Bonds

Bond Value= PV of coupons+ PV of par value

[ ]
1
1−
Bond Value= PV annuity+ PV lump sum= ( 1+ r )t F
C +
r ( 1+r )t
Discount Bond= Coupon Rate< YTM
Premium Bond= CR> YTM/ Discount Rate
Par Bond= CR= YTM

The higher the YTM, the lower the bond price

Annual Coupon Payment= N; I/Y; PMT; FV; CPT PV= -

Semiannual = Nx2; I/Y/2; PMT/2; FV; CPT PV= -

The Fisher Effect (1+R) = (1+r)(1+h)

R= Nominal rate
r= Real rate
h= Expected inflation rate
R ≈ r + h ≈ (two ways)

Stocks

One period-Finite Holding

FV(+PMT); PMT; N; I/Y; CPT PV= -
Two period-Finite Holding
CF; CF0 = 0; C01; F01; C02; F02; (NPV) I; CPT NPV= (*Last C0= Stock Price+ Dividend)
Zero Growth= Constant Dividend= Forever= Perpetuity= P0= D/R

Dividend Growth Model (Constant Div)

D0 ( 1+ g ) D
P0= = 1 (use 2nd one if dividend expected is given)
R−g R−g
P4 = D0(1 + g)5 / (R – g) = D5 / (R – g)
R= Discount Rate
g= Constant Dividend Growth Rate, g<R

Dividend Growth Model (Non-Constant Growth Div)

Step 1 Compute D1; D2; D3
Step 2 Expected Future Price P?
Step 3 PV
CF0; C01; F01; C02 = 1.38+9.66; F02; I; CPT NPV

D 0 ( 1+ g ) D1
R= + g= +g
P0 P0
R= Rate of return
g= Capital gains yield
D1
= Dividend yield
P0
Capital Budgeting

Find Investment’s Value

Step 1 Estimate expected future CF
Step 2 Required return
Step 3 PV of CF

NPV ≥ 0 = Positive = Accept = payback period< preset limit

Compute NPV
CF0 = ± P0; C01; F01; C02; F02; C03; F03; I; CPT NPV

Average Accounting Return (AAR)> Preset limit = Accept

AAR= Average NI/ Average Book Value

Internal Rate of Return (IRR)> Required return = Accept

CF0 +/-; C01; C02; C03; IRR CPT IRR

Computing cash flows – refresher

OCF = EBIT + depreciation – taxes
OCF = Net income + depreciation when there is no interest expense
OCF = (Sales – costs) (1 – T) + Depreciation*T (Tax shield approach)

Depreciation tax shield = D x T

D = depreciation expense
T = marginal tax rate

After tax salvage = salvage – T (salvage – book value)

Risk and Return

Expected Returns
 n n
E ( R )=∑ ❑ pi Ri=∑ ❑ pi=1
i=1 i=1
E (R)= Probability (returns) +…….

Risk Premium= E (R)- Risk-free rate

Variance σ 2; Standard Deviationσ

n
σ =∑ ❑ p i ¿
2

i=1

σ =√ σ
2

Portfolio Expected Returns

m
E( R P )=∑ ❑w j E( R j)
j=1
*Weighted average of ER
RP = w1R1 + w2R2 + … + wmRm
Standard deviation of a portfolio < ΣWiσi

Portfolio Beta βp = ΣWiβi

Beta Coefficient- Measure systematic risk
1- Same risk; <1 Less risk; >1 More risk

Reward-to-risk ratio
Slope = (E(RA) – Rf) / (βA – 0)

Market Equilibrium
E( R A )− R f E ( R M ) − R f
=
βA βM

Security Market Line (SML)

Slope= (E(RM) – Rf) / βM
Slope= E ( Ri ) =Rf + Bi x [E(RM) – Rf]
Slope = E(RM) – Rf = market risk premium
E(R) = [E(RM) – Rf]β + Rf
Capital Asset Pricing Model (CAPM)

• Pure time value of money – measured by the risk-free rate

• Reward for bearing systematic risk – measured by the market risk premium
• Amount of systematic risk – measured by beta

WACC

– Risk-free rate, Rf
 – Market risk premium, E(RM) – Rf
– Systematic risk of asset, β

SML/CAPM: RE = Rf + β (Rm – Rf)

DGM: RE = D1/Re + g
Average cost of equity= (SML+DGM)/2

Perpetuity stock
P0 = D/ RP
RP = D / P0

After Tax WACC

WACC=r D × ( 1 −Tc ) × ( DV )+(r × Ev )

E

After tax cost of debt = RD(1-TC)

WACC = wERE + wDRD(1-TC) + wPRP (Dividend)

– E = market value of equity = No. of outstanding shares x price per share

– D = market value of debt = No. of outstanding bonds x bond price
– V = market value of the firm = D + E
– wE = E/V = percent financed with equity
– wD = D/V = percent financed with debt

Compute WACC
Step 1 Cost of equity (CAPM)
Step 2 Cost of Debt (YTM)
Step 3 After tax COD
Step 4 Capital Structure Weight (W, D, V, w E , w D ¿

Step 5 WACC=r D × ( 1 −Tc ) × ( DV )+(r × Ev )

E / WACC = wERE + wDRD(1-TC) + wPRP

TOPIC 6
 INTEREST RATES AND BOND VALUATION
Q6.8 Bond Ratings. Companies pay rating agencies such as Moody's and S&P to rate their bonds, and the
costs can be substantial. However, companies are not required to have their bonds rated in the first
place; doing so is strictly voluntary. Why do you think they do it?
Companies pay to the rating agencies:
● Unrated bonds are hard to sell.
● Large investors only buy the rated bonds because large investors are not allowed to purchase
unrated bonds.

Q6.15 Bond Prices versus Yields.

a. What is the relationship between the price of a bond and its YTM?

● Bond prices- PV when discounting the future

● YTM- The interest rate used to discount future cash flow to find bond price/ back to their PV

b. Explain why some bonds sell at a premium over par value while other bonds sell at a discount. What
do you know about the relationship between the coupon rate and the YTM for premium bonds? What
about for discount bonds? For bonds selling at par value?

● Discount Bond- CR < YTM (PV<FV) (CY>YTM)

● Premium Bond- CR > YTM/ Discount Rate (PV>FV) (CY<YTM)
● Par Bond- CR = YTM (PV=FV) (CY=YTM)
c. What is the relationship between the current yield and YTM for premium bonds? For discount bonds?
For bonds selling at par value?
● Current yield= Annual Coupon payment/ Bond prices

Questions and Problems

Q3. Bond Prices. Lycan, Inc., has 7 percent coupon bonds on the market that have 8 years left to maturity.
The bonds make annual payments. If the YTM on these bonds is 10 percent, what is the current bond
price?
CR=0.07; PMT=1,000x0.7=70; N=8, I/Y=10, FV=1,000
PMT=70; N=8, I/Y=10, FV=1,000; CPT PV= ± 839.95
CR<YTM (Disc Bond)

Q4. Bond Yields. The Smart Choice Plc has 10 percent coupon bonds on the market with nine years left to
maturity. The bonds make annual payments. If the bond currently sells for $1,145.70, what is its YTM?
PV=1,145.7; FV=1,000; N=9; CR=0.1; PMT= 1,000x0.1=100
PMT=100; N=9; PV=± 1,145.7; FV=1,000; CPT I/Y= 7.7%
PV>FV, CR>YTM (Premium Bond)
Q5. Coupon Rates. Merton Enterprises has bonds on the market making annual payments, with 16 years to
maturity, and selling for $963. At this price, the bonds yield 7.5 percent. What must the coupon rate be
on Merton's bonds?
FV=1,000; N=16; PV=963 , I/Y=7.5
N=16; PV=± 963; I/Y= 7.5; FV=1,000; CPT PMT= 70.95
Coupon rate= 70.95/1000= 7.095%
CR<YTM (Disc Bond)
Q11. Nominal and Real Returns. An investment offers a 13 percent total return over the coming year. Bill
Bernanke thinks the total real return on this investment will be only 6 percent. What does Bill believe
the inflation rate will be over the next year?
The Fisher Effect (1+R) = (1+r) (1+h)

R=0.13; r=0.06

1+0.13 = (1+0.06) (1+h)

1.066 = 1+h
h = 0.066 or 6.6%
13%≈ 6 % +ℎ
h≈ 7 %

Q12. Nominal versus Real Returns. Say you own an asset that had a total return last year of 17 percent. If
the inflation rate last year was 2.9 percent, what was your real return?
The Fisher Effect (1+R) = (1+r) (1+h)

R=0.17; h=0.029

1+0.17 = (1+r) (1+0.029)

1.137 = 1+r
r = 0.137 or 13.7%
17%≈ r +2.9 %
h≈ 14.1 %

Q18. Bond Yields. PK Software has 7.5 percent coupon bonds on the market with 22 years to maturity. The
bonds make semi-annual payments and currently sell for 106 percent of par. What is the current yield
on PK's bonds? The YTM? The effective annual yield?
CR=0.075; PMT=1,000x0.075=75/2=37.5; N=22x2=44; FV=1,000; PV=106%x1,000=1,060

CY=75/1060=0.0708 or 7.08%

PMT=37.5; N=44; PV=± 1,060; FV=1,000; CPT I/Y= 3.48 (semi-annual)

YTM= 3.48 x 2= 6.96%= APR

2NDF RESET ENTER

2NDF ICONV NOM 6.96 ENTER
C/Y 2 ENTER CPT EFF= 7.08%
CR>YTM (Premium Bond)
Extra Tutorial Questions – Topic 6 (Bond Valuation)

1.Suppose a bond with a 10% coupon rate and semiannual coupons, has a face value of $1,000, 20 years to
maturity and is selling for $1,197.93. Calculate the YTM.

PMT=50; FV=1,000; PV=-1,197.93; N=40; CPT I/Y= 4

YTM= 4x2= 8%
2.BMW Ltd issued a set of bonds 3 years ago and has 18 months until maturity. The bond has a face value of
$1,000. The coupon on the issue is 9% pa paid in semiannual instalments. What is the price of the bond today
if the yield to maturity is 12% pa compounded half-yearly?

N=3; FV=1,000; PMT=45; I/Y=6; CPT PV= -959.9

Topic 8 - EQUITY MARKETS AND STOCK VALUATION

Q7.4 Dividend Growth Model. Under what two assumptions can we use the dividend growth model
presented in the chapter to determine the value of a share of stock? Comment on the reasonableness of
these assumptions.
● Constant growth rate (Start-up Comp)
● Dividend is constant (Dying Comp)
● Otherwise use general dividend valuation
Q7.6 Dividend Growth Model. Based on the dividend growth model, what are the two components of the
total return on a share of stock? Which do you think is typically larger?
● P0= D1/R-g
● R= Dividend yield (D1/P0) + Capital gain
● Capital gain larger
Q1. Stock Values. Umbak Properties just paid a dividend of $2.53 per share on its stock. The dividends are
expected to grow at a constant rate of 5.4 percent per year, indefinitely. If investors require a 10 percent
return on Umbak stock, what is the current price? What will the price be in three years? In 15 years?
D1 D4 D 16
p0 = p3= p15=
R− g R−g R−g
D 0 ( 1+ g ) D ( 1+ g ) 4 D ( 1+ g )16
= = 0 = 0
R−g R−9 R−9
= =
2.53(1+0.054) 4 16
= 2.53 ( 1+0.054 ) ❑ 2.53 ( 1+0.054 ) ❑
0.1− 0.054
0.1 −0.054 0.1 −0.054
= $57.97
= $67.88 = $127.59

Q2. Stock Values. The next dividend payment by Lalitha Singhe Traders will be $2.45 per share. The
dividends are anticipated to maintain a 5.5 percent growth rate, forever. If the stock currently sells for
$49.50 per share, what is the required return?
D0 ( 1+ g ) D
R= + g= 1 + g
P0 P0
2⋅ 45
= + 0.055
49.5
= 0.1045 or 10.45%

Capital gain> Dividend

Q4. Stock Values. Ziggs Corporation will pay a $3.85 per share dividend next year. The company pledges
to increase its dividend by 4.5 percent per year, indefinitely. If you require a 14 percent return on your
investment, how much will you pay for the company's stock today?
D0 ( 1+ g ) D1
R= + g= +g
P0 P0
3.85
0.14= +0.045
P0
3.85
0.095=
P0
 P0= $40.53

Q6. Stock Valuation. Suppose you know that a company's stock currently sells for $65 per share and the
required return on the stock is 10 percent. You also know that the total return on the stock is evenly
divided between capital gains yield and a dividend yield. If it's the company's policy to always
maintain a constant growth rate in its dividends, what is the current dividend per share?
D0 ( 1+ g ) D TR = Dividend yield + Capital gain yield
R= + g= 1 + g
P0 P0 D1
R= +g
P0
D0 ( 1+0.05 ) 1.1 = 0.05+0.05
0.1= +0.05
65 g = 0.05
3.25= D 0 (1.05)

D0 = $3.1

Q10. Growth Rates. The stock price of Jenkins Co. is $53. Investors require a 12 percent rate of return on
similar stocks. If the company plans to pay a dividend of $2.85 next year, what growth rate is expected
for the company's stock price?
D0 ( 1+ g ) D
R= + g= 1 + g
P0 P0
2.85
0.12 = +g
53
g = 0.0662 or 6.62%

Q12. Stock Valuation. Olympis Sisters will pay a dividend of $2.60 next year. The company has stated that
it will maintain a constant growth rate of 4.5 percent a year forever. If you want a 15 percent rate of
return, how much will you pay for the stock? What if you want a 10 percent rate of return? What does
this tell you about the relationship between the required return and the stock price?

D 0 ( 1+ g ) D1 D0 ( 1+ g ) D1
R= + g= +g R= + g= +g
P0 P0 P0 P0
2.6 2.6
0.15 = +0.045 0.1 = +0.045
P0 P0
P 0 = $24.7 P 0 = $47.27
● The higher return expectations, the stock will be sold at lower price.
● The stock price is very sensitive towards the require rate of return.

Extra Problem (Example)

1. BMW Ltd is about to be listed on the share market. You determine that BMW's required return is 16.55%.
Today’s dividend is $1.10 and after analysing their future prospects you forecast their dividend in a year's time
will be $1.20. You expect this dividend to grow by 12% for the next two years after that and then settle down to
a constant growth of 3% pa thereafter. What is a fair price for a BMW share?

D1=1.2 D4 CF0=0;
D2=1.2(1.12) =1.344 p3 = C01=1.2; F01=1;
D3=1.344(1.12) =1.505 R−g C02=1.344; F02=1;
D4=1.505(1.03) =1.55 1.55 C03=1.505; F03=1;
=
0.1655− 0.03 C04=1.55+12.99; F04=1;
I=16.55; CPT NPV= 10.01
= $11.44

Extra Tute Question (Practice)

ABC Bhd’s dividends are expected to grow at a rate of 20% per year for the next two years. At the end of the
two years, ABC dividend growth is expected to grow at 5% indefinitely. ABC has just paid a dividend of $1.10.
Compute the current value of this stock if the required rate of return is 15%.

D0=1.1 D3 CF0=0;
D1=1.1(1.2) =1.32 p2= C01=1.32; F01=1;
D2=1.32(1.2) =1.584 R−g C02=1.584; F02=1;
D3=1.584(1.05) =1.6632 1.6632 C03=1.6632+16.632; F03=1;
=
0.15− 0.05 I=15; CPT NPV= 14.37
= 16.632
 TOPIC 10 - RISK AND RETURN
Q11.1 Diversifiable and Nondiversifiable Risks. In broad terms, why is some risk diversifiable? Why are
some risks non-diversifiable? Does it follow that an investor can control the level of unsystematic risk
in a portfolio, but not the level of systematic risk?
Diversifiable Non-diversifiable
Company/Firm- Specific Risk Market Risk
Portfolio of stocks Everybody affected
Unsystematic Systematic

Q11.3 Systematic versus Unsystematic Risk. Classify the following events as mostly systematic or mostly
unsystematic. Is the distinction clear in every case?
a) Short-term interest rates increase unexpectedly. Systematic
b) The interest rate a company pays on its short-term debt borrowing is increased by its bank. Un
c) Oil prices unexpectedly decline. Sys/Un
d) An oil tanker ruptures, creating a large oil spill. Un
e) A manufacturer loses a multimillion-dollar product liability suit. Un
f) A Supreme Court decision substantially broadens producer liability for injuries suffered by product
users. Sys

Q11.5 Expected Portfolio Returns. If a portfolio has a positive investment in every asset, can the expected
return on the portfolio be greater than that on every asset in the portfolio? Can it be less than that on
every asset in the portfolio? If you answer yes to one or both questions, give an example to support
your answer.
● ERpf > E R s (Wrong, Only some, not every, average will be higher) Vice versa
● Mostly equal

Questions and Problems

Q7. Calculating Returns and Standard Deviations.
(a) Based on the following information, calculate the expected return and standard deviation for the two
stocks.
State of Probability of Rate of return if State Occurs
Economy State of Economy Stock A Stock B
Recession .20 .01 -0.25

Normal .55 .09 .15

Boom .25 .14 .38

n n
E ( R )=∑ ❑ pi Ri=∑ ❑ pi=1
i=1 i=1
E ( R A )=0.2 ( 0.01 ) +0.55 ( 0.09 ) +0.25 ( 0.14 )=0.0865∨8.65 %

E ( R B )=0.2 ( − 0.25 )+ 0.55 ( 0.15 ) +0.25 ( 0.38 )=0.1275∨12.75 %

n
σ 2=∑ ❑ p i ¿
i=1

Stock A

2 2 2 2
σ =0.2 ( 0.01− 0.0865 ) + 0.55 ( 0.09− 0.0865 ) +0.25 ( 0.14 −0.0865 )
¿ 0.001905
σ =0.0436 = 4.36%
Stock B

2 2 2 2
σ =0.2 (− 0.25 −0.1275 ) +0.55 ( 0.15 −0.1275 ) +0.25 ( 0.38 − 0.1275 )
¿ 0.04471875
σ =0.2115= 21.15%

(b) What is the expected return on a portfolio consisting of 80% in A and the balance in B?
( Use when no σ is required ¿
m
E( R P )=∑ ❑w j E( R j)
j=1

E ( R P )=0.8 ( 0.0865 )+ 0.2 ( 0.1275 )=0.0947=9.47 %

(c) What is the standard deviation of the portfolio in (b)?

Portfolio returns in boom¿ 0.8 ( 0.14 )+ 0.2 ( 0.38 )=0.188=18.8 %
Portfolio returns in normal¿ 0.8 ( 0.09 ) +0.2 ( 0.15 )=0.102=10.2 %
Portfolio returns in recession¿ 0.8 ( 0.01 ) +0.2 ( −0.25 ) =−0.042=4.2 %
Expected returns of portfolio¿ 0.2 ( −0.042 ) +0.55 ( 0.102 ) +0.25(0.188)=0.0947=9.47 %

Variance of Portfolioσ 2 = Σ pi (Ri – E(R)) 2

= 2 2 2
0.2 ( −0.042 −0.0947 ) + 0.55 ( 0.102 −0.0947 ) + 0.25 ( 0.188 − 0.0947 )

0.00594291
=
❑
Standard deviation of Portfolioσ = 0.0771= 7.71%

Q12. Calculating Portfolio Betas. You own a portfolio equally invested in a risk-free asset and two stocks.
If one of the stocks has a beta of 1.45 and the total portfolio is equally as risky as the market, what
must the beta be for the other stock in your portfolio
βp = ΣWiβi

1 1 1
A + B + Rf = 1B
3 3 3
 1 1 1
(1.45) + B + (0) = 1
3 3 3
1.45+ B+0=3
B = 1.55

Q13. Using CAPM. A stock has a beta of 1.25, the expected return on the market is 11.7 percent, and the
risk-free rate is 3.5 percent. What must the expected return on this stock be?
CAPM E(R) = [E(RM) – Rf]β + Rf

E(R) = [0.117-0.035]1.25 + 0.035

E(R) = 0.1375 or 13.75%

Q16. Using CAPM. A stock has an expected return of 12.5 percent and a beta of 1.40, and the expected
return on the market is 10.9 percent. What must the risk-free rate be?
CAPM E(R) = [E(RM) – Rf]β + Rf

0.125 = [0.109- R f]1.4 + Rf

-0.0276 = -1.4 R f + Rf

-0.4 Rf = -0.0276

R f = 0.069 or 6.9%

Extra Tute Question (Topic 8 – Risk and Return)

*Consider the following details for two shares, Share A and B.

State of economy Probability RA RB

Boom 30% 25% 30%

Normal 50% 15% 20%

Recession 20% 5% -10%

(a) What is the expected return for each share?

n n
E ( R )=∑ ❑ pi Ri=∑ ❑ pi=1
i=1 i=1

E ( R A )=0.3 ( 0.25 ) +0.5 ( 0.15 )+ 0.2 ( 0.05 )=0.16=16 %

E ( R B )=0.3 ( 0.3 )+ 0.5 ( 0.2 )+ 0.2 ( − 0.1 )=0.17=17 %
(b) What is the risk for each share?
Share A
2 2 2 2
σ =0.3 ( 0.25 −0.16 ) +0.5 ( 0.15 −0.16 ) + 0.2 ( 0.05 − 0.16 )
¿ 0.0049
σ =0.07 = 7%
Share B
2 2 2 2
σ =0.3 ( 0.3 −017 ) +0.5 ( 0.2 −0.17 ) + 0.2 ( − 0.1− 0.17 )
¿ 0.0201
σ =0.1418= 14.18%

(c) What is the expected return on a portfolio consisting of 40% in Share A and 60% in Share B?
m
E( R P )=∑ ❑w j E( R j)
j=1

E ( R P )=0.4 ( 0.16 ) +0.6 ( 0.17 )=0.166=16.6 %

(d) What is the risk of the portfolio in (d)?

Portfolio returns in boom¿ 0.4 ( 0.25 )+ 0.6 ( 0.3 ) =0.28=28 %
Portfolio returns in normal¿ 0.4 ( 0.15 )+ 0.6 ( 0.2 )=0.18=18 %
Portfolio returns in recession¿ 0.4 ( 0.05 )+ 0.6 (− 0.1 )=− 0.04=4 %
Expected returns of portfolio¿ 0.3 ( 0.28 ) +0.5 ( 0.18 ) +0.2(−0.04)=0.166=16.6 %

Variance of Portfolioσ 2 = Σ pi (Ri – E(R)) 2

= 2 2 2
0.3 ( 0.28 −0.166 ) + 0.5 ( 0.18− 0.166 ) +0.2 ( −0.04 − 0.166 )

0.012484
=
❑
Standard deviation of Portfolioσ = 0.1117= 11.17%
 TOPIC 11 - COST OF CAPITAL

Q12.1 WACC. On the most basic level, if a firm's WACC is 12 percent, what does this mean?
● You must have at least a rate of return of 12%
● ≥12%, more, better
Q12.4 WACC and Taxes. Why do we use an aftertax figure for cost of debt but not for cost of equity?
● Stocks- Dividend- Owners/Stockholders
● Bonds/Loans- Interest- Fixed amount- Interest exp is tax deductable

Q3 Calculating Cost of Equity. Stock in Matta Ltd has a beta of 0.90. The market risk premium is 7
percent, and T-bills are currently yielding 4 percent. Matta's most recent dividend was $1.90 per share,
and dividends are expected to grow at a 5 percent annual rate indefinitely. If the stock sells for $40 per
share, what is your best estimate of Matta's cost of equity
SML/CAPM: RE = Rf + β (Rm – Rf)

RE = 0.04 + 0.9 (0.07)

RE = 0.103 or 10.3%

DGM: RE = D1/Re + g

1.995
RE = +0.05
40
RE = 0.099875 or 9.99%
 Average cost of equity= (SML+DGM)/2

= (10.3%+9.99%)/2

= 0.1014 or 10.14%

Q6 Calculating Cost of Debt. ICU Window, Inc., is trying to determine its cost of debt. The firm has a
debt issue outstanding with seven years to maturity that is quoted at 108 percent of face value. The
issue makes semi-annual payments and has an embedded cost of 7.4 percent annually. What is ICU's
pretax cost of debt? If the tax rate is 39 percent, what is the aftertax cost of debt?
N=14; PV=± 1,080; FV=1,000; PMT=37; CPT I/Y=2.99% (Semiannual)
RD= 2.99% x 2= 5.98%
After tax cost of debt = RD(1-TC)
= 0.0598(1-0.39)
= 0.036478 or 3.65%

Q9 Calculating WACC. Mullineaux Corporation has a target capital structure of 60 percent common stock,
5 percent preferred stock, and 35 percent debt. Its cost of equity is 11 percent, the cost of preferred
stock is 5.5 percent, and the cost of debt is 7.2 percent. The relevant tax rate is 35 percent.
a. What is Mullineaux's WACC?

WACC = wERE + wDRD(1-TC) + wPRP

= 0.6(0.11) + 0.35(0.072) (1-0.35) + 0.05(0.055)

= 0.08513 = 8.51%

b. The company president has approached you about Mullineaux's capital structure. He wants to
know why the company doesn't use more preferred stock financing, since it costs less than debt.
What would you tell the president?

● After tax cost of debt R D AT = RD(1-TC)

= 0.072 (1-0.35)
= 0.0468 or 4.68%
● Lower than Ps

Q10 Taxes and WACC. Zymaca Mining has a target debt-equity ratio of .55. Its cost of equity is 14
percent, and its cost of debt is 8 percent. If the tax rate is 35 percent, what is the company's
WACC?
Total Capital = D+E
= 0.55+1 =1.55

WACC = wERE + wDRD(1-TC)

1 0.55
= ( 0.14 ) + ( 0.08 ) (1 − 0.35 )
1⋅55 1⋅55
= 0.108774193 or 10.88%
Extra Tute Question

A corporation has 10,000 bonds outstanding with a 10% coupon rate and semiannual coupons, has a face value
of $1,000, 20 years to maturity and is selling for $1,197.93.

The company’s 150,000 shares of preferred stock pays a $2.50 annual dividend, and sell for $36 per share.

The company’s has 1,000,000 shares of common stock. The next dividend payment by will be $2.45 per share.
The dividends are anticipated to maintain a 5.5 percent growth rate, forever. The stock currently sells for
$49.50 per share,

Assuming a 40% tax rate, what is the company’s WACC?

MV > Weightage > Cost > WACC

(a) What is the market value of the bonds?

10,000 x $1,197.93= $11,979,300
(b) What is the return required by bond holders?
N=40; PV=-1197.93; FV=1,000; PMT=50; CPT I/Y= 4 (semi-annual)
YTM= 4x2 =8%

(c) What is the market value of the preference shares?

150,000 x $36= $5,400,000
(d) What is the return required by preferred shareholders?
R P = D / P0
= 2.5/36
= 0.069444 =6.94%
(e) What is the market value of the common stock?
1,000,000 x $49.5= $49,500,000
(f) What is the return required by common stockholders?
RE = D1/Re + g
= 2.45/49.5+ 0.055
= 0.104494949= 10,45%

(g) What is the WACC?

Total MV= 66,879,300
WACC = wERE + wDRD(1-TC) + wPRP
= 0.74(0.1045) + 0.18(0.08) (1-0.4) + 0.08(0.0694)
= 0.091536559 =9.15%
 Topic 12 - CAPITAL BUDGETING: NPV & CAPITAL DECISIONS (Part 1)
Questions and Problems

Q8.3 Calculating Payback. Kleimner Manufacturing N.V. imposes a payback cutoff of three years for its
international investment projects. If the company has the following two projects available, should it
accept either of them?

● Payback A= 2+5000/19,000= 2.26 years

● Payback B= 3+12,000/55,000= 3.22 years
● Accept project A

Calculate the NPV of the projects if the required rate of return is 10%. Which project (s) should we
accept if both projects are i) mutually exclusive A and ii) independent? Both

Year Cashflow ($) A Cashflow ($) B

0 -45,000 -90,000

1 17,000 19,000

2 23,000 24,000

3 19,000 35,000

4 100,000 55,000
 Cash flow A Cash flow B
CF0= -45,000; CF0= -90,000;
C01= 17,000; F01=1; C01= 19,000; F01=1;
C02= 23,000; F02=1; C02= 24,000; F02=1;
C03= 19,000; F03=1; C03= 35,000; F03=1;
C04=100,000; FO4=1; C04= 55,000; FO4=1;
I= 10; CPT NPV= 72,039.14 I= 10; CPT NPV= 10,969.20

● Mutual Exclusive- Choose the best one

● Independent- As long as profitable (NPV>0)

Q8.4 Calculating AAR. You're trying to determine whether or not to expand your business by building a
new manufacturing plant. The plant has an installation cost of $17 million, which will be depreciated
straight-line to zero over its four-year life. If the plant has projected net income of $1,735,000,
$2,105,000, $1,945,000, and $1,342,000 over these four years, what is the project's average
accounting return (AAR)?
AAR= Average NI/ Average Book Value

Average NI= ($1,735,000+ $2,105,000+ $1,945,000+ $1,342,000)/ 4= $1,781,750

Average Book Value= (Initial Cost + Salvage Value)/2= $17,000,000/2= $8,500,000

AAR= 1,781,750/8,500,000= 0.209617647= 20.96%

Assume cut off @25% > 20.96% (Reject)

Q8.5 Calculating IRR. A firm evaluates all of its projects by applying the IRR rule. If the required return is 13
percent, should the firm accept the following project?

Year Cashflow ($)

0 -4,550

1 1,750

2 2,550

3 540

CF0=-4550;

C01=1,750; F01=1;

C02=2,550; F02=1;

C03=540; F03=1;

IRR CPT IRR= 3.61% <13% (Reject)