Review Final 2015

Financial Management

• Give 2 characteristics of Debt?

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– Commitment to make fixed payments in the future

– The fixed payments are tax deductible– Failure to make the payments can lead to

either default or loss of control of the firm to the party to whom payments are due.

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• How can we estimate the cost of debt for a company if the firm is rated?

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• If the firm is rated, use the rating to calculate the default spread. Add the default spread to the risk free rate.

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• Bookscape has an operating income of 3575 and a interest expense of 575. What is its interest coverage ratio?

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• Interest Coverage Ratio = EBIT / Interest Expenses = 6.22

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• What is the after tax cost of debt for Tata chemicals given the following information.

• Risk free rate 2.5%

• Country default spread for India 3%

• Default spread for company 3%

• Indian Tax rate 34%

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Pre-tax cost of debt = Riskfree Rate(Rs) + Country Default Spread + Company Default spread

= 2.5% + 3% + 3% = 8.5%After-tax cost of debt = Pre-tax cost

of debt (1- tax rate) = 8.5 (1-.34) = 5.61%

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• What is the cost of capital for Disney given the following information

• Cost of Equity 8%

• After tax cost of debt 4%

• Market value of debt 20b

• Market value of Equity 50b

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Debt/(Debt +Equity) = 28.5%

Cost of Capital = 8(.715)+4(.285) = 5.72 +1.14 = 6.86%

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• How do we get from accounting earnings to cash flows?

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– you have to add back non-cash expenses (like depreciation)– you have to subtract out cash outflows which are not expensed

(such as capital expenditures)– you have to make accrual revenues and expenses into cash

revenues and expenses (by considering changes in working capital).

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• Give an example of an investment or project?

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Major strategic decisions to enter new areas of business or new markets.

Acquisitions of other firms are projects as well, notwithstanding attempts to create separate sets of rules for them.

Decisions on new ventures within existing businesses or markets.

Decisions that may change the way existing ventures and projects are run.

Decisions on how best to deliver a service that is necessary for the business to run smoothly.

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• What is the benefit of depreciation?

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• The benefit of depreciation is therefore the tax benefit. In general, the tax benefit from depreciation can be written as:

• Tax Benefit = Depreciation * Tax Rate

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• How does an increase in working capital affect cashflows?

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• Any increase in working capital reduces cash flows in that year

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• What is a sunk cost and give an example?

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• Any expenditure that has already been incurred, and cannot be recovered (even if a project is rejected) is called a sunk cost. A test market for a consumer product and R&D expenses for a drug (for a pharmaceutical company) would be good examples.

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• Look at the following investment and say if the project should be taken or not if the cost of capital is 10%.

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Year Cashflow Salvage Value

0 -2000

1 -50

2 900

3 1000 700

• Simple CF CFn / (1+r)n

• -2000 - 50/1.1 + 900/(1.1)² + 1700(1.1)3

• = -2000 -55 +743 + 1277 = -34

• Don’t take the project

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• If our book value of equity is 4000 and the profit last year was 1000, what was the Return on Equity?

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• Return will be Return on Equity (ROE) = Net Income/BV of Equity

• =25%

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• Give 2 benefits and costs of debt?

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• Benefits of Debt– Tax Benefits– Adds discipline to management

• Costs of Debt– Bankruptcy Costs– Agency Costs– Loss of Future Flexibility

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• Other things remaining equal, the more certain a firm is about its future financing requirements and projects, the less debt the firm will use for financing current projects. True or False?

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• False

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• What are the 3 steps of finding the optimal debt ratio which minimizes the cost of capital for a firm?

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1. Estimate the Cost of Equity at different levels of debt:

2. Estimate the Cost of Debt at different levels of debt:

3. Estimate the Cost of Capital at different levels of debt

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• Why does the cost of equity and debt increase as the firm has a higher level of debt?

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• The firm becomes riskier

• Cost of Equity – Beta will increase

• Cost of debt – Bond rating will go down

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• How does the enhanced cost of capital approach improve accuracy?

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• In the enhanced cost of capital approach, the indirect costs of bankruptcy are built into the expected operating income. As the rating of the firm declines, the operating income is adjusted to reflect the loss in operating income that will occur when customers, suppliers and investors react.

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• What is the general viewpoint for payments of dividends to owners?

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• If a company has excess cash, and few good investment opportunities returning money to stockholders is good.

• If a company does not have excess cash, and/or has several good investment opportunities returning money to stockholders is bad.

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