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 (100,000 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: Sin millions Tatal debt 425 Total shareholders' equity 250 Net incane Far 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?

Because the market equity beta reflects the level of operating leverage,financial leverage,variability of sales,and other characteristics of a firm,there are situations where an analyst might have to adjust the beta because of changes in the capital structure.A situation that might require an analyst to estimate a new levered beta is a(n)___________________________________.

Shady Sunglasses operates retail sunglass kiosks in shopping malls.Below is information related to the company: (dollar amounts in thousands) Net Cash Flow from Operations 564 628 854 1059 1345 1655 Interest Expense after tax 122 134 148 145 155 148 Decrease (Increase) in Cash -75 -54 -48 -32 -61 -48 Required for Operations Net Cash Flow from Investing -287 -300 -310 -285 -294 -277 Net Cash from Debt Financing 210 204 140 85 -40 -46 Present Value Factors =8.5\% 0.922 0.849 0.783 0.722 0.665 Common Shares Outstanding in thousands 1512 Using the above information and assuming that steady-state growth in year 2017 and beyond will be 4% calculate Shady Sunglasses value per share.

Dividends measure the cash that ____________________ ultimately receive from investing in an equity share.

One criticism in using the CAPM to calculate the cost of equity capital is that ______________________________ and the __________________________________________________ are quite sensitive to the time period and methodology used in their computation.

In theory,the value of a share of common equity is the present value of ____________________________________________________________.

Zonk Corp. The following data pertains to Zonk Corp., a manufacturer of ball bearings (dollar amounts in millions): Tatal assets Interest-bearing debt Average pre-tax borrowring Cammon equity: Badk value Market value Incame tax rate Market equity beta \ 7460 \ 3652 10.5\% \2 950 \1 3685 35\% 1.13 -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 pretax borrowing cost of 14 percent and 30 percent common equity.Compute the revised equity beta for Zonk based on the new capital structure.

Why are dividends value-relevant to common equity shareholders?

According to the text,dividends are value-relevant even though the firm's dividend policy is irrelevant.How can that be true? What is the key assumption in the theory of dividend policy irrelevance?

Why do investors typically accept a lower risk-adjusted rate of return on debt capital than equity capital? Suppose a stable,financially healthy,profitable,tax-paying firm that has been financed with all equity and no debt decides to add a reasonable amount of debt to its capital structure.What effect will that change in capital structure likely have on the firm's weighted average cost of capital?

Investors typically accept a lower risk-adjusted rate of return on debt capital than on equity capital because:

The following financial statement data pertains to Southwater,Inc.,a manufacturer of women's suits (dollar amounts in millions): Total Assets Interest-Bearing Debt Average Pre-taxborrowing cost Common Equity: Book Value Market Value Income Tax Rate Market Equity Beta Market Premium Piek-frep interest rate \ 154,287 \ 33,984 7.75\% \ 21,365 \ 66,735 39.6\% 0.77 7.45\% 25\% Required: a.Calculate the company's cost of equity capital. b.Calculate the weight on debt capital that should be used to determine Northridge's weighted-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 Northridge's weighted-average cost of capital.