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I need someone to help me with the attached finance worksheet. There are 3 problems in this excel file - one problem on each individual tab. I am attaching a couple of additional files as well that has examples, formulas and content related to the problems.

A B C D E F G H I 1 Tool Kit Chapter 15 12/9/2012 2 3 Capital Structure Decisions 4 5 6 15-2 Business Risk and Financial Risk 7 8 9 Operating Leverage reflects the amount of fixed costs embedded in a firm's operations. Thus, if a high percentage of a firm's costs are fixed, hence 10 continue even if sales decline, then the firm is said to have high operating leverage. High operating leverage produces a situation where a small change in 11 sales can result in a large change in operating profit. The following example compares two operational plans with different degrees of operating leverage. 12 13 14 Figure 15-1 15 Illustration of Operating and Financial Leverage (Millions of Dollars and 16 Millions of Units, Except Per Unit Data) Plan A Plan U Plan L 17 1. Input Data $3 $3 $3 18 Required operating current assets $199 $199 $199 19 Required long-term assets $2 $2 $2 20 Resulting operating current liabilities $202 $202 $202 21 Total assets $200 $200 $200 22 Required capital (TA Op. CL) $200 $200 $150 23 Book equity $0 $0 $50 24 Debt 8% 8% 8% 25 Interest rate $2.00 $2.00 $2.00 26 Sales price (P) 40% 40% 40% 27 Tax rate (T) 110 110 110 28 Expected units sold (Q) $20 $60 $60 29 Fixed costs (F) $1.50 $1.00 $1.00 30 Variable costs (V) Plan A Plan U Plan L 31 2. Income Statements $220.0 $220.0 $220.0 32 Sales revenue (P x Q) 20.0 60.0 60.0 33 Fixed costs 165.0 110.0 110.0 34 Variable costs (V x Q) $35.0 $50.0 $50.0 35 EBIT 0.0 0.0 4.0 36 Interest $35.0 $50.0 $46.0 37 EBT 14.0 20.0 18.4 38 Tax Net income $21.0 $30.0 $27.6 39 Plan A Plan U Plan L 40 3. Key Performance Measures $21.0 $30.0 $30.0 41 NOPAT = EBIT(1 T) 10.5% 15.0% 15.0% 42 ROIC = NOPAT/Capital 10.4% 14.9% 13.7% 43 ROA = NI/Total assets 10.5% 15.0% 18.4% 44 ROE = NI/Equity 45 46 Note: ROA is not exactly equal to ROE for the Plan L or Plan U because total assets is not quite equal 47 to equity for these plans. This is because the operating current liabilities, such as accounts payable 48 and accruals, reduce the required capital investment of equity. 49 50 We can use the following formula to find the exact break-even quantity. F (P-V) 51 QBE = 52 Plan A F (P V) 53 QBE = $20 $2.00 $1.50 54 QBE = 40 Units. 55 QBE = 56 57 Plan U F (P V) 58 QBE = $60 $2.00 $1.00 59 QBE = 60 Units. 60 QBE = 61 62 63 64 65 66 67 Figure 15-2 68 Operating Leverage and Financial Leverage 69 70 Panel b: Finacial Leverage Panel a: Operating Leverage 71 ROE ROA 72 73 40.0% 40.0% 74 75 76 Cro s s over at 30.0% C ro s s over at 30.0% 76 Millio n 77 80 Millio n Units Units 78 20.0% 79 20.0% 80 81 Plan U Plan A 10.0% 10.0% 82 B reak-even Q Break-even Q 83 84 0.0% 0.0% 85 86 Units So ld 87 (Millio ns ) -10.0% -10.0% 88 Plan L Plan U 89 B reak-even Q B reak-even Q 90 -20.0% -20.0% 91 92 -30.0% -30.0% 93 94 0 20 40 60 8 0 100 0 20 40 60 80 100 120 140 95 96 97 Units So ld (Millio ns ) 120 140 A 98 99 100 101 102 103 104 105 106 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140 141 142 143 144 145 146 147 148 149 150 151 152 153 154 155 156 157 158 159 160 161 162 163 164 165 166 167 168 169 170 171 172 173 174 175 176 177 178 179 180 181 182 183 184 185 186 B C D E F G H I FINANCIAL RISK AND LEVERAGE Leverage magnifies the ROE. See Panel b of Figure 15-2 above. 15-5 Estimating the Optimal Capital Structure Figure 15-4 Strasburg's Current Value and Capital Structure (Millions of Dollars Except Per Share Data) Input Data: Tax rate Debt (D) # of shares (n) Stock price (P) NOPAT Free Cash Flow (FCF)a Growth rate in FCFa Cost of Capital: Cost of debt (rd) Beta (b) Risk-free rate (rRF) Mkt. risk prem. (RPM) Cost of equity: rs = rRF + b(RPM ) WACC Capital Structure: 40.00% Market value of equity (S = P x n) $50.00 Total value (V = D + S) % financed with debt (wd = D/V) 10.00 % financed with stock (ws = S/V) $20.00 $30.00 $30.00 0.00% Estimated Intrinsic Value: Value of operations: 8.00% Vop = [FCF(1+g)]/(WACCg) 1.25 6.30% 6.00% 13.80% 12.00% + Value of ST investments Estimated total intrinsic value Debt Estimated intrinsic value of equity Number of shares Estimated intrinsic price per share $200 $250 20% 80% $250.00 $0.00 $250.00 $50.00 $200.00 10.00 $20.00 Note: Strasburg's sales, earnings, and assets are not growing, so it does not need investments in operating capital. Therefore, FCF = NOPAT(1 T). The growth in FCF also is 0. a The optimal capital structure is the one that maximizes the value of the company. Also, that same capital structure minimizes the WACC. We begin by estimating how capital structure affects the costs of debt and equity. The effects on debt are usually estimated by talking with bankers and investment bankers. Discussions with its bankers indicate that Strasburg can borrow different amounts, but the more it borrows, the higher the cost of its debt. Note: the percentages are based on market values. Figure 15-5 Estimating Strasburg's Optimal Capital Structure (Millions of Dollars) Percent of Firm Financed with Debt (wd) 1. 2. 3. 4. 5. ws rd b rs rd (1T) 6. WACC 7. Vop 8. Debt 9. Equity 10. # Shares 11. Stock price 12. Net income 13. EPS Notes: 0% 100.00% 7.70% 1.09 12.82% 4.62% 10% 90.00% 7.80% 1.16 13.26% 4.68% 20% 80.00% 8.00% 1.25 13.80% 4.80% 30% 70.00% 8.50% 1.37 14.50% 5.10% 40% 60.00% 9.90% 1.52 15.43% 5.94% 50% 50.00% 12.00% 1.74 16.73% 7.20% 60% 40.00% 16.00% 2.07 18.69% 9.60% 12.82% $233.98 $0.00 $233.98 12.72 12.40% $241.96 $24.20 $217.76 11.34 12.00% $250.00 $50.00 $200.00 10.00 11.68% $256.87 $77.06 $179.81 8.69 11.63% 11.97% $250.68 $125.34 $125.34 6.25 13.24% $226.65 $135.99 $90.66 5.13 $18.40 $30.00 $2.36 $19.20 $28.87 $2.54 $20.00 $27.60 $2.76 $20.69 $26.07 $3.00 $20.79 $20.07 $20.98 $3.36 $17.66 $16.95 $3.30 $257.86 $103.14 $154.72 7.44 $23.87 $3.21 1. The percent financed with equity is: ws = 1 wd 2. The interest rate on debt, rd, is obtained from investment bankers. 3. The levered beta is estimated using Hamada's formula, and unlevered beta of b U = 1.09, and a tax rate of 40%: b = bU [1 + (1-T) (wd/ws)]. 4. The cost of equity is estimated using the CAPM formula with a risk-free rate of 6. 3% and a market risk premium of 6%: rs = rRF + (RPM)b. 5. The after-tax cost of debt is rd (1T), where T = 40%. 6. The weighted average cost of capital is calculated as: WACC = ws rs + wd rd (1-T). 7. The value of the firm's operations is calculated as: Vop = [FCF(1+g)] / (WACC g), where FCF = $30 million and g = 0. 8. Debt = wd x Vop 9. The equity after the recap & repurchase is SPost = Vop Debt = ws x Vop 10. The number of shares after the recap has been completed is found using: nPost = nPrior [(VopNew - DNew) / (VopNew-DOld)]. The subscript "Old" indicates values from the original capital structure where wd = 20%, the subscript "New" indicates values at the current capital structure after the recap & repurchase, and the subscript "Post" indicates values after the recap & repurchase. 11. The price after the recap & repurchase is: PPost = SPostPost. But we can also find the price as: PPost = (VopNew DOld)Prior. 12. EBIT is $50 million; see Figure 15-1. Net income is: NI = (EBIT r dD)(1 T). 13. Earnings per share is: EPS = NIPost. THE HAMADA EQUATION Hamada developed his equation by merging the CAPM with the Modigliani-Miller model. We use the model to determine beta at different amount of financial leverage, and then use the betas associated with different debt ratios to find the cost of equity associated with those debt ratios. Here is the Hamada equation: A 187 188 189 190 191 192 193 194 195 196 197 198 199 200 201 202 203 204 205 206 207 208 209 210 211 212 213 214 215 216 217 218 219 220 221 222 223 224 225 226 227 228 229 230 231 232 233 234 235 236 237 238 239 240 241 242 243 244 245 246 247 248 249 250 251 252 253 254 255 256 257 258 259 260 261 262 263 264 265 266 267 268 269 270 271 272 273 274 275 276 277 278 279 280 281 282 283 284 285 286 287 288 289 290 291 292 293 294 295 296 297 298 299 300 301 B C D E F G H I b = bU x [1 + (1-T) x (D/S)] b = bU x [1 + (1-T) x (wd/ws)] bU = b / [1 + (1-T) x (wd/ws)] Here b is the leveraged beta, bU is the beta that the firm would have if it used no debt, T is the marginal tax rate, D is the market value of the debt, and S is the market value of the equity. Levered beta, b Current wd Current ws Tax rate 1.25 20% 80% 40% bU 1.0870 As shown above, beta rises with financial leverage. With beta specified, we can determine the effects of leverage on the cost of equity. Data for Figure 15-6 wd rRF 0% 6.30% 6.52% 0.00% 0.00% rUnlevered-rRF rs-rUnlevered-rRF For graph 10% 6.30% 6.52% 0.43% 0.00% 20% 6.30% 6.52% 0.98% 0.00% 30% 6.30% 6.52% 1.68% 0.00% 40% 6.30% 6.52% 2.61% 0.00% 50% 6.30% 6.52% 3.91% 0.00% 60% 6.30% 6.52% 5.87% 0.00% Figure 15-6 Strasburg's Required Rate of Return on Equity at Different Debt Levels Required Ret urn on Equit y 20% rs 18% 16% Premium for Financial Risk: (b bU ) x RPM 14 % 12% 10% 8% Premium for Business Risk: bU x RPM = 6.52% 6% 4% 2% 0% 0% 10% 2 0% 30% 4 0% 5 0% 60% Risk-Free Rate: rRF = 6.3% Percent Financed wit h Debt Figure 15-7 Effects of Capital Structure on Cost of Capital Cost of Ca pit a l 20% 1 5% 1 0% 5% 0% -1 0% 0% 1 0% 20% 30% 4 0% 50% 60% Percent Fina nced wit h Debt Data for Figure below wd Vop Debt Equity (S) V for chart 0% $233.98 $0.00 $233.98 $0.00 10% $241.96 $24.20 $217.76 $0.00 Figure 15-8 Effects of Capital Structure on the Value of Operations $ 27 5 $ 250 $ 225 $ 200 $175 $ 1 50 $ 1 25 $ 1 00 $75 $ 50 20% $250.00 $50.00 $200.00 $0.00 30% $256.87 $77.06 $179.81 $0.00 40% $257.86 $103.14 $154.72 $0.00 50% $250.68 $125.34 $125.34 $0.00 60% $226.65 $135.99 $90.66 $0.00 A$ 50 302 303 304 305 306 307 308 309 310 311 312 313 314 315 316 317 318 319 320 321 322 323 324 325 326 327 328 329 330 331 332 333 334 335 336 337 338 339 340 341 342 343 344 345 346 347 348 349 350 351 352 353 354 355 356 357 358 359 360 361 362 363 364 365 366 367 368 369 370 371 372 373 374 375 376 377 378 379 380 381 382 383 384 385 386 387 388 389 390 391 392 B C D E F G H $ 25 $0 0% 1 0% 20% 30% 4 0% 50% 60% Percent Financed wit h Debt 15-6 Anatomy of a Recapitalization Strasburg will issue additional debt and use the proceeds to repurchase stock. This is a recapitalization, often called a "recap." When Strasburg announces its planned recapitalization, investors realize that the company will be worth more after the recap because it will have a lower cost of capital. Therefore, the stock price will increase when the plans are announced, even though the actual repurchase has not yet occurred. If the stock price did not increase until after the actual repurchase, it would be possible for an investor to buy the stock immediately prior to the repurchase, and then reap a reward the next day when the repurchase occurred. Curent stockholders realize this, and refuse to sell the stock unless they are paid the price that is expected immediately after the repurchase occurs. Figure 15-9 Anatomy of a Recapitalization (Millions, Except Per Share Data) Before Issuing Additional Debt (1) After Debt Issue, but Prior to Repurchase (2) Post Repurchase (3) Percent financed with debt: wd 20% 40% 40% Value of operations + Value of ST investments Estimated total intrinsic value Debt Estimated intrinsic value of equity Number of shares Estimated intrinsic price per share $250.00 0.00 $250.00 50.00 $200.00 10.00 $20.00 $257.86 53.14 $311.00 103.14 $207.86 10.00 $20.79 $257.86 0.00 $257.86 103.14 $154.72 7.44 $20.79 Value of stock + Cash distributed in repurchase Wealth of shareholders $200.00 0.00 $200.00 $207.86 0.00 $207.86 $154.72 53.14 $207.86 1. The value of ST investments in Column 2 is equal to the amount of cash raised by issuing additional debt but that has not been used to repurchase shares: ST investments = DNew DOld. Notes: 2. The value of ST investments in Column 3 is zero because the funds have been used to repurchase shares of stock. 3. The number of shares in Column 3 reflects the shares repurchased: nPost = nPrior (CashRep/PPrior) = nPrior ([DNew DOld]/PPrior). Figure 15-10 Effect of Capital Structure on Intrinsic Stock Price and Earnings per Share EPS St ock Price $ 25 $6 Pric e $ 20 $4 $ 15 $ 10 $2 $5 EPS $0 -1 0% 0% 1 0% 20% 30% 4 0% 50% $0 60% Percent Financed wit h Debt Shortcut Formulas Applied to Change in Capital Structure: w d Prior = 20%, wd Post = 40% Inputs: wd = VopNew = nPrior = DNew = DOld = 40% $257.86 10.00 $103.14 $50.00 Shortcuts: SPost = VopNew (1-wd) = nPost = nPrior (VopNew - DNew) / (VopNew - DOld) = PPost = (VopNew - DOld) / nPrior = $154.72 7.44 $20.79 I J K L M N O 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 Data Table for Figure x-axis for both panels. Q 0 20 40 60 64 76 80 100 120 140 ROA for Panel a Plan A Plan U 10.4% 14.9% ROE for panel b Plan U Plan L 15.0% 18.4% -18.0% -25.6% -12.0% -17.6% -6.0% -9.6% 0.0% -1.6% 1.2% 0.0% 4.8% 4.8% 6.0% 6.4% 12.0% 14.4% 18.0% 22.4% 24.0% 30.4% SECTION 15-2 SOLUTIONS TO SELF-TEST A firm has fixed operating costs of $100,000 and variable costs of $4 per unit. If it sells the product for $6 per unit, what is the breakeven quantity? F= V= P= $100,000 $4 $6 QBE 50,000 SECTION 15-5 SOLUTIONS TO SELF-TEST Use the Hamada equation to calculate the unlevered beta for JAB Industries, assuming the following data: bL = 1.4; T = 40%; wd = 45%. bL Tax rate wd Equity ratio bU 1.4 40% 45% 0.55 0.9390 Suppose rRF = 6% and RPM = 5%. What would the cost of equity be for JAB Industries if it has no debt? If wd is 45%? rRF 6% RPM 5% No debt: From 5, bu = rs,U Debt From 5, bL = rs,L 0.9390 10.70% 1.00 1.40 13.00% SECTION 15-6 SOLUTIONS TO SELF-TEST A firm's value of operations is equal to $800 million after a recapitalization (the firm had no debt before the recap). It raised $200 million in new debt and used this to buy back stock. The firm had no short-term investments before or after the recap. After the recap, w d = 25%. The firm had 10 million shares before the recap. What is S (the value of equity after the recap)? What is P (the stock price) after the recap? What is n (the number of remaining shares) after the recap? Vop D wd n0 $800 $200 25% 10 S= $600 P= $80.00 n= 7.5 Introduction Equity https://ecampus.wvu.edu/bbcswebdav/pid-2448697-dt-content-rid-6266... We now turn to stocks, both common and preferred. Since the cash flows provided by bonds are set by contract, it is generally easy to predict their cash flows. Preferred stock returns are also set by contract, which makes them similar to bonds; and they are valued in much the same way. However, common stock returns are not contractual. Common stockholders may get their returns either from dividends or through capital gains. But, the firm is not obligated to pay dividends. Investors must make their best estimate of what dividends, if any, the firm will pay. Two fairly straightforward models are used to estimate stocks' intrinsic (or "true") values: 1. The discounted dividend model, and 2. The corporate valuation model. Each of these is based on our DCF Model. The corporation has an infinite life, so there is no last period in the valuation models. The discounted dividend model shows that the price of an individual share at time zero is a reflection of all future dividends Dt. Stock Price The Corporate Valuation Model also follows the DCF model and notes that the value of the firm at time zero V0 is equal to the value of the debt and the value of the equity of the firm. To value a share of stock, we apply the Corporate Valuation Model to anticipated Free Cash Flow (FCFt) : Stock Price Firm Value And then subtract the market value of debt to get the value of all equity. Divide that value by the number of shares to get the value of a share of 1 of 2 8/24/2015 4:32 PM Introduction Equity https://ecampus.wvu.edu/bbcswebdav/pid-2448697-dt-content-rid-6266... stock. Price (Next Module 4 Objectives) West Virginia University Copyright 2010 2 of 2 8/24/2015 4:32 PM Objectives Module 4 1 of 1 https://ecampus.wvu.edu/bbcswebdav/pid-2448698-dt-content-rid-6266... At the end of this module you will be able to: Explain the legal rights of stockholders Explain the distinction between a stock's price and its intrinsic value Value a share of common stock using the Gordon Constant Growth Model Value a share of common stock that does not have constant growth characteristics Value a share of common stock using the corporate valuation model Value a share of preferred stock Explain the key characteristics of preferred stock (Next Readings) West Virginia University Copyright 2010 8/24/2015 4:32 PM Readings Module 4 1 of 1 https://ecampus.wvu.edu/bbcswebdav/pid-2448699-dt-content-rid-6266... Read Chapter 7: Stock Valuation, which has the following sections of particular interest: Legal Rights and Privileges of Common Stockholders Types of Common Stock Valuing Common Stocks Valuing a Constant Growth Stock Valuing Nonconstant Growth Stocks The Free Cash Flow Valuation Model Preferred Stock A light reading of the remaining sections will suffice. Next read Chapter 15 with attention to sections: An Overview of Capital Structure Capital Structure Theory A light reading of the remaining sections will suffice. (Next Legal Rights and Privileges of Common Stock) West Virginia University Copyright 2010 8/24/2015 4:33 PM Legal Rights for Stockholders 1 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448700-dt-content-rid-6266... A corporation's common stockholders are the owners of the corporation; and as such, they have certain rights and privileges. Control of the Firm A firm's common stockholders have the right to elect its directors, who, in turn, elect the officers who manage the business. In a small firm, usually the major stockholder is also the president and chair of the board of directors. In large, publicly owned firms, the managers typically have some stock, but their personal holdings are generally insufficient to give them voting control. Thus, the managements of most publicly owned firms can be removed by the stockholders if the management team is not effective. The Preemptive Right Common stockholders often have the right, called the preemptive right, to purchase on a pro rata basis any additional shares sold by the firm. In some states, the preemptive right is automatically included in every corporate charter; in other states, it must be specifically inserted into the charter. Types of Common Stock Although most firms have only one type of common stock, in some instances, classified stock is used to meet special needs. Generally, when special classifications are used, one type is designated Class A, another Class B, and so forth. Small, new companies seeking funds from outside sources frequently use different types of common stock. For example, when Google went public, it sold Class A stock to the public while its Class B stock was retained by the company's insiders. The key difference is that the Class B stock has 10 votes per share while the Class A stock has 1 vote per share. Google's Class B shares are predominantly held by the company's two founders and its current CEO. The use of classified stock thus enables the company's founders to maintain control over the company without having to own a majority of the common stock. For this reason, Class B stock of this type is sometimes 8/24/2015 4:33 PM Legal Rights for Stockholders 2 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448700-dt-content-rid-6266... called founders' shares. Since dual-class share structures of this type give special voting privileges to key insiders, these structures are sometimes criticized because they may enable insiders to make decisions that are counter to the interests of the majority of stockholders. Note that "Class A," "Class B," and so forth, have no standard meanings. Most firms have no classified shares; but a firm that does could designate its Class B shares as founders' shares and its Class A shares as those sold to the public, while another could reverse those designations. (Next Market Price and Intrinsic Values) West Virginia University Copyright 2010 8/24/2015 4:33 PM Market Price and Intrinsic Values 1 of 1 https://ecampus.wvu.edu/bbcswebdav/pid-2448701-dt-content-rid-6266... A manager should seek to maximize the value of his or her firm's stock. The stock price is simply the current market price, and it is easily observed for publicly traded companies. By contrast, intrinsic value, which represents the "true" value of the company's stock, cannot be directly observed and must instead be estimated. Determinants of Intrinsic Values and Stock Prices Intrinsic Value As the figure suggests, market equilibrium occurs when the stock's price equals its intrinsic value. If the stock market is reasonably efficient, gaps between the stock price and intrinsic value should not be very large and they should not persist for very long. (Next Constant Growth Model Valuation) West Virginia University Copyright 2010 8/24/2015 4:33 PM Gordon Model 1 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448702-dt-content-rid-6266... The Discounted Dividend Model The value of a share of common stock depends on the cash flows it is expected to provide, and those flows consist of two elements: 1. the dividends the investor receives each year while he or she holds the stock, and 2. the price received when the stock is sold. The final price includes the original price paid plus an expected capital gain. Keep in mind that there are many different investors in the market and thus many different sets of expectations. Therefore, different investors will have different opinions about a stock's true intrinsic value and thus proper price. The analysis as performed by the marginal investor, whose actions actually determine the equilibrium stock price, is critical; but every investor, marginal or not, implicitly goes through the same type of analysis. Expected Dividends as the Basis for Stock Values Stock prices are determined as the present value of a stream of cash flows, and the basic stock valuation equation is similar to the one for bonds. What are the cash flows that a corporation will provide to its stockholders? It is a stream of dividends; and the value of the stock today can be calculated as the present value of an infinite stream of dividends: Stock Price What about the more typical case, where you expect to hold the stock for a finite period and then sell it-what will be the value in this case? Recognize that for any individual investor, the expected cash flows consist of expected dividends plus the expected sale price of the stock. However, the sale price to the current investor depends on the dividends some future investor expects, and that investor's expected sale price is also dependent on some future dividends, and so forth. Therefore, for all present and future investors in total, expected cash flows must be based on expected future dividends. 8/24/2015 4:34 PM Gordon Model 2 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448702-dt-content-rid-6266... Constant Growth Stocks: In the generalized stock valuation model the time pattern of Dt can be anything: Dt can be rising, falling, or fluctuating randomly; or it can be zero for several years. For many companies it is reasonable to predict that dividends will grow at a constant rate. The constant growth model, or Gordon model, named after Myron J. Gordon, who did much to develop and popularize it represents this predictable pattern. Constant Growth Gordon's model was based upon stability in dividends, but also stability in the firm's growth, where dividends were consider a residual payout. In his model the growth rate g represents the growth rate of the firm, the growth rate of dividends, and the growth rate of stock price. Price The term rs is the required rate of return, which is a riskless rate plus a risk premium. Here are two video demonstrations. The first is an application of the constant growth model (Warning! You are about to download: Equity Problem Constant Growth) problem (Transcript). The second shows the effect of value from variations in the growth rate and discount rate (Warning! You are about to download: Equity Problem Growth Rates) problem. The Excel Workbook is also available. However, we know that if the stock is in equilibrium, the required rate of return must equal the expected rate of return, which is the expected dividend yield plus an expected capital gains yield. So we can solve for rs: Yield (Next non-Constant Growth Model Valuation) West Virginia University Copyright 2010 8/24/2015 4:34 PM FCF Model Valuation 1 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448704-dt-content-rid-6266... Valuing the Entire Corporation: Thus far we have discussed the discounted dividend model for valuing a firm's common stock. This procedure is widely used, but it is based on the assumption that the analyst can forecast future dividends reasonably well. This is often true for mature companies that have a history of steadily growing dividends. However, dividends are dependent on earnings; so a really reliable dividend forecast must be based on an underlying forecast of the firm's future sales, costs, and capital requirements. This recognition has led to an alternative stock valuation approach, the corporate valuation model. Value Rather than starting with a forecast of dividends, the corporate valuation model focuses on the firm's future free cash flows. We discussed free cash flow (FCF) in Chapter 3, where From this we develop the following: Constant FCF Growth 8/24/2015 4:34 PM FCF Model Valuation 2 of 2 https://ecampus.wvu.edu/bbcswebdav/pid-2448704-dt-content-rid-6266... (Next Preferred Stock) West Virginia University Copyright 2010 8/24/2015 4:34 PM Preferred Stock 1 of 1 https://ecampus.wvu.edu/bbcswebdav/pid-2448705-dt-content-rid-6266... Preferred stock is a hybrid-it is similar to a bond in some respects and to common stock in others. This hybrid nature becomes apparent when we try to classify preferred stock in relation to bonds and common stock. Like bonds, preferred stock has a par value and a fixed dividend that must be paid before dividends can be paid on the common stock. However, the directors can omit (or "pass") the preferred dividend without throwing the company into bankruptcy. So although preferred stock calls for a fixed payment like bonds, skipping the payment will not lead to bankruptcy. As noted earlier, a preferred stock entitles its owners to regular, fixed dividend payments. If the payments last forever, the issue is a perpetuity whose value, is found using the Gordon model with g = 0. Thus, Preferred Price Pp0 is the value of the preferred stock, D is the preferred dividend, and rp is the required rate of return on the preferred. Here are two video demonstrations for preferred stock. First, there is a preferred stock valuation (Course CD: Equity Problem Preferred Stock) problem. Second, there is a preferred stock yield (Course CD: Equity Problem Preferred Stock Rate) problem. The Excel Workbook with the problems is also available. (Next Efficient Market Hypotheses) West Virginia University Copyright 2010 8/24/2015 4:34 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448706-dt-content-rid-6266... RandomWalk Can someone be expected to consistently beat the market? The efficient market hypothesis (EMH) addresses the question of the relationship between the market price of a security and its intrinsic price. There are three forms of the EMH: Weak form efficiency Semi-strong form efficiency Strong form efficiency The key word in the heading is "consistently." Weak form efficiency purports that you cannot consistently beat the market (earn abnormally high returns) by using past prices and volume of trade activity to beat the market. That information is already fully contained in the stock price. This implies that if you study the trends in the data for a particular stock, you will not uncover something that others haven't already found and traded upon. Don't expect to consistently be the first to uncover a trend in the data. AT&T Price and Volume of activity (D indicates Dividends) AT&T Semi-strong form efficiency goes even further. Not only is past price and volume of activity included in the current market price, but the current price also reflects all publicly available information. Therefore, an individual cannot consistently beat the market based upon publicly available information. Certainly, the first to read and act will sometimes win, but the key word is "consistently." Strong form efficiency contends that the current market price includes past price and volume of activity, publicly available information, and privately held information. The contention is that rational individuals possessing information will act (buy or sell securities) until the price reflects its intrinsic value. It would be irrational to leave something on the table. Implications of the EMH Investors 1 of 3 8/24/2015 4:35 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448706-dt-content-rid-6266... If the EMH is true, then investors cannot be expected to consistently do better than the market. As a result, investors should evaluate their personal tolerance for risk, invest in a diversified portfolio, and hold on to that portfolio. This is known as a buy-and-hold strategy. Managers If the EMH is true, then managers should not concern themselves with whether or not their common stock is overpriced or under-priced. Companies should fine the optimal capital structure and stay there. Managers concerns should rest with the operational decisions that affect the top half of the income statement and let the bottom half of the income statement be a reflection of a one-time capital budgeting decision. Go to the discussion tool and respond to Discussion 4: Various proposals have been offered for overhauling Social Security, including proposals to invest part of contributions in the U.S. stock market. In light of the bull and bear markets of the past several years, do you think this is a good idea? Complete the Module There is extra credit material in Aplia that you may use for practice before completing module assignments and quizzes. These extra credit opportunities are immediately graded and provide feedback that should enhance your performance on the assignments and quizzes. Graded material includes chapter 7 problem sets. You are now ready to attempt to answer the second workbook. Go to the Assignments tool and select Assignment 4. Complete each worksheet in the Excel workbook, save, and attach your completed work. Once you have completed this section, go to the Assessment tool and select Quiz 4. 2 of 3 8/24/2015 4:35 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448706-dt-content-rid-6266... West Virginia University Copyright 2010 3 of 3 8/24/2015 4:35 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448707-dt-content-rid-6266... Capital Structure and Value Does Capital Structure, the mix of debt and equity, matter to the value of the firm? The impact of capital structure on value depends upon the effect of debt on the WACC and FCF. V = value of the firm FCF = Free Cash Flow WACC = Weighted Average Cost of Capital rs and rd are costs of stock and debt ws and wd are percentages of the firm that are financed with stock and debt, respectively Strong form efficiency As more debt is added to the structure, more financial risk is taken. Financial risk refers to the additional business risk concentrated on common stockholders when financial leverage is used. The amount of financial risk depends on the amount of debt and preferred stock finance. The financial risk is risk beyond the business risk--the uncertainty in future EBIT, NOPAT, and associated returns. This risk depends on business factors such as competition, operating leverage, etc. West Virginia University Copyright 2010 1 of 1 8/24/2015 4:35 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448708-dt-content-rid-6266... Does Capital Structure Matter? Modigliani and Miller Theorems Does Capital Structure, the mix of debt and equity, matter to the value of the firm? Franco Modigliani and Merton Miller asked this basic question in a series of papers and associated results known as the M&M theorems. Modigliani and Miller I Consider a world in which there is no government (and hence no taxes), there are no information asymmetries, and there is no default on loans. Additionally, there are no transactions costs, no restrictions or costs for short sales, and individuals can borrow or lend at the same rate as corporations. M&M prove that if the total cash flow to investors of Firm U (Unlevered; i.e., no debt) and Firm L (Leveraged; e.e., some debt financing), then arbitrage is possible unless the total values of Firm U and Firm L are equal. Because free cash flow and values of Firms L and U are equal, their WACCS are equal. Thus, the value of the unlevered firm is equal to the value of the levered firm. In this world, capital structure does not matter. Modigliani and Miller II Next, consider a world in which government (and hence no taxes) is introduced, there are no information asymmetries, and there is no default on loans. Additionally, there are no transactions costs, no restrictions or costs for short sales, and individuals can borrow or lend at the same rate as corporations. With tax deductible interest payments, M&M II shows that more debt is better and the value of the levered firm exceeds the value of the unlevered firm at an increasing rate in debt. Modigliani and Miller III Next, consider a world in which there isn't perfect information about the 1 of 2 8/24/2015 4:35 PM Efficient Market Hypotheses https://ecampus.wvu.edu/bbcswebdav/pid-2448708-dt-content-rid-6266... future and default may occur. In this case, while more debt initially increases the value of the levered firm, eventually the threat of bankruptcy begins to offset the gain from the tax shield and the value of the unlevered firm falls. There is a maximum value. There is an optimal capital structure. Moreover, the maximum value for the firm is associated with the minimum WACC at that same capital structure. West Virginia University Copyright 2010 2 of 2 8/24/2015 4:35 PM Workbook IV Name Before beginning this problem you must enter the last four digits of your student ID# The following worksheets correspond to assignments for the individual units in this lesson. Once you have completed all of these worksheets, send the saved workbook to the instructor before the closing date for this lesson. SameOld, Inc. has been expanding a relatively constant annual rate and it recently paid a dividend noted below. However, investors expect SameOld to continue paying dividends, which are expected to grow at the historical rate given below. If the required return on the stock is rs, what is the value of the stock today (P0)? INPUT DATA P0 WORK AREA D0 $0.48 g 0.00% rS 14% WTF is expanding rapidly, and it currently needs to retain all of its earnings, hence it does not pay any dividends. However, investors expect WTF to begin paying dividends, with the first dividend D2 coming 2 years from today. The dividend should grow rapidly--at a rate of g 3,4 per year--during years 3 and 4. After year 4, the company should grow at a constant rate of g per year. If the required return on the stock is rs, what is the value of the stock today (P0)? P0 WORK AREA D2 $0.25 g3,4 25% rS INPUT DATA 14% g 3.50% You buy a share of The GLS Corporation stock for the market price, P 0. You expect it to pay dividends each year, including a dividend of D3 in Year 3, and each of the dividends has grown at the historical constant growth rate. You expect to sell it at a price P3 at the end of three years. Calculate the growth rate, the expected dividend yield, and the stock's expected total rate of return. D3 P0 P3 INPUT DATA $0.79 $18.00 $19.48 growth rate Dividend yield Total yield WORK AREA