10/7/2014
Chapter 12
Estimating the Cost of
Capital
FINB423 Financial Management
7-1
The Cost of Capital
The Cost of Capital is the weighted average of the cost of
various sources of capital that a firm uses to fund its
investment.
These sources include
Case study 3: Cost of capital for Lowes.
Overview
Lowe's Companies, Inc. (stock ticker LOW) is a home improvement retailer. As of early 2012, it operated
over 1700 home improvement stores (giant hardware stores) in the United States, Canada, and Mexico. T
Financial
Information System
Jerome P. Aro
Wealth Maximization and
Risk
O Sensible financial decisions =
optimal financial decision
O Optimal financial decisions make
you better off than all the other
relevant alternatives, including doing
nothing at all.
8/21/2014
Chapter 7
Investment Decision Rules
FINB423 Financial Management
7-1
CAPITAL BUDGETING
Capital Budgeting: Process of selecting a capital
investment project for your business.
Capital Budgeting Objectives?
Maximize the value of the firm.
Maxi
9/16/2014
Problem 8.3
Problem 8.2
Year
Incremental Earnings Forecast ($000s )
Sales of Mini Mochi Munch
Other Sales
Cost of Goods Sold
Gross Profit
Selling, General & Admin.
Depreciation
EBIT
Income tax at 35%
Unlevered Net Income
1
9,000
2,000
(7,350)
3,
8/21/2014
Chapter 9
Valuing Stocks
FINB423 Financial Management
9-1
Valuing Stocks
How do investors decide whether to buy or sell a
stock?
What drives its value?
Return to Law of One Price, which implies that the
price of a security should equal the pre
9/16/2014
Problem 7.1
Problem 7.2
NPV = 12,000/1.1 10,000=909.09.
NPV = 200,000 + (1,000,000 / 1 + 0.20)9
= $6,193
Take it!
IRR = 12,000/10,000 1 = 20%
IRR = (1,000,000 / 200,000)1/9 1 =
19.58%
The cost of capital can increase by up to
10% without chan
10/13/2014
Problem 10.7
a.
Problem 10.33
a.
b.
c.
Standard deviation of returns variance 0.01867 13.66%
FINB423 Financial Management
7-1
Problem 10.34
a.
Beta
Stock
18 22
40
1
Market 30 10 40
A firm that moves independently has no systemic
risk, so be
10/24/2014
Problem 12.1
Problem 12.3
Alcoa has a higher equity cost of capital, because its E
coefficient is higher.
E(rE) = RF + E x [E(RM) - RF]
E(rE) = RF + E x [E(RM) - RF]
E(rE) = 3% + 0.57 (8% 3%) = 5.85%
E(rAlcoa) = RF + 2.0 x 0.05
E(rHormel)
8/21/2014
Chapter 8
Fundamentals of Capital
Budgeting
FINB423 Financial Management
8-1
8.1 Fundamental Principles of Project
Evaluation and Capital Budgteing
Fundamental Principles of Project Evaluation:
Project evaluation - the application of one or mor
10/24/2014
Problem 14.3
Problem 14.5
a. E[Value in one year] = 0.8(50) + 0.2(20) = 44
E = 44 / (1 +0.1) = $40 million
b. D = 20 / (1 + 0.05) = $19.05 million
Therefore, E = 40 19.05 = $20.95 million
c. Without leverage, r = 44 / 40 1 = 10%,
with leverage,
10/13/2014
Chapter 14
Capital Structure
in a
Perfect Market
FINB423 Financial Management
14-1
Equity Versus Debt Financing
Sources of long term financing:
Internal sources of capital - Retained earnings.
External sources of capital - Debt financing and
9/16/2014
Chapters 10 & 11
Measurements of Risk and
Return, Optimal Portfolio
Choice and Capital Asset
Pricing Model
FINB423 Financial Management
7-1
Return Measurements
Total dollar return = the return on an investment
measured in dollars.
Total dollar
Q1. A perpetuity-immediate pays X per year. Brian receives the first n payments, Colleen receives
the next n payments, and Jeff receives the remaining payments. Brian's share of the present value
of the original perpetuity is 40%, and Jeff's share is K.
C
Sample question solutions
Johan Maharjan
September 29, 2013
Q1
PV of Brians share= X.(Present value of an annuity immediate that pays 1 for n years) = 0.4 X
i
This implies that
Present value of an annuity immediate that pays 1 for n years =
1
i
1
1
(1 + i
Lecture 2: Annuities &
Perpetuities
Annuities
It is a sequence of payments with fixed frequency
The term annuity originally referred to annual payments (hence the
name), but it is now also used for payments with any frequency.
Annuities appear in many
Lecture 3: Valuing Bonds
Motivation for Studying Bond Valuation
Bond Fact: The U.S. debt market is more than twice the size of the combined
market capitalization of all U.S. stock markets. As of YE 2010, it was over $37
trillion! US equities of $14.3 tril
Lecture 4: Stock Valuations
1- 2
Valuing Stocks
Motivation for Valuing Stocks
How do investors decide whether to buy or sell a stock? What
drives its value?
Return to Law of One Price, which implies that the price of a
security should equal the present
Lecture 5: Valuing
Investment Opportunities
Motivation for Investment Decision Rules
We know that you should only undertake investment opportunities
that have positive NPVs.
Compare the PV of Benefits to the PV of the Costs
In practice, however, firms
Lecture 6
Fundamentals of Capital Budgeting
Learning Objectives
1. Given a set of facts, identify relevant cash flows for a capital
budgeting problem.
2. Explain why opportunity costs must be included in cash flows, while
sunk costs and interest expense m
Lecture 7
Overview of Key Concepts
Assumptions in this chapter
The project has average risk.
The firms debt-equity ratio is constant.
For now, it is assumed that the firm maintains a constant debt-equity ratio and that the
WACC remains constant over t
Quiz:
Jeff deposits 10 into a fund today and 20 fifteen years later. Interest is
credited at a nominal discount rate compounded quarterly for the
first 10 years, and at a nominal interest rate of 6% compounded
semiannually thereafter. The accumulated bal
Quiz 2:
You currently have $1000 in an account that pays a nominal
rate of interest of 8% compounded quarterly. You plan to
deposit $200 every two months with the first deposit one
month from now. What will be the value of the account one
month after the
Quiz 3
You have decided to invest in two bonds. Bond X is an n-year bond with
semiannual coupons, while bond Y is an accumulation bond (another name for
Zero Coupon Bond) redeemable in n/2 years. The desired yield rate is the same for
both bonds. You als
Quiz 4
The price of a share of stock issued by a certain company is 30 on January 1,
2000 . The price assumes annual dividends, with the first dividend due on
December 31, 2000 . The first dividend will be 1.65, with future dividends
expected to grow at a
Sample Mid-term exam solutions
Johan Maharjan
September 29, 2013
Q2
The Present Value of a perpetuity paying 1 at the beginning of each 6-month period =
20 d(2) = 0.10
d=1 1
0.10
2
2
d(2)
=
2
= 0.0975
v = 1 d = 0.9025
Since the second perpetuity pays X at
Finance 423
Mid-term Examination
Closed book, closed notes
Open calculator
20 points total
1.25 hours
Do not assume: ask for clarification
Name _
Signature _
Q1. Define perpetuity. Give an example. Why do you think perpetuity exist (after all no one lives
TIME VALUE OF MONEY
Lecture 1
Basic Concept
What do we mean by the time value of money?
Which one would you choose: $50 today or $60 today?
Which one would you choose: $50 today or $60 two years down the road?
We must be able to compare cash flows tha