- •What are agency costs, and who bears them?
- •Identify some factors beyond a firm’s control that influence its stock price.
- •Define ebitda and please define the reasons of calculating ebitda.
- •Explain statement of cash flows and types of questions it answers.
- •Identify and briefly explain the 3 different categories of activities shown in the statement of cash flows.
- •Define net operating working capital and total operating capital.
- •Determine nopat and explain why it might be a better performance measure than net income.
- •Define free cash flow and explain why free cash flow the most important determinant of a firm’s value.
- •Define the terms “Market Value Added”(mva) and “Economic Value Added (eva)”. Explain the differences between eva and accounting profit.
- •Determine characteristics of liquid assets and identify the ratios that are used to analyze a firm’s liquidity position and write out their equations.
- •Identify 4 ratios that are used to measure how effectively a firm is managing its assets, and write out their equations.
- •Explain the financial leverage and usage of financial leverage.
- •Identify and write out the
- •Describe 3 ratios that relate a firm’s stock price to its earnings, cash flow, and book value per share, and write out their equations.
- •Explain the calculation of book value per share and explain how inflation and goodwill cause book values to deviate from market values.
- •Define the usage of Du Pont system to analyze ways of improving the firm’s performance.
- •Define the standard deviation and coefficient of variation, and explain which one is a better measure for performance.
- •Explain the following statement: “most investors are risk averse”. Explain the relationship between risk aversion and rates of return.
- •Determine Security Market Line and construction of this line.
- •Explain Market Risk Premium and calculation.
- •Explain the correlation between returns on a project and returns on the firm’s other assets affect the project’s risk.
- •Define floating rate bonds and zero coupon bonds.
- •Define convertible bonds, bonds with warrants, income bonds, and indexed bonds.
- •Explain the reasons why bonds with warrants and convertible bonds have lower coupons than similarly rated bonds that do not have these features.
- •Explain what happens to the price of a fixed-rate bond if (1) interest rates rise above the bond’s coupon rate or (2) interest rates fall below the bond’s coupon rate.
- •Explain why prices of fixed-rate bonds fall if expectations for inflation rise. Define discount bond and a premium bond.
- •Explain the yield to maturity and yield to call, and describe their differences.
- •Differentiate between interest rate risk and reinvestment rate risk.
- •To which type of risk are holders of long-term bonds more exposed and short-term bondholders?
- •Explain and define mortgage bonds, debentures, and junk bonds.
- •Explain reasons for the existence of the preemptive right
- •Explain the reasons why a company uses classified stocks.
- •Define and differentiate between a closely held corporation and a publicly owned corporation
- •Define and differentiate between primary, secondary markets and ipo.
- •Determine the capital gains yield and the dividend yield of a stock.
- •Define the two parts of most stock’s expected total return.
- •Write out and explain the valuation formula for a constant growth stock.
- •Define the conditions that a company must hold if a stock to be evaluated using the constant growth model.
- •Explain how one would find the value of a supernormal growth stock.
- •Explain what is meant by terminal date and terminal value?
- •Define the conditions for a stock to be in equilibrium.
- •42.Efficient markets hypothesis.
- •Define the difference among the three forms of efficient market hypothesis: (1) weak form, (2) semistrong form, and (3) strong form.
- •2. Semi-Strong emh
- •3. Strong-Form emh
- •Explain the following statement: “Preferred stock is a hybrid security”.
- •Identify the firms 3 major capital structure components, and give their respective component cost symbols.
- •Explain the reasons of using after-tax cost of debt rather than the before-tax cost in calculating the weighted average cost of capital.
- •Explain three approaches that are used to estimate the cost of common equity.
- •Identify some problems with the capm approach.
- •Explain the two approaches that can be used to adjust for flotation costs.
- •Write out the equation for the weighted average cost of capital and explain.
- •Explain the calculation of debt structure in the capital structure used to calculate wacc.
- •Define the two factors that affect the cost of capital that are generally beyond the firm’s control.
- •Explain how a change in interest rates would affect each component of the weighted average cost of capital.
- •Three types of project risk and show the level of relevance.
- •Describe the pure play and the accounting beta methods for estimating individual project’s betas.
- •Identify some problem areas in cost of capital analysis. Explain how they invalidate the cost of capital procedures.
- •Define the determination of the capital structure weights that are used to calculate the wacc
Explain three approaches that are used to estimate the cost of common equity.
There are three methods one can use to derive the cost of retained earnings: a) Capital-asset-pricing-model (CAPM) approach
b) Bond-yield-plus-premium approach
c) Discounted cash flow approach
a) CAPM Approach
To calculate the cost of capital using the CAPM approach, you must first estimate the risk-free rate (rf), which is typically the U.S. Treasury bond rate or the 30-day Treasury-bill rate as well as the expected rate of return on the market (rm).
The next step is to estimate the company's beta (bi), which is an estimate of the stock's risk. Inputting these assumptions into the CAPM equation, you can then calculate the cost of retained earnings.
Formula 11.3
– CAPM
– Risk-free rate
- risk premium
Example: CAPM approach
For Newco, assume rf = 4%, rm = 15% and bi = 1.1. What is the cost of retained earnings for Newco using the CAPM approach?
Answer: ks = rf + bi (rm - rf) = 4% + 1.1(15%-4%) = 16.1%
b) Bond-Yield-Plus-Premium Approach
This is a simple, ad hoc approach to estimating the cost of retained earnings. Simply take the interest rate of the firm's long-term debt and add a risk premium (typically three to five percentage points):
Formula 11.4
Example: bond-yield-plus-premium approach
The interest rate on Newco's long-term debt is 7% and our risk premium is 4%. What is the cost of retained earnings for Newco using the bond-yield-plus-premium approach?
Answer: ks = 7% + 4% = 11%
c) Discounted Cash Flow Approach
Also known as the "dividend yield plus growth approach". Using the dividend-growth model, you can rearrange the terms as follows to determine ks.
Formula 11.5
Example: discounted cash flow approach Assume Newco's stock is selling for $40; its expected return on equity (ROE) is 10%, next year's dividend is $2 and the company expects to pay out 30% of its earnings. What is the cost of retained earnings for Newco using the discounted cash flow approach? Answer: g must first be calculated: g = (1-0.3)(0.10) = 7.0% ks = 2/40 + 0.07 = 0.12 or 12%
Identify some problems with the capm approach.
The first problem, if a firm’s stockholders are not well diversified, they may be concerned with stand-alone risk rather than just market risk. In that case, the firm’s true investment risk would not be measured by its beta, and the CAPM procedure would understate the correct value of ks. Further, even if the CAPM method is valid, it is hard to obtain correct estimates of the inputs required to make it operational because (1) there is controversy about whether to use long-term or short-term Treasury yields for kRF, (2) it is hard to estimate the beta that investors expect the company to have in the future, and (3) it is difficult to estimate the market risk premium.
Explain the two approaches that can be used to adjust for flotation costs.
The first approach simply adds the estimated dollar amount of flotation costs for each project to the project’s up-front cost. The estimated flotation costs are found as the sum of the flotation costs for the debt, preferred, and common stock used to finance the project. Because of the now-higher investment cost, the project’s expected rate of return and NPV are decreased.
The second approach involves adjusting the cost of capital rather than increasing the project’s cost. If the firm plans to continue to use the capital in the future, as is generally true for equity, then this second approach is better. The adjustment process is based on the following logic. If there are flotation costs, the issuing company receives only a portion of the total capital raised from investors, with the remainder going to the underwriter. When calculating the cost of common equity, the DCF approach can be adapted to account for flotation costs. For a constant growth stock, the cost of new common stock, ke, can be expressed as:
Cost of equity from new stock issues = ke =