Exam 11: Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

Carr Industries must raise $100 million on January 1, 2012 to finance its expansion into a new market. The company will use the money to finance construction of four retail outlets and a distribution center. The stores are expected to open later this year. The CFO has come up with three alternatives for raising the money: 1) Issue $100 million of 8% nonconvertible debt due in 20 years. 2) Issue $100 million of 6% nonconvertible preferred stock (100,00 shares). 3) Issue $100 million of common stock (1 million shares). The company's internal forecasts indicate the following 2012 year-end amounts before any option is chosen: in millions Tatil debt \ 425 Tatel sharehrlders' equity 250 Net income forr the year 10 Carr has no preferred stock outstanding but currently has 10 million shares of common stock outstanding. EPS has been declining for the past several years. Earnings in 2011 were $1 per share, which was down from $1.10 during 2010, and management wants to avoid another decline during 2012. One of the company's existing loan agreements requires a debt-to-equity ratio to be less than 2. Carr pays taxes at a 40% rate. Required: 1. Assess the impact of each financing alternative on 2012 EPS and the year-end debt to equity ratio. 2. Which financing alternative would you recommend and why?

To determine the appropriate weights to use in the weighted average cost of capital, an analyst will need to determine the ______________________________ of the debt, preferred stock and common equity capital.

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets \6 ,840 Interest-be aring debt \3 ,562 Average pre-tax borrowing cost 11.5\% Common equity. Book value \2 ,560 Market value \1 2,850 Income tax rate 35\% Market ecuity beta 1.24 - Assume that Zonk is a potential leveraged buyout candidate. Assume that the buyer intends to put in place a capital structure that has 70 percent debt with a pre tax borrowing cost of 14 percent and 30 percent common equity. Compute the weighted average cost of capital for Zonk based on the new capital structure.

Equity valuation models based on dividends, cash flows, and earnings have been the topic of many theoretical and empirical research studies in recent years. All of the following are true regarding these studies except:

Why is the dividends valuation approach applicable to firms that do not pay periodic (quarterly or annual) dividends?

Under the assumption of clean surplus accounting, how would you compute total dividends paid to common equityholders in order to value the firm?

Normally, valuation methods are designed to produce reliable estimates of the value of a firm's ______________________________.

Equity-based valuation models are based on all metrics except

One rationale for using expected dividends in valuation is

Under the cash-flow-based valuation approach, free cash flows can be used instead of dividends as the expected future payoffs to the investor in the numerator of the general valuation model because:

Identify the types of firm-specific factors that increase a firm's nondiversifiable risk (systematic risk). Identify the types of firm-specific factors that increase a firm's diversifiable risk (idiosyncratic risk or nonsystematic risk). Why do models of risk-adjusted expected returns include no expected return premia for diversifiable risk?

In what case will using dividends expected to be paid to shareholders yield the same valuation for the firm as using free cash flows expected to be generated by the firm?

If dividend projections include the effect of inflation, then the discount rate used should be a ____________________ rate.

The following financial statement data pertains to Northridge, Inc., a manufacturer of women's outerware (dollar amounts in millions): Total Assets \1 45,782 Interest-Bearing Debt \3 2,659 Average Pre-tax borrowing cost 8.25\% Common Equity: Book Value \2 2,515 Market Value \6 5,843 Income Tax Rate 40\% Market Equity Beta 0.85 Market Premium 7.5\% Risk-free interest rate 2.2\% Required: a. Calculate the company's cost of equity capital. b. Calculate the weight on debt c apital that should be used to determine Notthidge's weighte ch average cost of capital c. Calculate the weight on equity capital that should be used to determine Northridge's weighted-average cost of capital. d. Calculate Northricge's weighted-average cost of capital.

A company with a market beta of 1 has systemic risk ____________________ to the average amount of systemic risk of all equity securities in the market.

The CAPM computes expected rates of return on common equity capital using the following model: E[R_Ej] = E[R_F] + b_j x {E[R_M] - E[R_F]} What are the roles of each of the three components of this model?

If a firm has a market beta of 0.9, is subject to an income tax rate of 35 percent, has a risk-free rate of 6 percent, a market risk premium of 7 percent, and has a market value of debt to market value of equity ratio of 60 percent, what does the market expect the firm to generate in terms of equity returns using CAPM?

The following financial statement data pertains to Outside, Inc., a manufacturer of men's outerware (dollar amounts in millions): Total Assets \1 45,782 Interest-Bearing Debt \3 0,659 Average Pre-tax borrowing cost 9.25\% Common Equity: Book Value \2 2,515 Market Value \6 0,843 Income Tax Rate 42\% Market Equity Beta 0.88 Market Premium 8.5\% Risk-free interest rate 2.4\% Required: a. Calculate the company s cost of equity capital. b. Calculate the weight on debt capit al that should be used to determine Outside'sweightech-average cost of capital. c. Calculate the weight on equity capital that should be used to determine Outside'sweighted-average cost of capital. d. Calculate Outside's weighted-average cost of capital.

The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Total assets \6 ,840 Interest-be aring debt \3 ,562 Average pre-tax borrowing cost 11.5\% Common equity. Book value \2 ,560 Market value \1 2,850 Income tax rate 35\% Market ecuity beta 1.24 - Using the above information, calculate Zonk's weighted-average cost of capital:

Watson manufactures and sells appliances. Intro develops and manufactures computer technology. Trenton operates general merchandise retail stores. Selected data for these companies appear in the following table (dollar amounts in millions). For each firm, assume that the market value of the debt equals its book value. \ amounts in millions) Watson Intro Trenton Total Assets \ 13,532 \ 109,524 \ 44,106 Interest-Bearing Debt \ 2,597 \ 33,925 \ 18,752 Average Pretax Borrowing Cost 6.1\% 4.3\% 4.9\% Comunon Equity: Book Value \ 3,006 \ 13,465 \ 13,712 Market Value \ 2,959 \ 110,984 \ 22,521 Income Tax Rate 35,0\% 35.0\% 35,0\% Market Equity Beta 2.27 0.78 1.2 Required a. Assume that the intermediate-term yields on U.S. Treasury securities are roughly 3.5 percent. Assume that the market risk premium is 5.0 percent. Compute the cost of equity capital for each of the three companies. b. Compute the weighted average cost of capital for each of the three companies. c. Compute the unlevered market (asset) beta for each of the three companies.