173A notes

# 173A notes - Definitions: Capital Components:common stock,...

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Definitions: Capital Components:common stock, preferred stock, debt Component cost: required rate of return on each of the capital components Weighted average cost of capital (WACC): weighted average of all the cost components Target capital structure: say a firm is 60% common equity, 10% preferred and 30% debt, thats its capital structure Cost of Debt (rate of return debtholders require * (1-tax)) This is also called cost of New debt Cost of preferred stock (preferred dividends / net issuing price) Net issuing price is the price firms receive after deducting floating costs Ex. of costs of preferred stock: Say X has pref. Stock, Dividend = 10\$ / share, selling price = 100\$ / share, floatation = 2.5% or 2.5\$ / share, therefore it would be 10/(100-2.5) = 10.3 % Costs of common equity This occurs because the investors could otherwise reinvest their money somewhere else, so to stay with the company they need a rate of return to match the investments they could get elsewhere 3 methods to calculate: 1) CAPM MODEL: Finding Rm using DCF model, rm = ((d0*(1+g))/p0) + g = RF + Rpm = Rm, with RM calculate the return on equity by using CAPM model 2) DCF APPROACH: Rs= ((Do*(1+g))/Po) + G 3) BOND YIELD + BOND RISK PREMIUM APPROACH: just bond yield + bond risk premium WEIGHTED AVERAGE COST OF CAPITAL: % of structure thats debt * RoR debtholders want * (1-t) + % of structure thats preferred stock + preferred dividends / (pref stock price – floating costs) + % of structure thats equity * Rs | | | NOTE: Rs is cost of common equity, use one of the three methods Cost Of New (External) Equity: Re = ((Do*(1+g))/(Po*(1-F))) + G, F = Flotation cost %age, this all calculates the required return for new eq. Quiz Problems: Quiz #6: Problem #1: RR = 13%, RFR = 7%, MRP = 4%, suppose MRP increases 2%, whats new RR? first find Beta, .13 =.07 + x *.4; .06 = .04x; x = 1.5, now plug in new mrp of .06 and solve x = .07 + (.06)*1.5 = 16%. Problem 2. d1 = 3, g = 7%, B = 1.667 and is in equilibrium, RR on stock = 14%, RM = 10%, ppl think rm will increase 25% and RFR is unchagned, whats the new price of stock? First find RFR; .14= RF + (.1-RF)*1.667, .14 - .1667 = RF – 1.667 RF; -.0267 = -.667RF; RF = 4%; now use CAPM, RM = .04 + ((.1*1.25) - .04) * 1.667 = 18.2%; Now use gordon model, Vt = 3 / (.182 - .07) = 26.87\$ Problem 3 A has beta 1.5, B has beta .5, this means that as part of a diversified portfolio, the expected return on stock A is greater than expected return on B Problem 4 X has 20m\$ portfolio, beta is 1.5, RFR = 4.5%, MRP = 5.5%, x will receive 5 Mill in additional funds which he will invest, wants RoR = 13\$, what must the avg beta of new stocks be? First calculate weights, 20m / (20m+5m) = 80%, so weight of the new funds is 20%, next calculate the beta of the entire portfolio, which is (.13 - .045) / .055 = 1.546, now then, total beta = weight of old beta * old beta + weight of new beta * new beta, so 1.546 = .8 * 1.5 + .2*x, solve for x, x = 1.73 Project classifications: Replacement (maintenance) –

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## This note was uploaded on 09/08/2010 for the course BUS 171A at San Jose State.

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173A notes - Definitions: Capital Components:common stock,...

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