Module 3

Module 3, Chapter 12, Risk, Return, and the Capital Budgeting and Chapter 13 Weighted Average Cost of Capital

All  page numbers are references to Fundamentals of Corporate Finance, 7th  edition by Brealey, Myers, and Marcus (McGraw-Hill, 2012)

This module focuses on determining the required returns on capital budgeting projects.  In Chapter 12, we approach the problem where the risk, as measured by beta, is known.  In Chapter 13, we assume the risk of the project is not known.  In that case, we use the required return on Liabilities and Equity, known as the Weighted Average Cost of Capital, as a proxy for the required return on average-risk projects.

From Chapter 12

Things to Absorb -  Everything.  The main focus is on defining and measuring types of risk  and return. You need to be able to calculate returns and beta of individual securities and portfolios.  You should be able to calculate the weighted average return and beta of a portfolio.  Understand  the impact of diversification. You should be able to understand the Capital  Asset Pricing Model (CAPM) as it is the predominant theory of the relationship  between risk and return. You need to understand CAPM's uses and the inputs used  in CAPM's calculations.  You should be able to estimate, given a project’s beta, the required return on capital budgeting projects.

Things to Read - Read the Chapter.

Things to Do - Make 100 on the quiz.  Be able to solve End of Chapter Problems 1, 2, 4-8, 11-30.  For the problems, pay particular attention to those problems that discuss capital budgeting problems (e,g, 5, 6, 13, 14, 19, 29).

Calculator  links, Simple  and useful instructions for most calculators

1. Watch the Chapter 12 Overview video. The Powerpoints for all of this chapter’s videos are located here.

2. Watch the Chapter 12 Lecture. The Powerpoints for this video begin at about slide 4.  In this chapter, I want you to read before you watch the videos.

3. Read about computing Weighted Averages for Portfolios, on pages 162-170.  These weighted averages can be either betas or returns.

4. Watch the Computing Portfolio Returns and Beta Lecture. This includes a discussion of diversification.  The Powerpoints for this video begin at about slide 9.

5. Read the rest of the chapter.

6. Watch the Measuring Market Risks video, which includes a discussion of the weaknesses of the Capital Asset Pricing Model.  Powerpoints start about slide 23. 

7. Verify you could solve the End of Chapter problems listed at the top of the page. You can find the solutions to these problems in our E-book. 

8. If you need additional instruction, here are audio solutions to the most common types of stock valuation problems:Here  are audio solutions, created by Dr. Ronald Best, to several types of Risk and  Return problems;

a.  Audio Solution to:What is the expected return for the following stock?  (State your answer in percent with one decimal place.)  In the better economy, with probability of .5, the expected return is 32%. In  the same economy, with probability of .2, the expected return is 17%. In the  worse economy, with probability of .3, the expected return is  -10%.

b.  Audio Solution to:What is the expected return for the following  portfolio? (State your answer in percent with two decimal places.)  Stock AAA with expected return of 31.2% has a total value of $190,000. Stock BBB  with expected return of 24.0% has a total value of $350,000. Stock CCC with  expected return of 18.6% has a total value of $200,000. Stock DDD with expected  return of 11.9% has a total value of $500,000.

c.  Audio Solution to:If the risk-free rate is 4.3%, the expected return  on the market is 15.7%, and the expected return on Security  J is 21.5%, what is the beta for Security J? (Calculate your answer to two  decimal places.)

d.  Audio Solution to:You are considering buying a stock with a beta of  0.73. If the risk-free rate of return is 6.9 percent, and the  expected return for the market is 12.2 percent, what should the expected rate of  return be for this stock? (State your answer as a percentage.)

e.  Audio Solution to:If the risk-free rate is 6.9%, the market risk  premium is 7.0%, and the expected return on Security J is 29.4%,  what is the beta for Security J? (Calculate your answer to two decimal  places.)

f.  Audio Solution to:You are considering buying a stock with a beta of  2.05. If the risk-free rate of return is 6.9 percent, and the  market risk premium is 10.8 percent, what should the expected rate of return be  for this stock? (State your answer as a percentage.)

g.  Audio Solution to:You are holding a stock that has a beta of 2.4 and  is currently in equilibrium. The required return on the stock  is 20.4% and the return on a risk-free asset is 8%. What would be the return on  the stock if the stock's beta increased to 3.3 while the risk-free rate and  market return remained unchanged? (Calculate your answer to two decimal places  and state it as a percentage.)

h.  Audio Solution to: The risk-free return is 4.1% and the market return  is 14.0%. What is the expected return for the following portfolio?  (State your answer in percent with two decimal places.) Stock AAA with Beta of  3.4 has a total value of $125,000. Stock BBB with Beta of 2.9 has a total value  of $330,000. Stock CCC with Beta of 1.3 has a total value of $230,000. Stock  DDD with Beta of .9 has a total value of $500,000.

i.  Audio Solution to:Audio Solution to: You hold a diversified portfolio consisting of a $10,000 investment in each of 15 different common stocks (i.e., your total investment is $150,000). The portfolio beta is equal to 1.3 . You have decided to sell one of your stocks which has a beta equal to 1.2 for $10,000. You plan to use the proceeds to purchase another stock which has a beta equal to 1.8. What will be the beta of the new portfolio? Show your answer to 2 decimal places.

j.  Audio Solution to: You want your portfolio beta to be 0.90. Currently, your portfolio consists of $4,000 invested in stock A with a beta of 1.47 and $3,000 in stock B with a beta of 0.54. You have another $9,000 to invest and want to divide it between an asset with a beta of 1.74 and a risk-free asset. How much should you invest in the risk-free asset?

9.  There is a quiz based on the above material. The name of the quiz is Chapter  12.

Chapter 13

Things to absorb - Everything, plus remember some material from previous chapters.  This chapter applies Chapter’s 6, 7, and 12, Risk and Return concepts to the market value Balance Sheet of Corporations. The basic task is to calculate  the return on a portfolio, where the portfolio consists of the securities  issued by a single company (i.e., their long term debt and equity). This is a  review chapter in that we apply techniques learned in Chapters 6, 7, and 12 in a new way.  All of the general material to estimate Cost of Capital, including  after-tax cost of debt, cost of preferred stock, and the two methods of  calculating the cost of common equity. Understand how to calculate all of the  components of equation 13-1a on page 378. You should be able to convert a book value balance sheet to a market value balance sheet. You should be able to  calculate the Weights in the equation using a market value balance sheet. Pay particular attention to the concepts related to risk and return, as this topic  is often the source of concept questions. I will use this chapter to relate Risk  and Return for Capital Budgeting problems, so expect to see some Chapter 6, 7, and 12 materials in the Chapter 13 Quiz.

Things to Read - Read Chapter 13, and be prepared to re-read parts of Chapter 3, 6, 7, and 12.

Things to Do - Make 100 on the quiz.  There are only 19 End of Chapter Questions, you should be able to answer all of them.  Note that Problems 16-19 are good reviews for the Mid Term Exam.

Calculator  links, Simple and useful instructions for most calculators

1. Watch the Chapter 13 Overview video. The Powerpoints for all of this chapter’s videos are located here.

2. Watch the Chapter 13 Lecture. The Powerpoints for this video begin at about slide 4.  In this chapter, it does not matter if you read the chapter or watch the videos first.

3. Read about computing Weighted Average Cost of Capital, on pages 188-199.  These weighted averages can be either betas or returns.

4. Watch the Computing the Weighted Average Cost of Capital video.   The Powerpoints for this video begin at about slide 12.

5. Read the rest of the chapter.

6. You might want to watch the Computing the Components of the WACC video, Powerpoints start about slide 25.  But you already know how to do this from Chapters 6, 7, and 12.  You probably should watch the video on Adjustments for Project Risk and Pitfall of WACC.  Powerpoints start about slide 36.  This video also has a short discussion of how to value an entire company using WACC.

7. Verify you could solve the End of Chapter problems listed at the top of the page. You can find the solutions to these problems in our E-book. 

8. If you need additional instruction, here are audio solutions to the most common types of stock valuation problems:Here  are audio solutions, created by Dr. Ronald Best, to several types of WACC problems;

a.  Audio Solution to: Costly  Corporation plans a new issue of bonds with a par value of $1,000, a maturity of  28 years, and an annual coupon rate of 16.0%. Flotation costs associated with a  new debt issue would equal 9.0% of the market value of the bonds. Currently, the  appropriate discount rate for bonds of firms similar to Costly is 17.0%. The  firm's marginal tax rate is 30%. What will the firm's true cost of debt be for  this new bond issue?

b.  Audio Solution to: Costly  Corporation is also considering using a new preferred stock issue. The preferred  would have a par value of $400 with an annual dividend equal to 18.0% of par.  The company believes that the market value of the stock would be $968.00 per  share with flotation costs of $68.00 per share. The firm's marginal tax rate is  40%. What would the firm's cost of preferred be for this new preferred stock  issue?

c.  Audio Solution to: Costly  Corporation is considering using equity financing. Currently, the firm's stock  is selling for $47.00 per share. The firm's dividend for next year is expected  to be $3.40 with an annual growth rate of 5.0% thereafter indefinitely. If the  firm issues new stock, the flotation costs would equal 14.0% of the stock's  market value. The firm's marginal tax rate is 40%. What is the firm's cost of  internal equity?

d.  Audio Solution to: Costly  Corporation is considering using equity financing. Currently, the firm's stock  is selling for $31.00 per share. The firm's dividend for next year is expected  to be $5.50 with an annual growth rate of 5.0% thereafter indefinitely. If the  firm issues new stock, the flotation costs would equal 15.0% of the stock's  market value. The firm's marginal tax rate is 40%. What is the firm's cost of  external equity?

e.  Audio Solution to: Marginal  Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its  cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its  cost of external equity is 19.0%. Currently, the firm's capital structure has  $378 million of debt, $63 million of preferred stock, and $459 million of common  equity. The firm's marginal tax rate is 45%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $92 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at a total investment level  of $155 million?

f.  Audio Solution to: Marginal  Incorporated (MI) has determined that its before-tax cost of debt is 9.0%. Its  cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its  cost of external equity is 19.0%. Currently, the firm's capital structure has  $378 million of debt, $63 million of preferred stock, and $459 million of common  equity. The firm's marginal tax rate is 45%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $92 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at a total investment level  of $247 million?

g.  Audio Solution to: Marginal  Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its  cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its  cost of external equity is 19.0%. Currently, the firm's capital structure has  $378 million of debt, $63 million of preferred stock, and $459 million of common  equity. The firm's marginal tax rate is 45%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $92 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at a total investment level  of $157 million?

h.  Audio Solution to: Marginal  Incorporated (MI) has determined that its after-tax cost of debt is 9.0%. Its  cost of preferred stock is 15.0%. Its cost of internal equity is 17.0%, and its  cost of external equity is 19.0%. Currently, the firm's capital structure has  $378 million of debt, $63 million of preferred stock, and $459 million of common  equity. The firm's marginal tax rate is 45%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $92 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at a total investment level  of $247 million?

i.  Audio Solution to: Marginal  Incorporated (MI) has determined that its before-tax cost of debt is 7% for the  first $112 million in bonds it issues, and 8% for any bonds issued above $112  million. Its cost of preferred stock is 10%. Its cost of internal equity is 14%,  and its cost of external equity is 17%. Currently, the firm's capital structure  has $400 million of debt, $100 million of preferred stock, and $500 million of  common equity. The firm's marginal tax rate is 30%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $59 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at each of the following  total investment levels? (A)  Total investment level of $380 million? (B) Total investment level of $199  million? (C) Total investment level of $69 million?

j.  Audio Solution to: Marginal  Incorporated (MI) has determined that its after-tax cost of debt is 6% for the  first $100 million in bonds it issues, and 8% for any bonds issued above $100  million. Its cost of preferred stock is 9%. Its cost of internal equity is 12%,  and its cost of external equity is 14%. Currently, the firm's capital structure  has $600 million of debt, $100 million of preferred stock, and $300 million of  common equity. The firm's marginal tax rate is 30%. The firm is currently making  projections for next period. Its managers have determined that the firm should  have $75 million available from retained earnings for investment purposes next  period. What is the firm's marginal cost of capital at each of the following  total investment levels?(A)  Total investment level of $280 million? (B) Total investment level of $200  million? (C) Total investment level of $77 million?

k.  Audio solution  to: You  are considering buying common stock in Grow On, Inc. You have calculated that  the firm's free cash flow was $8.10 million last year. You project that free  cash flow will grow at a rate of 6.0% per year indefinitely. The firm currently  has outstanding debt and preferred stock with a total market value of $9.22  million. The firm has 1.20 million shares of common stock outstanding. If the  firm's cost of capital is 25.0%, what is the most you should pay per share for  the stock now?

l. Audio solution  to: You  are considering buying common stock in Super Growth, Inc. You have calculated  that the firm's free cash flow was $6.20 million last year. You project that  free cash flow will grow at a rate of 20.0% per year for the next three years,  and then 6.0% per year indefinitely thereafter. The firm currently has  outstanding debt and preferred stock with a total market value of $26.60  million. The firm has 1.68 million shares of common stock outstanding. If the  firm's cost of capital is 19.0%, what is the most you should pay per share for  the stock now?

12.  Be prepared for a 40-60 minute quiz over Chapter 13.

Revised October 22, 2014

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