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NOTES ON FINANCIAL STRUCTURE

I. Review on Cost of Capital.A. Cost of Equity Capital, Ke.

1. Use Dividend Model: Ke = (DIV1/Ps) + g

where:DIV1/Ps is the dividend yield andg is sustainable growth rate=ROE x (1- dividend payout ratio)

2. Use Capital Asset Pricing Model CAPM: Ke = RF + s[KM-RF]

B. Cost of Debt Capital, Kd. (referring to traded bonds)1. Five bond characteristics:

A. Face value of a bond also called par value, usually equals $1000.B. Coupon rate, CR = 4%C. Term to Maturity, T = 5 yearsD. Price of bond, Pb

E. Yield or interest rate on bond, Kd = 10%

2. Annual Interest or coupon payment = CR x Face Value3. If we know the interest rate, Kd, then we can find the bond price, Pb.

Pb = Coupon Payments [PV/A, r, T] + Face Value[PV/FV,r,T]

4. Alternatively, if we know the bond price, we can calculate the yield or interestrate, Kd. This is also called the yield to maturity (YTM) and represents the rateof return on the bond investment (or IRR)

C. Cost of Preferred Stock Capital, Kp.1. Main return from preferred stock is preferred dividends.2. Kp = DIV1/Pp or the dividend yield on the preferred stock.

II. In Corporate Finance, we combine all the capital used to fund the projects byweighting each capital by its relative funding. This is called Weighted Average Cost ofCapital, or WACC.

A. Higgins uses symbol Kw.

Kw = [% in debt]Kd(1-tax rate) + [% in preferred]Kp + [% in common]KeORKw = [D/V]Kd(1-tax rate) + [P/V]Kp + [E/V]Ke

where V = {D + P + E)

B. Assumptions necessary to use this Kw are:1. the firm maintains the same capital structure.

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2. The new project in question has the same risk level as the current firmprojects.

C. Hence the implications of WACC or Kw are:1. If the firm changes their capital structure the % used to fund the projects

will change.2. Also ifthe firm project risk changes then the cost of capitals, Kd, Kp, andKe change. The reason is that riskier projects must earn a higher return. So ifGeneral Foods decides to enter the software business, it should use the costsof capital relevant to a software project risk level (called asset risk). Perhaps,use Microsoft's cost of capital rather than GF.3. This means that the asset risk and return dictates the cost of capital and notthe other way around. However, financial leverage does impact the cost ofcapital for debt and equity, Kd and Ke, respectively.

D. Therefore to calculate Kw:

1. Determine the correct risk level to calculate Ke, Kd, Kp. Often usingcomparable firms, particularly for Ke.2. However, the risk in Ke, for example, reflects the financial risk ofthatcomparable firm's risk. So we unlever the financial risk. That is, calculate theasset risk for a ZERO DEBT (unlevered) firm.3. Recalculate Ke, Kd, and Kp based onyourcompanys capital structure..4. Now re-calculate new WACC or Kw.

E. For example, if General Foods, GF, decides to go into the software business, theyshould use Microsoft's asset risk level to match the project risk.

1. First find Microsoft's beta, s = 2.5. Suppose Microsoft has a financialleverage or D/E of .25 and GF's debt ratio, D/E is 1.0. By choosing Microsoft'sbeta, we have adjusted for asset risk. Now we must adjust for financial risk.2. Unlever the beta, using the formula:

sU = sL/[1 + (1-tax rate)(D/E)]

sU = 2.5/[1 + (1 - .35)(.25)] = 2.5/[1 + .1625] = 2.15

This is the beta risk of a software company with ZERO DEBT (Unlevered)

3. Recalculate with company's debt level. GF's debt ratio is 1.0, so we nowadjust for the financial risk of GF.

sL = sU [1 + (1-tax rate)(D/E]

= 2.15 [1 + (1 - .35)(1.0)] = 2.15[1.65] = 3.55

This assumes that GF will maintain their current capital structure eventhough their asset risk (business risk) has changed. Suppose GF feels their

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lower risk food business can support the additional risk from the softwareproject.

4. Use CAPM to calculate new Ke for GF's software project cost of equitycapital. Suppose the market risk premium equals .086 and the US Tbill yields .02

today.

Ke = RF + s[KM - RF]

5. Suppose GF maintains its current debt-equity funding. Also Kd is expected torise slightly to reflect the higher asset risk. The yield to maturity is expected toequal 10% and the corporate tax rate is 35%. Calculate WACC or Kw.

Kw = [D/V]Kd(1 - tax rate) + [E/V]Ke

F. Another example: Suppose General Foods decides to enter the power generating

business. They decide that PG&E is the approximate asset risk for their new project.PG&E 's beta is 0.75 and their debt ratio, D/E is 2.0. Find the new cost of equitycapital for GF's new venture in power plants.

1. Determine the appropriate asset risk.

2. Unlever beta:

3.Calculate the levered beta for GF.

4. Calculate Ke using CAPM. Assume market risk premium is .086 and the US Tbillyields .02 today.

Ke = RF + s[KM - RF]

5. Assume that the new venture won't affect GF's current long-run capital structure.If the cost of debt capital, Kd is 8%, calculate Kw.

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A CASH FLOW PROBLEM

Revenues generated by a new fad product are forecast as follows:

Year Revenues

Yr 1 $40,000Yr 2 30,000Yr 3 20,000Yr 4 10,000Thereafter 0

Expenses are expected to be 40% of revenues, and working capital required in each yearis expected to be 20% of revenues in the following year. The product requires animmediate investment of $50,000 in plant and equipment. Tax rate is 35% and assumethat the plant and equipment can be sold at the end of 4 years for $10,000.

A. What is the initial investment in the problem, including working capital.

B. If the plant and equipment are depreciated over 4 years to a salvage value of zerousing straight-line depreciation, and the firm's tax rate is 35%, what are the project cashflows in each year?

C. If the opportunity cost of capital is 10%, what is the NPV?

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