Finance (Managerial) 212 Semester 2, 2009 Review

Cost of Capital
Cost of Debt o rd*(1-t) o This is because interest payments are tax deductible o To find the cost of debt, find the Yield-to-Maturity of a bond, remember that if the bond is trading at par the YTM = coupon rate Cost of Preference Shares o A preference share is essentially the same as a perpetuity, therefore the o
rp = Dp P0

o Remember that dividends are paid from after-tax income, so essentially this is already considered and after-tax cost. Cost of Equity o DDM Uses the concept of the Present Value of future cash flows, so essentially you are trying to find the rate that will make the present value of the future cash flows (dividends) equal to the current price D rs = 1 + g P0 Where D1 = D0(1+g) And where g = Retention rate * ROE Retention rate = 1-payout ration ROE = NI/Equity (both of which are accounting values) o CAPM Looks at the cost of equity as an opportunity cost of capital, what should you earn on the security, given the risk that you are taking, and the return that you could earn on a risk-free asset and the market as a whole. rs = rrf + b( rm rrf ) WACC o Weighted average cost of capital is the average cost of each component cost of capital, where the weights are determined by the market value of the securities.

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o WACC = wd * rd * ( 1 t ) + wp * rp + ws * rs Floatation Costs o As firms have to hire underwrites to issue new securities, there are always a flotation cost involved in this issue of the new securities. If there is a flotation cost, then you have to calculate the Net Price (i.e. What you (the company) will receive from the sale). o Net Price = Price-flotation cost ($) = Price *(1-floatation %) o This means that the cost of NEW securities will always be higher that existing securities, because the moneys received will be less than the full price.

Capital Budgeting
NPV Cash flows o It is very important that you be able to differentiate between expenses and cash flows. o Cash flows are what you need to use, however you need to look at the expenses to see if it has any tax effect. If it does, then you need to take these into consideration. Opportunity Cost (Depreciation Expense (tax savings) forgone) o Remember that when you are replacing an existing machine, you need to consider the opportunity cost of selling that machine. IF you sell a machine that still has a depreciable value, then you need to consider, that you will no longer be able to depreciate that machine, therefore you income will increase, which means you will have to pay more tax You also need to consider that you if you sell the machine at t=0 (i.e., when you buy the new machine) then will not be able to sell it later (if it has any value left), so again selling it now, you are losing the opportunity to sell it later. MIRR vs IRR (see article on blackboard) EAV o Remember that if you have projects that have unequal lives (one project is longer than the other) you cannot use NPV as a means of deciding which project is better. This means that you need to use EAV. Essentially you are trying to find the PMT, to see that if you made the same cash flows each year for the life of the project, how much you would make each year. (PMT in the present value of an ordinary annuity, see TVM chapter for more details)

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Capital Structure
MM Prop I and Prop II (without taxes and with taxes) o You need to understand how the different capital structure theories will affect the value of a company. Look at the figure 14-9. o Also you need to understand the maximizing share value (minimizing WACC) is NOT the same as maximizing the EPS of share. Recapitalization o New stock price o New cost of equity using Hamada re-levering of beta

Derivative Securities
o Risk Management and 7 reasons for risk mgt o Options
Options CALL PUT "RIGHT to BUY" "RIGHT to SELL" Buyer / Holder Long BUY the "RIGHT to BUY" BUY the "RIGHT to SELL"

Seller / Writer

Short

SELL the "RIGHT to BUY"

SELL the "RIGHT to SELL"

o You need to look at how the price (premium) of an option changes when the spot price changes, and need to look at how time to maturity will change the value of an option. o Be able to separate out the Exercise Value (Intrinsic Value) and option premium (time value) of an option (both for put and call options) Futures vs. Forward o You need to be able to differentiate between a futures and a forward contact. Hedging o Why might companies hedge, input price risk o What is a short hedge, what is a long hedge? Swaps o What are swaps, and how can they be used to manage the risk of a company?

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