior debt) to venture assets

13. Explain the meaning of investment risk of loss and describe how risk can be defined

relative to an average value.

Chapter 7: Types and Costs of Financial Capital 121

Risk is the chance or probability of financial loss from a venture investment. More

generally, investment risk is the chance that a security’s future value will differ from what it

is expected to be.

14. Describe the following: (a) expected rate of return, (b) standard deviation, and (c)

coefficient of variation.

(a) Expected rate of return is the probability-weighted average of possible rates of return.

(b) Standard deviation is a measure of the dispersion of possible outcomes around the

expected return.

(c) Coefficient of variation shows the dispersion risk per unit of expected rate of return.

15. Describe the historical average annual return relationships among long-term U.S.

government bonds, corporate bonds, small firm common stocks, and large firm common

stocks.

Small firm common stocks have the highest average annual return followed by large firm

common stocks. The third highest return is corporate bonds, and the lowest is long-term

U.S. government bonds.

16. What is the difference between private equity investors and publicly traded stock investors?

Private equity investors own firms that are typically closely held while investors in publicly

traded stocks own firms whose shares trade in a public secondary market.

17. How does an organized securities exchange differ from an over-the-counter market?

market is a network of dealers connected via computer.

18. What is meant by an investment risk premium? What is a market risk premium?

An investment risk premium is the additional return above the risk-free rate that investors

can expect to earn by investing in a risky common stock.

The market risk premium is the additional return above the risk free rate per unit of beta

risk that a stock investor can expect.

19. What rates of returns have venture capitalists earned on average in recent years? How do

these returns compare against the average venture capitalists returns over the past twenty

years?

122 Chapter 7: Types and Costs of Financial Capital

During the last few years of the 20th century, VC returns were higher than ever before in

history. Returns have been much lower since the “dot com” boom ended.

As shown in Table 7.1, for the 20 year period ending during 2014, venture capital holding

period returns (all stages) averaged 34.1 percent compared with 9.6 percent for the S&P

500 stock index. However, the 10-year average venture capital holding period return (all

stages) was only 10.0 percent compared to 8.1 percent for the S&P 500. Recovery from the

financial crisis of 2007-2008 and the great recession of 2008-2009 resulted in five-year

venture capital holding period returns for all stages of 14.9 percent versus 15.7 percent for

the S&P 500.

20. How do we estimate the cost of equity capital for private ventures? In developing your

answer describe the major components that are considered when estimating the rates of

return required by venture investors.

Equity capital for private ventures is estimated by adding together the risk free rate, an

inflation premium, an advisory premium, a liquidity premium, and a hubris projections

premium.

21. What discount rates are typically used for development- stage, startup-stage, survival-

stage, and early-growth-stage ventures?

The discount rate for the development stage is typically above 40%, between 30% and 50%

for the startup stage, between 25-45% for the survival stage, and between 25-35% for the

early growth-stage.

Weighted average cost of capital (WACC): weighted average of the cost of the individual

components of interest-bearing debt and common equity capital.

23. How is a venture’s WACC likely to change as it moves through a successful life cycle?

Most early-stage financing is high-cost equity capital. However, the opportunity to use

usually less-costly debt increases as a successful venture progresses through its life cycle.

Thus, the WACC is likely to decrease over time for a successful venture.

24. From the Headlines—Ecosphere: You have been retained as a consultant for Ecosphere and

tasked with assessing the financial viability of their commercial ventures. What types of

financial ratios would you enlist in your report to Ecosphere? What approach would you

take to determining a relevant cost of capital for those ventures?

Answers will vary: Ecosphere has a great deal of variety in the types of products and

services it targets. As it grows from tourism and handicrafts toward biofuels and other

more capital-intensive operations, it would be beneficial to monitor its inventory turns and

Chapter 7: Types and Costs of Financial Capital 123

taking some notice of trends in overall asset efficiency (as it adds property, plant and

equipment) for newer operations (biofuels, etc.). Profit margins should be monitored

(overall and line item) as it expands into new areas.

1. [Inflation and Risk Premiums] Voice River, Inc. provides media-on-demand services via the

Internet. Management has been studying current interest rates. A lender is willing to make

a two-year loan to Voice River at a 12 percent annual interest rate. The U.S. government is

currently paying 8 percent annual interest on its two-year securities.

inflation premium expected at this time?

Inflation premium = risk free rate – real rate = 8% - 3% = 5%

B. What is the amount of the total risk premium that Voice River will have to pay?

Risk premium = nominal interest rate – risk free interest rate = 12% - 8% = 4%

C. If a 1 percent liquidity premium is built into the 12 percent rate, what is the

default risk premium on the loan?

Default risk premium = risk premium – liquidity premium = 4% – 1% = 3%

2. [Maturity and Default Risk Premiums] Following is interest rate information currently

being observed by the Electronic Publishing Corporation.

One-year bank loans 6.0

Five-year U.S. government securities 7.0

Five-year bank loans 9.5

A. What is the amount of the maturity risk premium on one-year versus five-year U.S.

government securities?

7% - 4.5% = 3.5%

124 Chapter 7: Types and Costs of Financial Capital

B. What is the amount of the maturity risk premium on one-year versus five-year bank

loans?

9.5% - 6% = 3.5%

C. What is the default risk premium on one-year bank loans and on five-year bank loans?

5 Year; 9.5% - 7% = 2.5%

3. [Expected Rate of Return and Risk Measures] A venture investor, BKAngel, is considering

investing in a software venture opportunity. However, the rate of return to be realized next

year is likely to vary with the economic climate that actually occurs. Following are three

possible economic outcomes, the probability that each one will occur, and the rate of return

projected for each outcome:

Economic Probability of Rate of

Climate Occurrence Return

Recession .25 -20.0%

Normal .50 15.0

Rapid Growth .25 30.0

Expected rate of return = (.25) x (-20%) + (.50) x (15%) + (.25) x (30%) = 10%

B. Calculate the variance and standard deviation of the rates of return for the software

venture?

Variance = (.25) x (-20% - 10%)^2 + (.5) x (15% - 10%)^2 +(.25) x (30% - 10%)^2 =

337.5

Standard deviation = (Variance)^(1/2) = (337.5)^(1/2) = 18.37%

C. Calculate the coefficient of variation of the rates of return for the software venture.

If the coefficient of variation of rates of return for BKAngel’s prior venture investments

is 1.5, would the software venture be considered as being less or more risky?

1.837. The coefficient of variation for this venture would be considered to be more

risky since it is above 1.5.

4. [Expected Rate of Return and Risk Measures] A potential venture investment has the

following possible outcomes:

Performance Probability of

Rate of

Chapter 7: Types and Costs of Financial Capital 125

Outcome Occurrence

Return

Home Run (Success) .15

500.0%

Breakeven .35

15.0

Strikeout (Failure) .50 -100.0

5.25% + (-50%) = 30.25%

B. Calculate the variance and standard deviation of the rates of return for the venture.

30.25%)^2 = .15 x 220,665.06 + .35 x 232.56 + .50 x 16,965.06 = 33,099.76 + 81.41 +

8,482.53 = 41,663.69

Standard deviation = (Variance)^(1/2) = (41,663.69)^(1/2) = 204.12%

C. Calculate the coefficient of variation of the rates of return for the venture. If the

coefficient of variation of rates of return for your prior venture investments is 4.0,

would the new venture be considered as being less or more risky?

= 6.748. The coefficient of variation for this new venture would be considered to be

more risky relative to prior venture investments since it is above 4.0.

7. [Loan Present Values] Jerry’s Tree Services is trying to raise debt funds from a prospective

venture investors, SureWay LLC. SureWay indicated to Jerry Lau that the annual interest

rate on risky venture loans is currently 15 percent. Jerry is seeking a 3-year loan with

annual payments. He is willing to pay back $100,000 at the end of 3 years. However, due

to cash flow problems, he can afford to pay interest at a 12 percent annual rate.

A. Calculate the dollar amount that SureWay venture investors would lend to Jerry’s Tree

Services.

N=3

I%/Yr = 15%

PMT = $12,000

FV = $100,000

PV = ? = $93,150.32

B. What would be the dollar amount of the loan if the loan was made for only

two years?

126 Chapter 7: Types and Costs of Financial Capital

N=2

I%/Yr = 15%

PMT = $12,000

FV = $100,000

PV = ? = $95,122.87

8. [Loan Present Values] Refer to Problem 7. Show how your answer to Part A of Problem 7

would change if Jerry were willing to pay 16 percent annual interest and a principal

payment of $100,000 at the end of three years.

N=3

I%/Yr = 16%

PMT = $16,000

FV = $100,000

PV = ? = $100,000

9. [Expected Rate of Return and Hubris Premiums] Following is rate of return component

information for FirstVenture investors.

Rate Return

Component Component

Liquidity premium 5.5%

Risk-free rate 6

Advisory premium 9

Investment risk premium 11.5

Target rate of return 40

A. Calculate the expected rate of return before considering premiums for illiquidity,

advisory activities, and hubris projections.

- Bond Basics-All You Wanted to Know About Bonds-VRK100-05102009Uploaded byRamaKrishna Vadlamudi, CFA
- Understanding the Yield Curve Part 3 Salomon Brothers 1995Uploaded byZoe Yang
- fins2624 online question bank ch 15Uploaded byAllenRuan
- Dynamics of Swaps SpreadsUploaded byAkshat Kumar Sinha
- CFO SVP Vice President Finance in St Louis MO Resume Matt StrateUploaded byMattStrate
- Chapter 7 Corporate FinanceUploaded byCalistoAmemebe
- Central Bank Liquidity RatesUploaded byZerohedge
- 935-2567-1-PBUploaded byAgusdiwana Suarni
- Bonds ValuationUploaded byAli Jumani
- Federal Reserve - Slow Ride on the Stimulus Withdrawal Plan, 19th June 2013Uploaded byAngel Broking
- Assignment FIN205 S2_ 2017Uploaded byJapheth Capati
- Case Digest on Civil Law ReviewUploaded byF Anton Nicolas
- Is Government Spending Too Easy an AnswerUploaded byfarik007
- When Will the Fed End Its Zero Rate Policy?Uploaded byea12345
- Borio - Monetary policy and bank lending.pdfUploaded byEduardo Tocchetto
- Bernanke Makes TwoUploaded byLe Mai
- macro-bond feb wk 4-17Uploaded byapi-278033882
- 2016 Stein Greenwood HansonUploaded byKrishnan Muralidharan
- INR Term Deposit Fact Sheet - dec 2010Uploaded bydips11
- CA11_Sol_1108Uploaded byYogeshAgrawal
- TD Chief Economist on Risks to EconomyUploaded byrichardck61
- ES316 Hw5 Due 10th NovemberUploaded byrafael
- 2016-04 Wrestling With Negative Interest RatesUploaded byMichael Benzinger
- The Hindu Business Line Housing FinanceUploaded byNir Jack
- Sample Mid-Term ENGR301G Fall08Uploaded bySamuel
- mathprojectbankUploaded byapi-299007163
- rates1Uploaded bymounabs
- Learn Excel 09Uploaded bymhussain
- Valuka Feeds crab reportUploaded byPrince Asif
- National IncomeUploaded bypratik_rono

- Quiz Compilation - Managing Ethics & CSRUploaded byMiftahudin Miftahudin
- Chap 15 SolutionsUploaded byMiftahudin Miftahudin
- ch 4Uploaded byMiftahudin Miftahudin
- Ch 5Uploaded byMiftahudin Miftahudin
- Chap 13 SolutionsUploaded byMiftahudin Miftahudin
- Chap 11 SolutionsUploaded byMiftahudin Miftahudin
- Ch 2Uploaded byMiftahudin Miftahudin
- Chap 14 SolutionsUploaded byMiftahudin Miftahudin
- Chap 12 SolutionsUploaded byMiftahudin Miftahudin
- Chap 9 Solutions-2Uploaded byMiftahudin Miftahudin
- ch 6Uploaded byMiftahudin Miftahudin
- Chap 10 SolutionsUploaded byMiftahudin Miftahudin
- Chap 8 SolutionsUploaded byMiftahudin Miftahudin

- LN04Mish769581_10_LN04.pptUploaded bySadia Saeed
- VAR, SVAR and VECMUploaded byjohnpaulcorpus
- How The Economic Machine WorksUploaded byNenden Maryani
- standard and poors on surinameUploaded byapi-234406870
- WBS01_01_que_20160519Uploaded byali
- Les champions de la Grande DistributionUploaded byMohamed belcourt
- Investment BankingUploaded byAnshul Sood
- 1 - 1945 - B6 - Income Tax to InflationUploaded byVilma Santos Recto
- Country Paper: Lao PDRUploaded byADBI Events
- Final Stability Report2013Uploaded bymithun4243
- Philip II of SpainUploaded bymisssees
- MONETARY POLICY in Islam Umer ChapraUploaded byAbdulRehmanKhilji
- PS - Chap 10 Bodie 9eUploaded byKrishan988
- fiscal policy - debate rubric and notesUploaded byapi-429688581
- IPA EnglishUploaded byfrancisfrancisnet
- IIP CPIDataReleaseUploaded byAngel Broking
- 1113 Monetary Policy and Economic PolicyUploaded byBárbara Barrera Gonzalez
- Empson, R. Whose land is it anyway - balancing the expectations and demands of different trusting partnership in mongolia.pdfUploaded byEdwin A. Valientes
- DemonetizationUploaded bySuman Poudel
- The Shell Money of the Slave TradeUploaded byapmendez317
- Stagflation [1]Uploaded byne002
- Robert Kiyosaki Why the Rich Get RicherUploaded byGábor Balázsik
- 1-19_CH20_Krugman_13195Uploaded byvedran1980
- Hoor GheeUploaded byHaider Sarwar
- Pakistan+Tobacco+Co[1].Uploaded bymc09122
- NDRG research paperUploaded byTodd Clausen
- Marcelo Curado - Industrialização e Desenvolvimento - Uma Análise Do Pensamento Econômico BrasileiroUploaded byEugenio Pereira
- 2015-globalreport-151015111658-lva1-app6892.pdfUploaded bypledgerje
- Soln Ch 05 Historical ReturnUploaded bySilviu Trebuian
- inflation_ppt.pptxUploaded byDeepanjanMajhee