7/29/2019 FM II Midterm Formula Sheet

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Cost of Capital WACC

Cost of Debt

Apply tax savings1)

= rd (Tax savings) Where rd = Debt interest rate before tax (found using calculator ' i' )= rd (1 - Tax Rate)

After-Tax Component Cost of Debt = Interest Rate - Tax Savings

Find yield (interest rate) of debt using fi nancial calculator (bonds have pmt)1)

Pps (1 -F)Component Cost of Preferred Stock = R = D

Component Cost of Preferred Stock (R ) -The cost used in the weighted average cost of capital calculationPreferred stock are not tax deductible

Cost of Preferred Stock

Cost of Common Stock (Three Approaches) Use Average of All Three Methods in WACC

Step1: Estimate the risk-free rate (rrf)Step2: Estimate the current expected market risk premium (RPm) which is the ex pected market return minus the risk-free rateStep3: Es timate the stock's beta coefficient, (bi), and use it as an index of the stock's risk.Step 4: Plug in numbers into CAPM formula

= rRF + (rM - rRF) X b= Real Risk-Free Rate of Interest (r*) + Inflation Premium (I P) + [ return on market (rm) - Real Risk-Free Rate of Interest (r*) + Inflation Premium (I P)] X beta (bi)

CAPM Formula = rs = rRf + (RPm) X bi

The CAPM Approach1)

Prs = D + Expected g

Required Rate of Return on Equity:Dividend-Yield-Plus-Growth-Rate (Discounted Cash Flow (DCF)2)

rs = Bond Yield + Risk Premium

Bond-Yield-Plus-Risk-Premium Approach3)

WACC = w d (rd) ( 1 -T) + wps (rps) + wce (rs)

Calculating WAAC

Capital Structure

P - VQbe = F Where: F = Fixed Costs P = Sales Price Per Unit V = Variable Cost Per Unit

Operating Break-Even

WACC rsUValue of Leverage Firm = Value of Unleveraged Firm = EBIT = EBIT

MM Theory: Zero Taxes

rsuVu = S = EBIT (1-T) Where Vu = Value of Unleveraged firm EBIT = Earnings before interest and taxes rsu = cost of equity for unleveraged firm

Value of Unleveraged Firm

VL = VU + V tax shield Where VL = Value of Leveraged Firm Vu = Value of Unleveraged Firm V Tax Shield = Total Debt Used x Tax Rate (%)Value of Levered Firm

MM Theory: Corporate Taxes

(1-Td)VL = VU + [ 1 - (1 - Tc) (1 - Ts) ] D Where: Tc = corporate tax rate Td = personal tax rate on debt income Ts = personal tax rate on stock income

MM Theory: Personal & Corporate Taxes

Cashflows

FCF = Investment Outlay Cash Flow + Operating Cash Flow + NOWC Cash Flow + Salvage Cash FlowDefining a Project's Free Cash Flows:

CCA tax shield = CCA tax rateCCA Tax

Capital Budgeting

1. Prepare a table showing the cash flows during each ye ar of the proposed project.2. Compute the present value of each cash flow, usi ng a discount rate (WACC) that reflects the cost of acquiri ng investment capital. This discount rate is often called the hurdle rate or minimum desired rate of return .3. Compute the net present value , which is the sum of the present value s of the cash flows.4. Compare NPV of projects. Accept the proje ct proposal with largest net present value (NPV) equal to or greater than zer o. Reject other project.

Discounted Cash Flow AnalysisNet Present Value

Enter the Initial Inve stment as a negative into CF register at Year 01)Enter cost savings in CF register for each year2)Compute IRR3)

If the IRR i s equal to or greater than the hurdle aka WACC ( discount rate/cost of acquiring investment capital) , accept investment proposal1)Decision Rule

Internal Rate of Return

First, enter cash inflows i n the financial calculator register1)Find NPV2)Find PV of inflows (NPV)3)Find PV of outflows4)Find i using PV of outflows as PV and PV of inflow s as FV5)

Constant FlowModified Rate of Return

Cash Inflow during full recovery year (cash inflow for the year the project becomes positive)Payback = Number of Years that have passed before full recovery + Unrecovered cost at start of year (cost after all previous cash inflows have been taken out from initial outflow)

Payback Period

D = Prefe rred DividendP = The Preferred Stock PriceF = Flotation cost as a percentage of price, can also be dollar amount(Underwriting Cost)

{All three are same formulas}

D = Dividend expected to be paid at end of year 1 (If not given, apply growth rate to D )g = Expected growth rate

Where: P = Current Price of Stock

Where wd = Weight of debtwps = Weight preferred stockwce = Weight common equity

rd = Cost of debt before taxrps = Cost of preferred stockrs = Cost of common stock

Percentage Flotation Cost

[1+rd (1-t)]^t (1+rd (1 - T)^N f = % Flotation costs INT = $ interest per periodt = Tax rate rd (1-t) = after tax cost of debt

M (1 - F ) = INT ( 1 -T) + M . Where: M = Bond par value N = # of pmts

Using CalculatorN = Number of payments PV = Bond Par Value ( 1 -F) PMT = Payment (1-T) FV = Bond Par Value

Solve for i/y

Cost of New Common Equity = (re)

P ( 1 -F )re = re = ___ D ____ + g

Flotation Costs = (F)

Adjusting the Cost of Stock for Flotation Costs

FM II: Midterm Formula SheetFebruary-23-138:28 PM

Textbook Reading Notes Page 1