Professional Documents
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Later:
Corporate Finance: (The Investment
Decision - Capital Budgeting)
Assets
Current Assets
Fixed Assets
Assets
Current Assets
Fixed Assets
Assets
Current Assets
Fixed Assets
Long-term Debt
Preferred Stock
Common Equity
Bonds
Preferred Stock
Common Equity
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Typically, the funds are raised through the sale of corporate bonds.
Net proceeds are the funds actually received by the firm from
the sale of a security.
Flotation costs are the total costs of issuing and selling a
security. They include two components:
1.
2.
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where
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adjusted
for taxes.
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EBIT
- interest expense
EBT
- taxes (34%)
EAT
- dividends
Retained earnings
with stock
400,000
0
400,000
(136,000)
264,000
(50,000)
214,000
with debt
400,000
(50,000)
350,000
(119,000)
231,000
0
231,000
1-
= Before-tax
After-tax
Marginal cost of
cost of
tax
Debt
Debt
rate
rd
rd (1 - T)
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rP = DP / P0
Since preferred stock is an external financing, we
should consider flotation costs associated with issuing
preferred stock
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rP
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where
P0
D1
rs
g
=
=
=
=
1.50
rs
.051 .1135 11.35%
(25 1)
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The CAPM technique differs from the constantgrowth valuation model in that it directly considers the
firms risk, as reflected by beta, in determining the
required return or cost of common stock equity.
The constant-growth model does not look at risk; it
uses the market price, P0, as a reflection of the
expected riskreturn preference of investors in the
marketplace.
The constant-growth valuation and CAPM techniques
for finding rs are theoretically equivalent, though in
practice estimates from the two methods do not always
agree.
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Opportunity costs
If managers are investing stockholders funds,
stockholders will expect to earn an acceptable rate
of return.
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Historical Weights
based on actual capital structure proportions.
Target Weights
Reflects the firms desired capital structure proportion.
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Weights
wN = N/V = percent financed with common equity
wp = P/V = percent financed with preferred stock
wd = D/V = percent financed with debt
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WACC = wd rd (1-T) + wp rp + ws rs
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Source
Cost
Capital
Structure
debt
preferred
common
10.62%
10.81%
11.35%
48.22 %
1.02 %
50.76 %
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Project IRR
SML
24%
17%
10%
1.3
2.0
k = 4% + 0.6(14% 4% ) = 10%
Required Return
20%
15%
10%
IRR
17%
18%
12%
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SM
L
rF FIRM ( rM rF )
Hurdle
rate
Incorrectly accepted
negative NPV projects
rF
FIRM
A firm that uses one discount rate for all projects may over time increase the risk
of the firm while decreasing its value
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2
+ 0.07 = 0.123, or 12.3%
40(1-0.05)
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RM63.6 mil
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IRR
8.7%
9.5%
8.0%
Initial Investment
RM40 mil
RM35 mil
RM25mil
IRR
9.5%
8.7%
8.0%
Initial Investment
RM35 mil
RM40 mil
RM25mil
Cumulative Investment
RM 35 mil
RM 75 mil
RM100 mil
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B (9.5%)
A (8.7%)
Investment
Opportunity Schedule
C (8.0%)
RM63.6 mil
RM35 mil
RM75 mil
RM100 mil
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