Diversification c costs associated with bankruptcy i

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diversification c. Costs associated with bankruptcy i. Lawyers’ costs ii. Assets sell for less than true value Risk-adjusted Discount Rates 1. Consistent with CAPM 2. Investors require higher returns for more risky ventures. 3. Discount rate is adjusted upward to compensate for risks involved in project 4. Cash flows are the expected value - risk adjustment made in discount rate, not cash flows. 5.
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1. If chance of bankruptcy, unsystematic risk is important 2. Risk-adjusted discount rate approach is most recognized method of incorporating risk into capital budgeting decision. 3. Financial manager MUST account for the risk of projects Cost of Capital You know what your stocks and bonds are selling for and you want to determine what investor’s required rate of return on them is. Input 1. D1 2. G 3. V (value) 4. Solve for K Cost of capital is the rate of return which a firm must earn on funds currently being invested to justify raising the funds to finance those assets. After tax cost of debt = before cost of debt(1- tax rate) Cost of preferred stock = preferred stock dividend / required rate of return Cost of common stock = (common stock dividend for year 1 / price that security is selling for) + g Leverage
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Substitution of fixed costs for variable costs. Once system is in balance, additions to sales will result in large increases in profits Two types of leverage 1. Operating a. Fixed costs in the production, sales, or management function 2. Financial a. Financing division i. Ex. interest charges, dividends 3. Both types of leverage involve a trade-off between risk and return
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