MIDTERM FINMA REVIEWER

VALUATION AND RATES OF RETURNS

10-1. How is valuation of any financial asset related to future cash flows?

The valuation of a financial asset is equal to the present value of future cash
flows.

10-2. Why might investors demand a lower rate of return for an investment in
Microsoft as compared to United Airlines?

Because Microsoft has less risk than United Airlines, Microsoft has relatively high
returns and a strong market position; United Airlines has had financial difficulties
and emerged from bankruptcy in 2006.

10-3. What are the three factors that influence the required rate of return by
investors?

The three factors that influence the demanded rate of return are:

a. The real rate of return

b. The inflation premium

c. The risk premium

10-4. If inflationary expectations increase, what is likely to happen to yield to maturity

on bonds in the marketplace? What is also likely to happen to the price of
bonds?

If inflationary expectations increase, the yield to maturity (the required rate of

return) will increase. This will mean a lower bond price.

10-5. Why is the remaining time to maturity an important factor in evaluating the
impact of a change in yield to maturity on bond prices?

The longer the time period remaining to maturity, the greater the impact of a
difference between the rate the bond is paying and the current yield to maturity
(required rate of return). For example, a 2 percent ($20) differential is not very
significant for one year, but very significant for
20 years. In the latter case, it will have a much greater effect on the bond price.
10-6. What are the three adjustments that have to be made in going from annual to
semiannual bond analysis?

The three adjustments in going from annual to semiannual bond analysis are:

1. Divide the annual interest rate by two.

2. Multiply the number of years by two.

3. Divide the annual yield to maturity by two.

10-7. Why is a change in required yield for preferred stock likely to have a greater
impact on price than a change in required yield for bonds?

The longer the life of an investment, the greater the impact of a change in the
required rate of return. Since preferred stock has a perpetual life, the impact is
likely to be at a maximum.

10-8. What type of dividend pattern for common stock is similar to the dividend
payment for preferred stock?

The no-growth pattern for common stock is similar to the dividend on preferred
stock.

10-9. What two conditions must be met to go from Formula 10-7 to

Formula 10-8 in using the dividend valuation model?

To go from Formula (10-7) to Formula (10-8):

The firm must have a constant growth rate (g).

The discount rate (Ke) must exceed the growth rate (g).
10-10. What two components make up the required rate of return on common stock?

The two components that make up the required rate of return on common stock
are:

a. The dividend yield D1/P0.

b. The growth rate (g). This actually represents the anticipated growth in
dividends, earnings, and stock price over the long term.

10-11. What factors might influence a firm’s price-earnings ratio?

The price-earnings ratio is influenced by the earnings and sales growth of the firm, the
risk (or volatility in performance), the debt-equity structure
of the firm, the dividend policy, the quality of management, and a number of other
factors. Firms that have bright expectations for the future tend to trade at high P/E
ratios while the opposite is true of low P/E firms.

10-12. How is the supernormal growth pattern likely to vary from the normal, constant
growth pattern?

A supernormal growth pattern is represented by very rapid growth in the early years
of a company or industry that eventually levels off to more normal growth. The
supernormal growth pattern is often experienced by firms in emerging industries,
such as in the early days of electronics or microcomputers.

10-13. What approaches can be taken in valuing a firm’s stock when there is no cash
dividend payment?

In valuing a firm with no cash dividend, one approach is to assume that at some point
in the future a cash dividend will be paid. You can then take the present value of
future cash dividends.

A second approach is to take the present value of future earnings as well as a future
anticipated stock price. The discount rate applied to future earnings is generally
higher than the discount rate applied to future dividends.
COST OF CAPITALS

11-1. Why do we use the overall cost of capital for investment decisions
even when only one source of capital will be used (e.g., debt)?

Though an investment financed by low-cost debt might appear

acceptable at first glance, the use of debt could increase the overall
risk of the firm and eventually make all forms of financing more
expensive. Each project must be measured against the overall cost of
funds to the firm.

11-2. How does the cost of a source of capital relate to the valuation
concepts presented previously in Chapter 10?

The cost of a source of financing directly relates to the required rate

of return for that means of financing. Of course, the required rate of
return is used to establish valuation.

11-3. In computing the cost of capital, do we use the historical costs of

existing debt and equity or the current costs as determined in the
market? Why?

In computing the cost of capital, we use the current costs for the
various sources of financing rather than the historical costs. We must
consider what these funds will cost us to finance projects in the
future rather than their past costs.

11-4. Why is the cost of debt less than the cost of preferred stock if both
securities are priced to yield 10 percent in the market?

Even though debt and preferred stock may be both priced to yield 10
percent in the market, the cost of debt is less because the interest on
debt is a tax-deductible expense. A 10 percent market rate of interest
on debt will only cost a firm in a
35 percent tax bracket an aftertax rate of 6.5 percent. The answer is
the yield multiplied by the difference of (one minus the tax rate).

11-5. What are the two sources of equity (ownership) capital for the firm?

The two sources of equity capital are retained earnings and new
common stock.
11-6. Explain why retained earnings have an associated opportunity cost?

Retained earnings belong to the existing common stockholders. If the

funds are paid out instead of reinvested, the stockholders could earn
a return on them. Thus, we say retaining funds for reinvestment
carries an opportunity cost.

11-7. Why is the cost of retained earnings the equivalent of the firm’s own
required rate of return on common stock (Ke)?

Because stockholders can earn a return at least equal to their present

investment. For this reason, the firm’s rate of return (Ke) serves as a
means of approximating the opportunities for alternate investments.

11-8. Why is the cost of issuing new common stock (Kn) higher than the cost
of retained earnings (Ke)?

In issuing new common stock, we must earn a slightly higher return

than the normal cost of common equity in order to cover the
distribution costs of the new security. In the case of the Baker
Corporation, the cost of new common stock was six percent higher.

11-9. How are the weights determined to arrive at the optimal weighted
average cost of capital?

The weights are determined by examining different capital structures

and using that mix which gives the minimum cost of capital. We must
solve a multidimensional problem to determine the proper weights.

11-10. Explain the traditional, U-shaped approach to the cost of capital.

The logic of the U-shaped approach to cost of capital can be explained

through Figure 11-1. It is assumed that as we initially increase the
debt-to-equity mix, the cost of capital will go down. After we reach an
optimum point, the increased use of debt will increase the overall
cost of financing to the firm. Thus, we say the weighted average cost
of capital curve is U-shaped.
11-11. It has often been said that if the company can’t earn a rate of return
greater than the cost of capital, it should not make investments.
Explain.

If the firm cannot earn the overall cost of financing on a given project,
the investment will have a negative impact on the firm’s operations
and will lower the overall wealth of the shareholders.

Clearly, it is undesirable to invest in a project yielding 8 percent if the

financing cost is 10 percent.

11-12. What effect would inflation have on a company’s cost of capital?

(Hint:

Think about how inflation influences interest rates, stock prices,

corporate profits, and growth.)

Inflation can only have a negative impact on a firm’s cost of capital,

forcing it to go up. This is true because inflation tends to increase
interest rates and lower stock prices, thus raising the cost of debt and
equity directly and the cost of preferred stock indirectly.

11-13. What is the concept of marginal cost of capital?

The marginal cost of capital is the cost of incremental funds. After a

firm reaches a given level of financing, capital costs will go up
because the firm must tap more expensive sources. For example, new
common stock may be needed to replace retained earnings as a
source of equity capital.