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CFA LEVEL 1 – CORPORATE FINANCE MODULE

CFA LEVEL 1 – CORPORATE FINANCE MODULE. PROBLEM REVIEW SESSION 2. COST OF CAPITAL. Equation. The equation to calculate cost of equity using the dividend discount model is R e = D 1 /P 0 + g. Calculation. D1/P0 = 2.00/50.00 = .04 g = (1 – payout ratio) X (ROE) g = (1 - .40) X .16

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CFA LEVEL 1 – CORPORATE FINANCE MODULE

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  1. CFA LEVEL 1 – CORPORATE FINANCE MODULE PROBLEM REVIEW SESSION 2

  2. COST OF CAPITAL

  3. Equation The equation to calculate cost of equity using the dividend discount model is Re = D1/P0 + g

  4. Calculation D1/P0 = 2.00/50.00 = .04 g = (1 – payout ratio) X (ROE) g = (1 - .40) X .16 g = .6 X .16 = .096 Re = .04 + .096 = .136 = 13.6%

  5. Equation After-tax cost of debt = Yield to maturity X (1 – Tax Rate)

  6. Yield to Maturity To solve for Yield to Maturity FV = $1,000 maturity value PMT = $30 semi-annual coupon payment PV = $950 issue amount N = 16 semi-annual periods Solve for i

  7. Yield to Maturity i = .0341 or 3.41% for each period Multiply by 2 to obtain annual i = 6.82% Tax Rate = 35% After-tax cost is 6.82%(1 – 35%) = 4.43%

  8. Solution Rp = Dp/(Po – Selling Costs) Rp = 3.63/(62.70 – 3.3) Rp = .0611 = 6.11%

  9. Solution Capital Asset Pricing Model Re = Rf + β(Rm – Rf) Re = 4% + 1.2(11% - 4%) Re = 4% +1.2(7%) Re = 4% + 8.4% Re = 12.4%

  10. Comprehensive Problem

  11. Other Information

  12. Questions

  13. Questions

  14. Solutions After-Tax Cost of Debt FV = $1,000 PMT = $36.25 (72.50/2) PV = $875 N = 40 (20 years x 2) Solve for i = .042834 = 4.2834% X 2 = 8.5669% After-Tax Cost = i X (1 – tax rate) = 8.5669% X (1 – 40%) = 5.14%

  15. Cost of Equity using CAPM Re = Rf + β(Rm – Rf) Rf = T Bond Rate = 5.5% - bond comparable to stock market β = 1.25 Rm = 11.5% - future expected return Re = 5.5% + 1.25(11.5% - 5.5%) = 13%

  16. Debt and Equity Weighting Best to use market value of debt and equity Market value of debt = 40,000 bonds X $875 per bond = $35 million Market value of equity = 10 million shares X $7.50 per share = $75 million Total capital = $35 million + $75 million = $110 million Wd = $35 million/$110 million = 31.8% We = $65 million/$110 million = 68.2%

  17. WACC WACC = (Wd X Kd) + (We X Ke) WACC = (31.8% X 5.14%) + (68.2% X 13%) WACC = 1.63% + 8.87% WACC = 10.5%

  18. Working Capital Management

  19. Operating Cycle Credit Sales = $50,000 Cost of Goods Sold = $40,000 Accounts Receivable = $5,000 Inventory – Ending Balance = $4,600 The operating cycle for this company is closest to: • 42.0 days • 47.9 days • 78.5 days

  20. Solution Operating Cycle = days in inventory + days in receivables Days in inventory = Inventory/Cost of Goods/365 = 4,600/(40,000/365) = 41.98 days Days in receivables = Receivables/Credit Sales/365 = 5,000/(50,000/365) = 36.50 days Operating Cycle = 41.98 + 36.50 = 78.5 days

  21. Borrowing Cost Options Three choices to borrow $1 million for 1 month • Draw down a line of credit at 7.2% with a .5% commitment fee on full amount • Banker’s acceptance at 7.1%, an all inclusive rate • Commercial paper at 6.9% with a dealer’s commission of .25%, and a backup line cost of .33% Which option would result in the lowest borrowing cost?

  22. Line of Credit Line of Credit = (Interest + Commitment Fee)/Net Proceeds x 12 (7.2% X $1 million X 1/12) = $6,000 (.5% X $1 million x 1/12) = $416.67 ($6,000 + $416.67)/$1 million x 12 = .077 = 7.7%

  23. Banker’s Acceptance Banker’s Acceptance Cost = Interest/Net Proceeds X 12 Interest = (7.1% X $1 million x 1/12) = $5,916.67 Net Proceeds = $1 million – Interest = $1 million - $5,916.67 = $994,083.33 Cost = $5,916.67/$994,083.33 X 12 = .0714 = 7.14%

  24. Commercial Paper Commercial Paper Cost = (Interest + Dealer Commission + Backup Cost)/Net Proceeds X 12 (6.9% X $1 million) + (.25% X $1 million) + (.33% X $1 million) = $5,750 + $208.33 + $277.78 = $6,236.10 Net Proceeds = $1 million – Interest - $1 million - $5,750 = $994,250 Cost = $6,236.10/$994,250 X 12 = .0753 = 7.53%

  25. Financial Statement Analysis

  26. DuPont Analysis DuPont analysis involves breaking return-on-assets ratios into their: • Marginal and average components • Operating and financing components • Profit margin and turnover components

  27. DuPont Analysis Return on Assets = Net Income/Assets Profit Margin = Net Income/Sales Asset Turnover = Sales/Assets Therefore Return on Assets = Profit Margin x Asset Turnover

  28. DuPont System The DuPont system breaks down return on equity into: • Return on assets and the financial leverage ratio • Profit margin, the tax retention ratio, and inventory turnover • Gross profit margin, total asset turnover, and the debt-to-equity ratio

  29. DuPont System The DuPont system expands upon the calculation of return on equity to consider the financial leverage of a firm Return on equity is a function of a firm’s return on assets, and how much of the assets are financed by the equity of the firm ROE = ROA X (Total assets/Total equity)

  30. DuPont System A company’s net profit margin is 5%, asset turnover is 1.5 times, and financial leverage is 1.2 times. Its return on equity is closest to: • 9.0% • 7.5% • 3.2%

  31. Solution Return on Equity = Net Income/Equity = Net Income/Revenue X Revenue/Total Assets X Total Assets/Total Equity Net Income/Revenue = Profit Margin = 5% Revenue/Total Assets = Turnover = 1.5 Total Assets/Total Equity = Financial Leverage = 1.2 ROE = 5% X 1.5 X 1.2 = 9.0%

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