Module 6 - Stock Valuation and Weighted Average Cost of Capital (Chapters Seven and Nine)

All  page numbers are references to Corporate Finance: A Focused Approach, 5th  edition by Ehrhardt and Brigham (Cengage, 2013)

Chapter  7 applies Chapter 4 Time Value of Money techniques to the valuation of common  stock and preferred stock.

Need to Absorb - The attributes of common stocks including the rights of  shareholders, how to use the Constant Growth Model, how to value non-constant  growth stocks, and the attributes and valuation of preferred stock. On exams,  this chapter almost always calculations to include a CAPM problem, a constant  growth stock valuation problem, a non-constant growth valuation  problem.

Do not need to Absorb - Types of common stock in (7.2) and stock market  reporting (7.3), I am unlikely to ask on exams about stock valuation using  multiples or Free Cash Flow Valuation (these are fair game for quizzes).

Need to Read - Read the Chapter.

Need to Do - Make 100 on the Quiz.  You should be able to answer all of the  end of chapter questions and problems. Note, virtually all of the end of  chapter problems have been used on past quizzes and exams. Problems 7, 17, and  18 would not be on an Exam.

Calculator  links, if needed.

Simple  and useful instructions for most calculators

1. Watch  the Chapter  Introduction and Overview video.  The Powerpoints for all of this chapter's videos are located here.

2.  Read pages 289-301. I strongly suggest you watch the Stock  Valuation Concepts and Constant Growth Model video. After this video, you should be  able to solve problems 1-4, 8-11, 14, and 19.

5.  Read pages 301-304 to learn about valuing Non-constant Growth stocks.

5.  Watch the Valuing  Non-Constant Growth Stocks video.  After this video, you should be able to solve problems 5, 13, 14, 20 and  21.

6.  Read the rest of the chapter.

7.  If you feel the need, watch the Free  Cash Flow and Market Multiple Valuation video.  This also covers features of preferred stock.

8.  Solve the remaining problems listed at the top of the page. You can find the  solutions to these problems on our D2L page. If you need additional  instruction, here are audio solutions to the most common types of stock  valuation problems:

a.  Audio solution to: Timeless Corporation issued preferred stock with a  par value of $700. The stock promised to pay an annual dividend  equal to 19.0% of the par value. If the appropriate discount rate for this stock  is 10.0%, what is the value of the stock?

b.  Audio solution to: Forever, Inc's preferred stock has a par value of  $1,000 and a dividend equal to 13.0% of the par value. The stock  is currently selling for $907.00. What discount rate is being used to value the  stock?

c.  Audio solution to: Here and After Corporation plans a new issue of  preferred stock. Similar risk stock currently offers an annual  return to investors of 17.0%. The company wants the stock to sell for $569.00  per share. What annual dividend must the company offer?

d.  Audio solution to: You are considering buying common stock in Grow On,  Inc. The firm yesterday paid a dividend of $5.20. You  have projected that dividends will grow at a rate of 8.0% per year indefinitely.  If you want an annual return of 20.0%, what is the most you should pay for the  stock now?

e.  Audio solution to: You  are considering buying common stock in Grow On, Inc. You have projected that the  next dividend the company will pay will equal $4.00 and that dividends will grow  at a rate of 5.0% per year thereafter. If you would want an annual return of  13.0% to invest in this stock, what is the most you should pay for the stock  now?

f. Audio solution  to: Growing,  Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a  dividend of $7.50. You believe that dividends will grow at a rate of 24.0% per  year for two years, and then at a rate of 5.0% per year thereafter. You expect  an annual rate of return of 18.0% on this investment. If you plan to hold the  stock indefinitely, what is the most you would pay for the stock  now?

g. Audio solution  to: Growing,  Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a  dividend of $5.60. You believe that dividends will grow at a rate of 24.0% per  year for three years, and then at a rate of 10.0% per year thereafter. You  expect an annual rate of return of 18.0% on this investment. If you plan to hold  the stock indefinitely, what is the most you would pay for the stock  now?

h. Audio solution  to: Growing,  Inc. is a firm that is experiencing rapid growth. The firm yesterday paid a  dividend of $8.00. You believe that dividends will grow at a rate of 22.0% per  year for years one and two, 15.0% per year for years three and four, and then at  a rate of 9.0% per year thereafter. If you expect an annual rate of return of  21.0% on this investment, what is the most you would pay for the stock  now?

i. 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?

j. 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?

9.  Be prepared for a 60 minute quiz, with roughly 14 questions. The name of the  quiz is Chapter 7.

Chapter  9

Weighted  Average Cost of Capital - This chapter applies Chapter 6 Risk and Return  concepts to the 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 previously learned in Chapters  5-7.

Need  to Absorb - 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 9-2 on page 359. 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. Section 11b discusses how to make  project and division WACC adjustments, and is often a source of exam questions.  Section 12 is a good source of concept questions. I will use this chapter to  relate Risk and Return for Capital Budgeting problems, so expect to see this  again in Chapter 10 and 11 materials in the quizzes.

Do  not need to Absorb - Section 10 on WACC for small and private companies. Section  11a on factors the firm cannot control. It is highly unlikely we will ask Final  Exam questions where the firm needs to issue new common equity, thus calculating  the Cost of Common Equity with adjustments for flotation costs should have a low  priority. Flotation costs could appear in quiz questions.

Need to Read - Read the Chapter.

Need to Do - Make 100 on the quiz.  Be able to solve Concept Review Questions 1-5 (all of  them), and Problems 1-12, 15-17 (ignoring issues related to flotation costs).  For my face to face classes, my Final Exam questions are often similar to  Self-Test 1 and Problems 15 or 16. For my on line classes, the questions are  more likely to be 3-4 separate questions, such as Problems 3, 5, 6, 7, 8, 9.

Calculator  links: Most  Calculator Types

1. Watch  the Chapter  Introduction and Overview video.  The Powerpoints for all of this chapter's videos are located here.

2.  Read pages 357-366.

3.  Watch the video, WACC  Overview, Costs of Debt, and Cost of Preferred Stock.  After this video, you should be able to answer end of chapter Questions 1 and 2  and Problems 1, 2, and 9.

4.  Read pages 367-374.

5.  Watch the video Costs  of Common Stock. After  this video, you should be able to answer end of chapter Questions 3 and 4 and  Problems 3-6, and 10-12.

6.  Read pages 375-377.

7.  Watch the video Weights  and Calculations of the WACC. After  this video, you should be able to solve Problems 15 and 16.

8.  Read the remaining part of the chapter.

9.  Watch the video on Adjusting  for Project Risk, Divisional Costs of Capital, and Odds and Ends. After this video, you should be  able to solve the  remaining suggested questions and problems.

10.  Here are audio solutions, courtesy of Dr. Ronald Best, to problems that are  similar to those covered in this chapter;

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?

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?

11. Be prepared for a 40-60  minute quiz over Chapter 9.