Harvard University Finance for Business Paper

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OZJ123

Business Finance

Harvard University

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There are multiple choice and some questions, like

  • Which is true about common stock and preferred stock
    • Common stock does not allow voting rights for the shareholder
    • Preferred stock and common stock represent ownership in a Company
    • For both, the investors return is tied to the performance of the Company and may result in a gain or loss
    • All of the Above
    • Both b and c
    1. 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?

I also post some example that the class mentioned.

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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 © 2019 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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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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 $200 million in debt. The Company
has no equity. The tax rate is 30%. What is the cost of debt?
Cost of debt ($) = Interest expense * (1 – tax rate)
Cost of debt ($) = $25M * (1 – 30%)
Cost of debt ($) = $17.5M
Cost of debt (%) = Interest * (1 – tax rate) / Total debt
Cost of debt (%) = $25M * (1 – 30%) / $200M
Cost of debt (%) = 8.75%

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?
Cost of debt = 8%
Cost of equity = 6%
WACC = Cost of debt * Debt % * (1 – tax rate) + Cost of equity * Equity %
WACC = 8% * 40% * (1 – 40%) + 6% * 60%

WACC = 5.52%

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.
Present value of perpetuity = FCF / (Cost of equity – Growth rate)
Company A total enterprise value = $82M / (12% - 7%)
Company A total enterprise value = $1.64B

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?
Cost of debt = Interest * (1 – tax rate) / Total debt
Cost of debt = $1.2M * (1 – 40%) / $25M
Cost of debt = 2.88%
Cost of equity = Risk-free rate + Beta * Equity risk premium
Cost of equity = 2.5% + 1.15 * 6%
Cost of equity = 9.4%
WACC = Cost of debt * Debt % * (1 – tax rate) + Cost of equity * Equity %
Where Debt % = Debt ...


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