Shareholder Value
Name:
Midterm
Spring 2020
Multiple Choice
1. Shareholder value refers to:
a. The WACC of a Company
b. The balance sheet of a Company
c. Is thought of as the measure of a Company’s success to the extent to which it
enriches shareholders
d. None of the above
2. A Company’s earnings process includes all of the following except:
a. An analysts call for investors and analysts
b. An earnings announcement
c. A budget review
d. Future earnings expectations
3. Capital budgeting is:
a. A process whereby companies make decisions where to invest funds for the future
b. Includes analyzing project for optimal returns
c. Requires the WACC to be at different rates
d. A & B
e. All of the above
4. Projects which typically have low or negative returns include:
a. Regulatory Projects
b. Marketing Projects
c. New Acquisitions
d. All of the Above
e. None of the Above
5. What is one of the major differences between an economic P&L versus an accounting
P&L
a. The application of GAAP
b. The treatment of Non-cash (eg depreciation, amortization, etc)
c. The treatment of deferred revenue
d. A and B
e. B and C
6. Which statement is true:
a. As the WACC decreases, the NPV increases
b. As the WACC decreases, the NPV decreases
c. As the WACC increases, the NPV increases
d. The NPV is not impacted by changes in WACC
7.
8.
Capital budgeting includes:
a. Estimating operating expenses
b. Project analysis
c. Determining where a company should invest
d. Both A and B
e. Both B and C
Which is true about common stock and preferred stock
a. Common stock does not allow voting rights for the shareholder
b. Preferred stock and common stock represent ownership in a Company
c. For both, the investors return is tied to the performance of the Company and may
result in a gain or loss
d. All of the Above
e. Both b and c
9.
A Company has interest expense of $25 million and $200 million in debt. The Company
has no equity. The tax rate is 30%. What is the cost of debt?
10. A Company has debt of 40% and equity of 60%. The cost of debt is 8% and the cost of
equity is 6%. The risk free rate is 2%, beta is 1.2 and the marginal tax rate is 40%.
What is the Company’s cost of debt? What is the Company’s cost of equity? What is
the WACC?
11. Company A has a Free Cash Flow (FCF) of $82 million. Their growth rate is 7% and
cost of equity is 12%. What is the value of the Company? Use the terminal value in
perpetuity.
12. Company Z provides financial services for its customers. They have debt of $25 million
of which they pay $1.2 million per annum in interest expense. They have $105 million in
common stock at 6%. The company’s Beta is 1.15 and the risk-free rate is 2.5%. The
tax rate is 40%. What is the cost of debt? What is the cost of equity? What is the
WACC?
13. You are in charge of Marketing and Advertising for a large gaming company. You have
been asked to determine the best return for a campaign and you have two options to
evaluate as outlined below. The Company’s WACC is 6%. The Company has set its
own internal hurdle rate at 14%. Calculate the NPV, IRR, MIRR and payback period for
each option. Which option would you choose? If the Company’s internal hurdle rate is
14%, which projects will be approved?
Option 1:
Direct mailing. The Company will perform a direct mailing campaign to with catalogs
mailed to 50,000 households. Based upon past experience, the Company can obtain
8% as clients. The average gross client revenue in year 1 is $112 which will increase
$20 each year after year 1. In year 2, only 60% of the first year clients will be a repeat
client. In year 3, 50% of year 2 clients will remain a client and in year 4, 50% of 3rd year
clients will be retained. Costs per client is $54 and is anticipated to increase 2% each
year subsequent to year 1. The mailing will cost a total of $10.50 per household.
Option 2:
Television. The Company will perform a television campaign over a period of 4 months.
Each month, their commercials will run multiple times for a cost of $250,000 per month.
Based upon historical data, the advertising will reach 85,000 households each month (eg
each month has a new set of households). Of those households 5% will become
customers. The average gross client revenue in year 1 is $112 which will increase $20
each year after year 1. In year 2, only 60% of the first year clients will be a repeat
client. In year 3, 50% of year 2 clients will remain a client and in year 4, 50% of 3rd year
clients will be retained. Costs per client is $54 and is anticipated to increase 2% each
year subsequent to year 1.
14. Company Y is developing a new product line. The product line will be a new gaming
system to compete with XBOX. The product requires an investment of $567,000 for
inventory and $22,000 for shipping. The Company has a WACC of 7% and an effective
tax rate of 40%. This product is expected to generate the following results:
Sales
Year
1
2
3
4
# of Units
3,000
4,365
4,900
5,800
Price
$228 per unit
$231 per unit
$240 per unit
$250 per unit
Type of Cost
Direct Costs
Direct Costs
Direct Costs
Direct Costs
Amount
$125 per unit
$130 per unit
$135 per unit
$140 per unit
Costs
Year
1
2
3
4
The Company has to pay rent of $125,000 each year for its facility (rent), $40,000 for utilities
and pays 5% of total revenue in annual bonuses.
What is the NPV, IRR, MIRR and Payback period for the project? Would you do the project or
not?
Capital Budgeting: Decision
Criteria
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Assume a company’s market beta equals 0.8, the risk free rate is 5%,
and the cost of equity equals 8%. What is the company’s cost of
capital?
Beta – 0.8
Risk Free Rate – 5%
Cost of Equity - 8%
K(e) = k(rf) + B(k(e) – k(rf))
K(e) = .05 + 0.8( .08 - .05 ) = .074 = 7.4%
No debt so WACC = 7.4%
2
US Steel has $3.16 billion in total debt. Interest expense for the year was $214 million. The
company’s equity is $1.17 billion and pays 6%, its market beta is 2.65 and its assumed tax rate is
37%. Assume the risk-free rate is 2.5%.
Info:
Total Debt: $3.16 billion; interest expense $214 million
Total Equity: $1.17 billion; 6%
Beta – 2.65
R(f) – 2.5%
Tax Rate – 37%
What is the company’s cost of debt?
Debt: $3.16 billion; interest expense $214 million
Interest Rate = $214 million / $3.16 billion = 6.8%
Cost of Debt = R(d) x (1 – t(r))
=
.068 x ( 1 - .37)
= .0428 or 4.28%
What is the company’s cost of equity?
R(E) = R(f) + B (R(E) – R(f)) =
R(E) = .025 + 2.65 (.06 - .025) = 0.25 + 0.93 = .118 or 11.8%
3
US Steel has $3.16 billion in total debt. Interest expense for the year
was $214 million. The company’s equity is $1.17 billion and pays 6%, its
market beta is 2.65 and its assumed tax rate is 37%. Assume the risk
free rate is 2.5%.
What is the weighted average cost of capital?
Cost of Debt: 4.28%
Total Debt: $3.16 billion
Cost of Equity: 11.8%
Total Equity: $1.17 billion
Total debt + equity = $3.16 billion + $1.17 billion = $4.33 billion
Total debt/(Total debt + Equity) = $3.16 billion/ $4.33 billion = 73%
Total equity/(Total debt + Equity) = $1.17 billion / $4.33 billion = 27%
WACC = (% of debt x cost of debt) + (% of equity x cost of
equity)
WACC = (.73 x .0428) + (.27 x .118) = 0.0312 + 0.0319
WACC = .0631 or 6.31%
4
UPS was trading at $96.23 per share on August 31st. It’s dividend per share was $3.12, its market
Beta is .99, its borrowing rate is 2.4%. and its tax rate is 37%. The company has $85.26 billion in
equity and its long term debt is $15.52 billion. The risk free rate is 2.5% and growth rate is 4%.
Information:
Price Per Share - $96.23 (8/31)
Dividend Per Share - $3.12
Beta - .99
Total Debt: $15.52 billion; rate of debt – 2.4%
Total Equity: $85.26 billion;
Risk free rate – 2.5%
Rate of Growth – 4%
Tax Rate – 37%
What is the cost of debt?
Cost of debt = R(d) x (1 – t(r)) = .024 x (1 - .37) = .0151 or 1.51%
What is the cost of equity using the dividend growth model?
K(E) = Div / [P x (1 + g )]
Div =
K(E) = $3.12 (1 + .04) / [ $96.23 x (1 + .04)] = $3.24 / $100.08 = .0324 or 3.24%
5
What is the weigted average cost of capital?
Total Debt: $15.52 billion; rate of debt – 1.51% (tax effected)
Total Equity: $85.26 billion; rate of equity – 3.24%
Total debt and equity = $100.78 billion
% of equity = $85.26 billion / $100.78 billion = 84.6%
% of debt = $15.52 billion / $100.78 billion = 15.4%
WACC = (% of equity x rate of equity) + (% of debt x rate of debt) NOTE debt was tax
effected prior slide
WACC = (.846 x .0324) + (.154 x .0151) = .0274 + .0023 = 0.0297 = 2.97%
6
Financial Statement
and Analysis
1. Assume the interest rate on a company’s debt is 6% and that the
company’s tax rate is 35%. What is the company’s cost of debt
capital?
2. Assume that the company’s financial statements report that its
average outstanding debt totals $1.6 billion and its total interest
expense equals $80 million. If its tax rate is 35%, compute the cost
of debt capital.
3. Assume that a company has $1.2 billion in debt, its cost of debt is
5%, it has $2 billion in equity, and its cost of equity capital is 7%.
The Company’s tax rate is 40%. Compute the company’s WACC.
4. Assume that a company has $1 billion in preferred stock and $3
billion in common stock. Also it pays 6% dividends on the preferred
stock and its cost of equity capital is 7%. The company has no
debt. Compute the company’s WACC.
Weighted Average Cost of Capital
•
•
•
•
•
•
•
Cost of debt = 7%
Marginal tax rate = 40%
Risk free interest rate = 5.28%
Equity risk premium = 5%
Beta = 1.344
Cost of equity = 12%
Debt 30%; Equity 70%
WACC = d x kd x (1 – tc) + (1 – d) x ke
d = ratio of debt to total capital (based on market values)
Kd = pretax cost of debt
tc = corporate marginal tax rate
ke = cost of equity
WACC = .30 x .07 x (1-.40) + (1 - .30) x .12
WACC = 9.66%
1. Assume the interest rate on a company’s debt is 6% and that
the company’s tax rate is 35%. What is the company’s cost of
debt capital?
WACC = d x kd x (1 – tc) + (1 – d) x ke
Cost of debt: cost of debt x (1 – tax rate)
.06 x (1 – 35%)
.06 x .65%
Cost of debt: 3.9%
2. Assume that the company’s financial statements report that its average outstanding debt totals
$1.6 billion and its total interest expense equals $80 million. If its tax rate is 35%, compute the
cost of debt capital.
WACC = d x kd x (1 – tc) + (1 – d) x ke
Cost of debt: cost of debt x (1 – tax rate)
.
($80 million / $1.6 billion) x (1 – 35%)
5% x 65%
Cost of debt: 3.25%
3. Assume that a company has $1.2 billion in debt, its cost of debt is 5%, it has $2 billion in equity, and its
cost of equity capital is 7%. The Company’s tax rate is 40%. Compute the company’s WACC.
WACC = d x kd x (1 – tc) + (1 – d) x ke
Debt plus equity = $1.2 billion + $2.0 billion equity = $3.2 billion
WACC = ($1.2 billion/ $3.2 billion) x 5% x (1 – 40%) + ($2.0 billion / $3.2 billion) x 7%
(37.5% x 5% x 60%) + (62.5% x 7%)
1.125% + 4.38%
WACC = 5.505%
.
4. Assume that a company has $1 billion in preferred stock and $3 billion in common stock. Also it pays 6%
dividends on the preferred stock and its cost of equity capital is 7%. The company has no debt. Compute
the company’s WACC.
WACC = d x kd x (1 – tc) + (1 – d) x ke
Equity
Preferred stock of $1.0 billion @ 6%
Common stock of $3.0 billion @ 7%
Total: $4.0 billion equity
Debt - $0 debt
($1.0 billion/ $4.0 billion) x 6% +
(.25 x 6%) + (.75 x 7%)
1.5% + 5.25%
6.75%
($3.0 billion/ $4.0 billion) x 7%
If the kRF = 7%, ke = 6%, and the firm’s beta is 1.2,
what’s the cost of common equity based upon the
CAPM?
ke = kRF + (ke – kRF) β
= 7.0% + (6.0%)1.2 = 14.2%
If D0 = $4.19, P0 = $50, and g = 5%, what’s the
cost of common equity based upon the DCF
approach?
D1
D1
D1
= D0 (1+g)
= $4.19 (1 + .05)
= $4.3995
ks
= D1 / P0
= $4.3995 / $50
= 13.8%
What is the expected future growth rate?
The firm has been earning 15% on equity (ROE = 15%) and retaining
35% of its earnings (dividend payout = 65%). This situation is expected
to continue.
g = ( 1 – Payout ) (ROE)
= (0.35) (15%)
= 5.25%
If kd = 10% and Risk Premium = 4%, what is ke using the
own-bond-yield-plus-risk-premium method?
• This method produces a ballpark estimate of ke, and can serve as a
useful check.
ke = kd + RP
ke = 10.0% + 4.0% = 14.0%
Cost of Equity
•
•
•
•
•
•
Calculate cost of equity:
Cost of debt = 7%
Marginal tax rate = 40%
Risk free interest rate = 5.28%
Equity risk premium = 5%
Beta = 1.344
•
•
•
•
Cost of equity
Risk free interest rate + equity risk premium + Beta
Cost of equity = 5.28% + (1.344 * 5.0%)
Cost of equity = 12%
Weighted Average Cost of Capital
•
•
•
•
•
•
•
Cost of debt = 7%
Marginal tax rate = 40%
Risk free interest rate = 5.28%
Equity risk premium = 5%
Beta = 1.344
Cost of equity = 12%
Debt 30%; Equity 70%
WACC = d x kd x (1 – tc) + (1 – d) x ke
d = ratio of debt to total capital (based on market values)
Kd = pretax cost of debt
tc = corporate marginal tax rate
ke = cost of equity
WACC = .30 x .07 x (1-.40) + (1 - .30) x .12
WACC = 9.66%
Consider Two Hypothetical Firms Identical Except
for Debt
Capital
Debt
Equity
Tax rate
EBIT
NOPAT
ROIC
Firm U
$20,000
$0
$20,000
40%
$3,000
$1,800
9%
Firm L
$20,000 (6% rate)
$10,000 (12% rate)
$10,000
40%
$3,000
$1,800
9%
14
Cost of Debt, Cost of Equity and WACC
Cost of Debt
Firm U
rate x (1 – tax rate)
0% x (1 – 40%)
0%
Cost of Equity
6%
WACC
6%
Firm L
rate x (1 – tax rate)
12% x (1 – 40%)
7.2%
6%
(.50 x 7.2 %) + (.50 x 6%)
6.6%
Impact of Leverage on Returns
Firm U
$3,000
0
$3,000
1 ,200
$1,800
Firm L
$3,000
1,200
$1,800
720
$1,080
ROIC (NI+Int)/Total
9.0%
11.4%
ROE (NI/Equity)
9.0%
10.8%
EBIT
Interest
EBT
Taxes (40%)
NI
Debt + Equity]
16
Why does leveraging increase return?
• More cash goes to investors of Firm L.
• Total dollars paid to investors:
• U: NI = $1,800.
• L: NI + Int = $1,080 + $1,200 = $2,280.
• Taxes paid:
• U: $1,200
• L: $720.
• In Firm L, fewer dollars are tied up in equity.
17
Impact of Leverage on Returns if EBIT Falls
Firm U
Firm L
EBIT
$2,000
$2,000
Interest
0
1,200
EBT
$2,000
$800
Taxes (40%)
800
320
NI
$1,200
$480
ROIC
6.0%
6.0%
ROE
6.0%
4.8%
Leverage magnifies risk and return
18
Impact of Leverage on Returns if EBIT Rises
Firm U
EBIT
$4,000
Interest
0
EBT
$4,000
Taxes (40%)
1,600
NI
$2,400
ROIC
12.0%
ROE
12.0%
Leverage magnifies risk and return
Firm L
$4,000
1,200
$2,800
1,120
$1,680
14.0%
16.8%
19
Choosing the Optimal Capital Structure:
Example
Beta = 1.0; rRF = 6%; Cost of Equity = 6%.
Cost of equity:
= rRF +b (Cost of Equity)= 6% + 1(6%) = 12%
• Currently has no debt: wd = 0%.
• WACC = rs = 12%.
• Tax rate is T = 40%.
20
Current Value of Operations
Expected FCF = $30 million.
Firm expects zero growth: g = 0.
Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.12 − 0)
Vop = $250 million.
21
Other Data for Valuation Analysis
Company has no short term investments.
Company has no preferred stock.
100,000 shares outstanding
22
Current Valuation Analysis
($ in millions)
Voperations
+ ST Inv.
VTotal
− Debt
S
÷n
P
$250
0
$250
0
$250
10
$25.00
Current Assets
Long Term Debt
Adjusted Value
# of Shares
Price per Share
23
The Cost of Equity at Different Levels of Debt
• Market theory implies that beta changes with leverage (debt).
• bU is the beta of a firm when it has no debt (the unlevered beta)
• b = bU [1 + (1 - T)(wd/we)] where:
Bu = unleveraged beta
T = tax rate
wd = total debt
we = total equity
24
The Cost of Equity for wd = 20%
• Step 1: FIND BETA
b = bU [1 + (1 - T)(wd/ws)]
= 1.0 [1 + (1-0.4) (20% / 80%) ]
= 1.15
• Step 2: FIND COST OF EQUITY
re= rRF + bL ( Cost of Equity)
= 6% + 1.15 (6%) = 12.9%
25
Step 3: CALCULATE WACC
WACC = [wd x (1 - T) x rd ] + [we x re]
WACC = 0.2 (1 – 0.4) (8%) + 0.8 (12.9%)
WACC = 11.28%
Repeat this for all capital structures under consideration.
26
Beta, rs, and WACC
wd
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
ws
100%
80%
70%
60%
50%
b
1.000
1.150
1.257
1.400
1.600
rs
12.00%
12.90%
13.54%
14.40%
15.60%
WACC
12.00%
11.28%
11.01%
11.04%
11.40%
The WACC is minimized for wd = 30%. This is the optimal
capital structure.
27
Corporate Value for wd = 20%
• Vop = [FCF(1+g)]/(WACC − g)
Vop = [$30(1+0)]/(0.1128 − 0)
Vop = $265.96 million.
• Debt = DNew = wd Vop
Debt = 0.20(265.96) = $53.19 million.
• Equity = S = ws Vop
Equity = 0.80(265.96) = $212.77 million.
28
Value of Operations, Debt, and Equity
wd
0%
20%
30%
40%
50%
rd
0.0%
8.0%
8.5%
10.0%
12.0%
ws
100%
80%
70%
60%
50%
b
1.000
1.150
1.257
1.400
1.600
rs
12.00%
12.90%
13.54%
14.40%
15.60%
WACC
12.00%
11.28%
11.01%
11.04%
11.40%
Vop
$250.00
$265.96 $272.48
$271.74
$263.16
D
$0.00
$53.19
$81.74
$108.70
$131.58
S
$250.00
$212.77
$190.74
$163.04
$131.58
Value of operations is maximized at wd = 30%.
29
Value Before and After Debt
Before Debt
After Debt,
Before Rep.
Vop
$250
$265.96
+ ST Inv.
0
53.19
VTotal
$250
$319.15
− Debt
0
53.19
S
$250
$265.96
÷n
10
10
P
$25.00
$26.60
$250
$265.96
Total shareholder
wealth: S + Cash
30
After Issuing Debt
• Stock price increases from $25.00 to $26.60.
• Wealth of shareholders (due to ownership of equity) increases from
$250 million to $265.96 million.
31
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