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I hope you are all doing well. I will be in my office Wednesday from 2: 00 pm until 5: 00 pm. Please be sure to stop by the computer room in Rate Hall to check out the database we discussed last night in class. Go through the steps we reviewed last night and that part of your speech requirement should go much better. Last night we began the discussion of break points. We defined a break point and gave the formula for the break point.
We reviewed the one page break point handout and indicated many concepts associated with this concept. You should review this handout to make sure that you have learned all of these concepts and ideas. Be sure to understand the breakdown of the financing components and understand this the break point concept works because we assume that we keep a firm's capital structure constant. On the simple break point example I want you to really understand the meaning of the $ 250, 000 amount.
This is the total financing, debt plus equity, that $ 100, 000 in lower cost debt will support given a 40 % debt capital structure. What is depreciation generated cash flow? When will you have two break points of debt? Of equity?
When will you have no break points? What is the formula for the break point? On page 5 of the Supplemental Materials Package we started a comprehensive problem to illustrate the break point concept. The break point concept shows that as a firm demands more capital the cost of this capital rises. Since capital is acquired in lumps this gives rise to a 'step' function or spikes in the WACC.
The WACC schedule shows how the cost of capital rises relative to the amount of capital raised. We used market value weightings to calculate WACC because we want our capital cost to be reflective of current market conditions. Make sure you understand all of the components of the example problem at the bottom of page 5. On page 6 we calculated the break point for equity and the break point for debt. We also incorporated depreciation generated cash flow into the problem. On page 7 we calculated three WACC's.
The component cost of short-term debt jumped first followed bythe component cost of equity. Debt jumped first because the break point of debt was a lower dollar amount than the break point of equity. We had two break points and three WACC's. On page 8 we showed how to compare a project's Expected IRR to the estimate of a firm's WACC.
Projects are ranked in order of declining IRR so projects with higher IRR's are funded first. Would project D be acceptable if its IRR was 7 %? No. Accepting project D would mean not selecting projects with higher IRR's. Also, project D is not acceptable because we have used up all or our lower cost (6 %) capital. We will study this issue (time permitting) later.
On page 9 we worked problems 1 and 2 and asked that you work problems 3 and 4 for homework. The answers are on the page for you to verify. On page 10 we worked problems 1 and 2. You should work problems 3, 4, and 5 for homework. Finally, we worked a comprehensive WACC problem on page 11. Remember that you will not have the template to use on exam.
The problem incorporated flotation costs for debt and equity. We calculated and used the market value weightings. The capital asset pricing model was briefly introduced as an alternative way to calculate the cost of equity capital (Ks). You just need to learn the formula for the quiz and exam. Do note that the formula assumes that stock investments should have returns in excess of the risk free rate and that stocks with higher market risk (as measured by BETA) will have higher expected returns. Beta is a measure of a stock's systematic (market) risk.
The higher the beta the higher the market risk of the stock. We used three methods to estimate Ks and then we averaged these numbers. On page 12 of the Supplemental Materials Package we calculated Ke. I will just give you Ke (or the adjustment factor) on an exam. Next we calculated the after tax, after flotation cost tax effect, cost of debt on a semiannual basis. We used this number to calculate the component cost of debt.
Notice that the calculation of WACC we did not adjust (the component cost of debt) for taxes. We had adjusted for taxes in previous steps. We calculated WACC (1) using Ks and WACC (2) using Ke. The cost of debt did not jump because there was no statement in the problem indicating that we would exhaust all of our lower cost debt. The flotation costs for debt are all paid in cash when bonds are issued. Writing this cost off each year lowers our tax bill and lowers the cost of debt.
If you have any questions about the material please do come by the office tomorrow for help. Assignment: For next week read pages 521 to 524 and 536 to 538 in the textbook. Will begin to work problems on pages 147 to 162 in the Supplemental Materials Package. Read textbook pages 468 to 473. We will begin to work problems on pages 163 to 176 in the Supplemental Materials Package. Work the problems on pages 13 to 18 in the Supplemental Materials Package.
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