4 factors that affect the cost of money (Inflation, risk, opportunity cost, time preferences for

consumption)
Fisher Equation: = /1+ Real discount rate dont use
inflation
Determinants of interest rates: r = r * + IP + TP + DP + LP(liquidity) + OP(callable, convertible)
Yield Curve: as time horizon deepens, rates increase as a reward for additional exposure to the risk
of default
Risk free rate: companies use 30YR, For projects use appropriate term, always term premium
Treasury Info: T-Bill(1-2YRS), Notes(2-10), Bonds(10YRS)
Pure Expectations Hypothesis: There is no maturity term premium long-term rates are an average
of short-term rates.
EAR = [1+(APR/N)^N]-1 Ordinary Annuity PV = Cash flows/R*[1-(1/(1+r)^N)] only use EAR if
specified, adjust N to months. IF problems ask for outstanding balance =Find PV. Look how to
rearrange #s.
Two things needed for valuation: Cash flow and discount rates
CAPM Model: The expected return for all assets is determined by the assets correlation to the
market portfolio and the risk free return. rA = rf+A (rm-rf ) - makes assumption that markets are
efficient (a market in w/ an investor cant beat the market in the 10YR term) is a good assumption and
holds true
Rm-Rf= Market Risk Premium or Equity Risk Premium Use long-run measure of the market
premium. historical data surveys Use the Beta that is: most closely associated with the
cyclicality and risk components going forward may differ from the published companys Beta how
might we adjust? Use appropriate term risk-free rates, which follow these rules: 1. match term 2.
adjust for any term premium
Beta stocks volatility in relation to the market, is slope Rm all risky assets available to investors,
use SP 500 as proxy
Alpha = E(re) Re what a manger adds to fund, if markets are efficient alpha = 0 (expected
return-required return)
CAPM Controversy: Limitation in measuring the market portfolio; therefore it is difficult to calculate
a market premium. Betas vary over time. The model is hard to prove or disprove. The model has
competitors.
Capital Sources: common stock, preferred stock, bonds, and any other LT debt always use market
values or target capital structure. R= cost, required return, market value
WACC = wd rd (1-T) + wP rP + we re (debt is the cheapest, equity is the most expensive)
*LOOK AT MKT VALUES*
MVD = PPB X # outstanding Rd =Assume semi-annual coupons, coupon pmt = cpn% X FV/N Find I/Y
or YTM of bond for
MVP = PPS X outstanding Rp = (Div/P0) no growth rate. If it doesnt give Dividend take Par x %
dividend on preferred
MVE = PPS X outstanding or Enterprise Value debt + Excess cash. Re = (D1/P0)+ g(dividend growth
rate) - Or use CAPM
Only can use WACC for companies in the same industries use target rates if you cant use CAPM
Calculating betas (comparative) 1. Find the betas of comparable firms. 2. Un-lever their betas.
(remove the effect of capital structure) 3. Find their weighted average by weighting them according to
similarity to target company. 4. Re-lever the new beta to reflect the target capital structure for the
target firm.
Note: You can use R(costs)
in place of Beta Unlevering Beta = ((1-T)*Wd*Bd+We*Be) / (1-T)*Wd+We
Relever Beta: e BU (1T)(D / E)(BU Bd ) ------- can use all Bs as Rs
How do we value a firm? 1. NPV with WACC 2. Adjusted Present Value (APV) 3. Flow-to-Equity (FTE)
Pro-Forma Cash Flows: Cash flow at year 0 & change in WC not considered for company or
recuperated, is for a project

Sales/Revenue COGS = Gross Profit OPEX(SGA) DEP = EBIT- Interest = EBT TAX = NI NOPAT =
EBIT(1-Tax)
OCF = NOPAT + Depreciation and Amortization FCF = OCF + Change in WC(decrease = positive, vice
versa)+ CAPEX
Terminal Value (At some point, we assume the cash flows become a perpetuity or a growing
perpetuity)
TV = FCFn+1(take last year and grow to next)/WACC G **add terminal value to the last CF in
Enterprise Value
Salvage Value: Sell Price-Book Value= Gain/Loss. If you lose you get a tax credit and add back to
salvage value
Enterprise Value = NPV of FCF YRS 1-year n before constant growth + TV. MVE = EV Debt +
Excess Cash
MACRS is different value every year. Uses depreciation percentages.
PPS = MVE/# of outstanding shares
TAXES Marginal rate is relevant, next dollar, tax is bracket by bracket of income. Taxtreatmentofsources
anduses:Interest&DividendsPaidInterest&DividendsReceivedCapitalgainsTaxLossCarryBackandCarryForward

Progressive goes up as a percentage

Modigliani & Miller (M&M) Debt Irrelevance Proposition No taxes No direct financial distress
costs No indirect financial distress costs No direct transaction costs Firm managers dont have
private information about the firms prospects No agency problems between managers and investors
Investors can borrow or lend on their own account on the same terms as the firm Markets are
perfectly competitive and thus efficient
How does adding debt affect value? affects cash flows to shareholders affects risk for
shareholders
Expected Average Return = Prob X ROE +Prob 2 X ROE 2 for all periods summed together
Risk held in Isolation or Standard Deviation=sqrt(probability(Expected Avg Return-r)^2+ other
terms) r=ROE
Equity Value = expected net income/required return on equity
Tax shield = MVD * Tax Rate. PV( tax shields) = (T *RD*D)/RD = T*D = TS. ATS = T*rD*D(same as
MVD)
Interest Expense: Rd X D Where D=MVE. MVFL = MVFU + TS. MVE= NI(re-g) MVE=MVFU
How does capital structure effect cost of capital? WACC does not capture capital structure
change effects easily We will look at a method for assessing change in costs due to structure
changes This will require the calculation of unlevered bet. Conclusions on WACC Changes in the
target capital structure will affect both the weights and the costs of capital. Re-calculating WACC can
be onerous (time burden). Perhaps a method that does not use WACC could prove more efficient. We
could use a model that uses the cost of the companys capital as if it is 100% equity financedalso
known as Adjusted Present Value or APV
EX: The Tip-Top Paving Co. wants to be levered at a debt to value ratio of .6. The cost of debt is 11%,
the tax rate is 34%, and the cost of equity for an all equity firm is 14%. What will be Tip-Top's cost of
equity? Hint: we can use the Be formula for the re calc. 16.97% Re = rua + (1-T)(d/e)(rua-rd) 14%
+.66(.6/.4)(14%-11%) = 16.97%
Ex: Moser Manufacturing doesnt pay dividends. Growth for the company is expected to be 15 percent.
For the coming year, the company expects the following:
EBIT of $500,000
Depreciation of $250,000
Tax rate of 40%
Change in NOWC of $100,000
Capital Expenditures of $350,000
Market Value of Debt of $5,000,000 No excess cash.
1,000,000 shares outstanding

WACC = 16.9%
What is the current price of Moser stock using the NPV/WACC method? ANSWER: $0.26 per share FCF
= 500,000*.6 + $250,000 - $100,000 - $350,000 = $100,000 EV Firm = $100,000/(.169-.15) =
$5,263,157.90 MVE = $5,263,157.90 - $5,000,000 = $263,157.90 PPS = $263,157.90/1M shares =
$.26